to a friend.
Catherine Gelb
Cover by John Yanson
Catherine Gelb is
editor of The CBR.
Beijing appears to realize that SOEs and PRC
capital markets must be able to function in an economy more exposed to
market forces--not least to meet some of the requirements of WTO membership.
By the end of the decade foreign investors had grown frustrated by the difficulties of making their PRC investments profitable. In particular, they had tired of China's opaque policymaking process, in which sudden policy changes are poorly explained, and of the many restrictions on their business activities, from outright prohibition of investment in certain industries to controls on foreign exchange conversion.
Deteriorating market conditions in the late 1990s compounded these difficulties. China's economy entered a severe slowdown, which deepened during the Asian crisis of 1997-98. Beijing had only just succeeded in taming runaway inflation, but the clampdown on credit that was part of this effort helped expose the structural weaknesses of the partially marketized economy. Unused capacity reached record highs, sought-after urban spenders started saving, and foreign investors worried that the government's reform and liberalization efforts were stalling.
China's signing of bilateral market-access agreements with the United States and the European Union on the terms of China's World Trade Organization (WTO) entry, in most foreign investors' eyes, came not a moment too soon. The terms of WTO membership require that China eliminate some of the most troublesome legal and regulatory barriers to trade and investment. Membership obligations will also serve as a source of external pressure on China's domestic reforms, especially of its state-owned enterprises (SOEs) and financial sector.
Rude awakening
Veteran foreign investors can testify that even prior to the mid-1990s, foreign companies encountered restrictive, bureaucratic, and opaque legal and regulatory procedures for setting up and operating in China. Veterans have also learned that China is a highly fragmented economy in which investment rules and procedures--and consumer markets--vary widely from city to city and province to province.
Some frustrations nonetheless surprised investors new to the market in the mid-1990s. Many encountered unforeseen weaknesses in infrastructure. They discovered that the distribution system, for instance, was fragmented and inefficient--and that foreign companies were forbidden to set up their own networks to solve this problem. Another surprise was how quickly major urban markets on the coast became saturated and extremely competitive.
Some companies, amidst the enthusiasm of the early 1990s, entered the market for the wrong reasons. They made basic business mistakes--such as failing to analyze the market for their product or failing to conduct sufficient due diligence, particularly on partners and locations--that came back to haunt them later.
The government's responses to the enormous inflows of foreign investment in many cases only added to investors' difficulties. Beijing's attempt to harness FDI for the country's development goals is one high-profile example. This policy was embodied in the 1995 Catalogue Guiding Foreign Investment in Industry, updated in 1998 and to be released again soon, which classifies industries according to whether foreign investment in them is "permitted," "encouraged," "restricted," or "prohibited." This catalogue barred foreign companies from forming wholly foreign-owned enterprises in industries it considered of national importance, such as automotive vehicles. It prohibited foreign investment entirely in areas, such as telecommunications services, that it considered sensitive from a national security perspective. Other government policies were intended to compel investors to transfer the most advanced technologies to Chinese firms.
Decisions Beijing made for other domestic reasons, such as the phasing out of tax breaks and loopholes to bolster its own finances, threatened to cut into foreign-invested enterprise (FIE) revenues significantly. In late 1995, for instance, China announced with little warning plans to phase out a tax exemption on imports of capital equipment. This exemption was popular with FIEs but was costing the government tax revenue. Indeed, some foreign companies estimated that their costs would rise by as much as 20 percent if the duty exemption were to be ended. After vigorous objections by foreign investors, and several delays, the government decided to reinstate the exemption in 1997. But companies that still benefit from this exemption must meet stringent requirements, including scrupulous tracking of each piece of equipment covered by the exemption.
In other cases, China allowed foreign investors to undertake ventures that danced on the edge of legality. The government would review these experiments and either amend PRC law to make them wholly legal or crack down as called for under existing rules. The lack of transparency in China's policymaking process meant that these changes could come swiftly. Many foreign investors had not factored the risks of these experimental ventures into their investment equations.
Some policies, often undertaken for understandable reasons, had unintended effects on legitimate foreign operations. For example, China tightened controls on foreign exchange flows in 1998, a move aimed largely at preventing Chinese companies from sending foreign currency abroad illegally. After relaxing controls in 1994 and liberalizing its current account in 1996, excessive smuggling and foreign currency leakage prompted the central government to pay closer attention to foreign exchange conversions. Though foreign investors were not direct targets of this move, they were drawn into the net. Many saw their shipments languish at Customs for weeks as their trading companies awaited approval to convert currency. Also in 1998, China cracked down on illegal direct-selling operations that were responsible for bilking unsuspecting Chinese of their savings, but the new rules threatened to close down legitimate operations as well.
The turnaround
FDI flows have turned a corner this year, a reflection of the cautious optimism that has emerged in the foreign business community in China. Signings of new contracts in the first half of this year rose almost 25 percent over the first half of 1999, totaling $24.17 billion. This renewed interest in China projects is due in some measure to the completion of China's WTO agreements with the United States and European Union. The far-reaching terms to which China agreed reassured investors about the commitment of China's leaders to further market openings (see WTO: A Done Deal?, and The CBR, January-February 2000)
The resurgence of investment may also be due in part to the government's recent moves to lure foreign investors back. The country needs as much foreign investment as it can get as it embarks on massive economic reforms--FIEs are some of the fastest-growing actors in the economy, and key generators of jobs. Examples of this new awareness include Beijing's issuance of new rules allowing foreign investment in retail ventures in western China, and its solicitation of input from foreign investors with PRC holding companies on ways to improve the attractiveness of that vehicle.
Certainly the new investment activity reflects the economic recovery in Asia, which, on the eve of the crisis, accounted for 40 percent of China's FDI inflows. But more important than Asia's recovery has been Beijing's aggressive economic stimulus plan, which appears to have helped revive economic growth. Second- and third-quarter GDP growth rates both exceeded 8 percent, ensuring that 2000 GDP growth will top last year's 7.1 percent rate. And the Consumer Price Index has, after more than two years of deflation, turned (just barely) positive this year.
But China is not out of the economic woods yet. Consumers' uncertainty over their economic future appears to be tempering the recovery--demand is still not rebounding as strongly as Beijing would like, and the gap between urban and rural incomes is as wide as ever. Consumers' uncertainty may well be warranted. The government appears to be taking more aggressive steps to push ahead with the deepest reforms yet, despite the inevitable, and unpredictable, economic and social disruptions this will cause over the next few years.
Still China
Seasoned foreign investors will be the first to point out that, WTO notwithstanding, the official and unofficial rules of running a successful business in China will not change easily or quickly--if they change at all. For this reason, newcomers and veterans alike will need to understand the current rules, regulations, procedures, and less formal aspects of running an operation in China. They must also identify which WTO-induced changes will affect these rules and practices. Among the most important issues facing foreign investors are
- The legal limits of the foreign investment regime, specifically
the investment structures
China's updates of its foreign investment laws and regulations to meet WTO commitments are unlikely to affect major features of the country's foreign investment structures. New investors and veterans expanding their operations will find themselves choosing from virtually the same options as investors a decade ago: the representative office, the joint venture, or the wholly foreign-owned enterprise. In recent years more vehicles have emerged, such as the holding company and the foreign-invested share company. But the basic structures are likely here to stay (see Investor's Growing Pains). - China's implementation of WTO commitments
China must adapt its laws and regulations to accommodate its WTO obligations. This process is at the top of foreign investors' lists of concerns about their future prospects in the PRC. Revisions of existing laws will change the rules in ventures they currently run. The government will also have to enact--and enforce--new laws to guide the market-opening measures that China must phase in during the first decade of its membership. The PRC government has only just begun its own assessment of what is involved in this process, and PRC and foreign companies are doing what they can to prepare as well (see WTO: A Done Deal?). - Intellectual property rights (IPR) protection
Foreign investors are more concerned than ever about protection and enforcement of IPR, part of a larger problem of enforcement of China's growing body of laws and regulations. Past bilateral agreements with the United States helped China develop an international-standard set of laws and administrative rules on IPR. But poor enforcement of these rules, and some spectacular loopholes, have undermined their effectiveness. One major reason foreign investors are feeling good about China's impending WTO entry is that adherence to WTO obligations will require China to enforce its IPR protections more effectively (see IPR Protection and Enforcement: A Guide). - Human resources
The difficulties of hiring, and keeping, valuable employees have plagued FIEs for years. But foreign companies have realized that devoting resources to the development and maintenance of a stable workforce is crucial to their PRC operations' success (see Human Resources Take Center Stage). - Relations with the PRC government
Similarly, companies are recognizing that public relations campaigns to develop and maintain their images and brands are not enough, on their own, to cement their position in the China market. Corporations now know that just as they must engage with US policymakers back home, they must also focus on developing relationships with key policymakers in China's government, at both the central and local levels (see A New Relationship Network).
Underlying it all, the economy
Investors recognize that WTO membership is no cure-all. Indeed, they have shown their willingness, for now, to bear with the PRC economy as it moves into a period of significant restructuring. This restructuring will reach down to the roots of the country's system of resource allocation--the basic function of any economy. Beijing appears to realize that SOEs and PRC capital markets must be able to function in an economy more exposed to market forces--not least to meet some of the requirements of WTO membership.
The government is finally tackling the task of transforming its largest SOEs into profitable companies, and is stepping up efforts to restructure the burdened financial sector. One of the biggest tasks the government must undertake on its own is the reform of the social welfare system, to accommodate the rising numbers of unemployed and older Chinese.
The central government faces opposition from protectionist forces throughout the economy and government, who want to slow down preparations for the inevitable openings. The government also is facing pervasive corruption that is proving difficult to clean up. Whether Beijing can overcome these forces will determine whether its economic reforms succeed.
Dot the i's and cross the t's
Five years ago The CBR published a special issue on the basics of investing in China. The articles addressed how to select a project, an investment vehicle, and a partner, and offered advice on contract negotiations, navigating the approval process, and making an investment in China work. This issue of The CBR takes that discussion a step further, updating some of the central topics of that issue but also touching on some of the most pressing questions investors have about the PRC investment environment today. Current investors are not the only ones to benefit from these discussions; newcomers will also need to understand these issues if they are to make informed investment decisions.
Foreign Direct Investment in China
| Utilized FDI in China by Type of Enterprise, 1999 ($ billion) | ||||
|---|---|---|---|---|
| Type of Enterprise | 1979-96 | 1997 | 1998 | 1999 |
| Equity Joint Ventures | 90.72 | 19.50 | 18.35 | 15.83 |
| Cooperative Enterprises | 38.03 | 8.93 | 9.72 | 8.23 |
| Wholly Foreign-Owned Enterprises | 42.55 | 16.19 | 16.47 | 15.55 |
| Joint Shareholding Companies | 0 | 0.29 | 0.71 | 0.29 |
| Cooperative Development* | 5.28 | 0.36 | 0.18 | 0.38 |
| Others | -- | -- | 0.04 | 0.04 |
| Total | 176.58 | 45.26 | 45.46 | 40.32 |
| Totals may not add up because of rounding. | ||||
| *Includes Hong Kong, Taiwan, Macao companies | ||||
| Top Ten Foreign Investors in China by Source Country or Region, 1999 | |||
|---|---|---|---|
| Country/Region | Number of Projects | Amount Contracted ($ billion) |
Amount Utilized ($ billion) |
| Hong Kong | 5,902 | 13.33 | 16.36 |
| United States | 2,028 | 6.02 | 4.22 |
| Japan | 1,167 | 2.59 | 2.97 |
| The Virgin Islands | 495 | 3.49 | 2.66 |
| Singapore | 503 | 2.26 | 2.64 |
| Taiwan | 2,499 | 3.37 | 2.60 |
| Germany | 196 | 0.94 | 1.37 |
| South Korea | 1,547 | 1.48 | 1.27 |
| United Kingdom | 230 | 1.09 | 1.04 |
| France | 110 | 0.47 | 0.88 |
| FDI in China by Destination, 1999 | |||
|---|---|---|---|
| Province, Municipality, or Autonomous Region | Number of Projects | Amount
Contracted ($ million) |
Amount
Utilized ($ million) |
| Anhui | 199 | 558.68 | 261.31 |
| Beijing | 645 | 1,786.72 | 1,975.25 |
| Chongqing | 169 | 506.88 | 238.93 |
| Fujian | 1,439 | 4,869.96 | 4,024.03 |
| Gansu | 67 | 82.36 | 41.04 |
| Guangdong | 3,013 | 5,474.51 | 11,657.50 |
| Guangxi | 223 | 673.63 | 635.12 |
| Guizhou | 43 | 66.85 | 40.90 |
| Hainan | 158 | 791.76 | 484.49 |
| Hebei | 520 | 889.46 | 1,042.02 |
| Heilongjiang | 313 | 395.24 | 318.28 |
| Henan | 261 | 646.64 | 521.35 |
| Hubei | 260 | 821.78 | 914.88 |
| Hunan | 320 | 501.98 | 653.74 |
| Inner Mongolia | 68 | 17.74 | 64.56 |
| Jiangsu | 1,926 | 6,470.72 | 6,077.56 |
| Jiangxi | 245 | 331.36 | 320.80 |
| Jilin | 355 | 450.49 | 301.20 |
| Liaoning | 1,147 | 3,296.87 | 1,061.73 |
| Ningxia | 29 | 62.28 | 51.34 |
| Qinghai | 15 | 14.21 | 4.59 |
| Shaanxi | 157 | 426.93 | 241.97 |
| Shandong | 1,717 | 3,110.87 | 2,258.78 |
| Shanghai | 1,472 | 4,103.70 | 2,836.65 |
| Shanxi | 79 | 234.44 | 391.29 |
| Sichuan | 195 | 492.88 | 341.01 |
| Tianjin | 575 | 1,590.54 | 1,763.99 |
| Xinjiang | 52 | 61.51 | 24.04 |
| Yunnan | 138 | 325.94 | 153.85 |
| Zhejiang | 1,113 | 1,947.93 | 1,232.62 |
| Other* | 5 | 58.50 | 383.89 |
| Total | 16,918 | 41,223.02 | 40,318.71 |
| NOTE: Totals may not add up because of rounding. | |||
| *Investment received by PRC government organs. | |||
| FDI in China by Sector, 1999 | ||||
|---|---|---|---|---|
| Sector | Number of Projects | Amount
Contracted ($ million) |
Amount
Utilized ($ million) |
|
| Farming, Forestry, Livestock Farming, Fishing | 762 | 1,471.70 | 710.15 | |
| Mining | 130 | 322.21 | 557.14 | |
| Manufacturing | 12,042 | 25,331.80 | 22,603.34 | |
| Textiles | 535 | 1,198.52 | 1,370.89 | |
| Chemicals | 867 | 1,758.74 | 1,919.28 | |
| Pharmaceuticals | 198 | 692.62 | 684.41 | |
| Ordinary Machinery | 485 | 904.47 | 976.69 | |
| Special Equipment | 500 | 743.33 | 509.95 | |
| Electronic
and Telecommunications Equipment |
922 | 3,942.71 | 3,145.72 | |
| Power, Gas, and Water Production and Supply | 116 | 1,635.19 | 3,702.74 | |
| Construction | 247 | 1,096.19 | 916.58 | |
| Geological Prospecting and Water Conservancy | 10 | 53.97 | 4.52 | |
| Transportation, Storage, and Post and Telecommunications Services | 205 | 1,114.01 | 1,551.14 | |
| Wholesale, Retail, and Food-relatedServices | 825 | 1,204.13 | 965.13 | |
| Finance and Insurance | 3 | 37.08 | 97.67 | |
| Real Estate | 669 | 4,177.85 | 5,588.31 | |
| Social Services (including Hotels) | 1,474 | 3,016.80 | 2,550.66 | |
| Healthcare, Sports, and Social Welfare | 28 | 67.27 | 147.69 | |
| Education, Culture, and the Arts | 29 | 60.72 | 60.72 | |
| Scientific Research Services | 62 | 133.72 | 110.13 | |
| Others | 316 | 1,488.52 | 752.68 | |
| Total | 16,918 | 41,223.02 | 40,318.71 | |
| NOTE: Totals may not add up because of rounding. | ||||
| Sources: PRC National Bureau of Statistics, China Monthly Statistics, China Statistical Yearbook, 2000; Ministry of Foreign Trade and Economic Cooperation | ||||
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