Kenneth Davies
hina has been highly successful in attracting and absorbing large quantities of foreign direct investment (FDI) as a result of policies developed over the past quarter of a century. There is scope for both quantitative and qualitative improvement of China's FDI inflows, however.
Policy options intended to increase China's attractiveness as a destination for long-term, high-technology, high-value-added investments from Organization for Economic Cooperation and Development (OECD) countries are outlined in China: Progress and Reform Challenges, the latest in the OECD's Investment Policy Review series. This report was produced after consultation with numerous governmental and business organizations (including The US-China Business Council) at the request of the Chinese government and constitutes an input into the policymaking process in China. The report's findings provide a useful overview of the role FDI plays in China's economy.
A mixed review
In 2002, China became the world's largest recipient of FDI. Yet in per capita terms, China receives less FDI than many other developing countries and far less than developed countries such as those in the OECD. Hong Kong and the overseas-Chinese diaspora account for a disproportionately large share of China's FDI inflows, while the OECD countries are generally under-represented compared with both their share of global FDI and their share of China's international trade. Although foreign investors have started to bring relatively advanced technology into China, FDI in China is still heavily weighted towards labor-intensive manufacturing. Attempts to spread the benefits of FDI from the coastal region into China's poorer hinterland have yet to bear fruit.
There is no doubt that FDI has brought benefits to China. It has created millions of jobs not only in foreign-invested enterprises (FIEs) themselves but also in domestic concerns that supply FIEs with inputs and distribute their products. FIEs have brought new products to Chinese consumers as well as new production processes that have spread to domestic enterprises. Competition from FIEs was initially feared by domestic enterprises, but the latter have, on balance, gained more than they have lost from such competition: It is precisely in those sectors that were first opened to foreign investment that domestic companies have improved and expanded and are now holding their own in the global marketplace. FIEs are responsible for the rapid growth of China's merchandise trade in the past two decades. They now account for half of all exports and imports and have moved from deficit to surplus in such trade.
China has amassed a copious quantity of laws and regulations governing FDI since the open-door policy was initiated in 1978. Such legislation has provided a basis for foreign investment, but it has also added unnecessary complexity. For instance, each type of FIE in China has its own law, resulting in an element of inflexibility—notably in the field of mergers and acquisitions (M&A) involving different types of FIEs—which could be removed by making FIEs instead subject to an overall company law.
The regulatory environment for FDI has improved as a result of China's accession to the World Trade Organization (WTO) in 2001. Trade-related measures in China's FDI laws such as requirements for export performance, foreign-exchange balancing, foreign trade balancing, and local content requirements have been abolished. Service sectors previously closed to foreign investment are being gradually opened over a five-year period. FIEs are able to trade abroad and distribute their products more freely within China.
Room for improvement
China maintains numerous restrictions on FDI, however. Proposed FDI projects are classified into four categories according to the Catalogue Guiding Foreign Investment in Industry: prohibited, restricted, permitted, and encouraged. The prohibited category understandably contains items that are off-limits in most countries on grounds of national security. It also includes sectors—for example, production of bodiless lacquerware or enamel products—in which the presumed intention of protecting traditional techniques could be better fulfilled by means other than obstructing financial inflows. Subjecting proposed FDI projects to the stringent and time-consuming approval process used for projects in restricted areas is difficult to justify. It would be far simpler to abolish the catalogues and publish instead a short list of prohibitions on clearly explained grounds, such as those of national security.
Applying for project approval has become easier in recent years, especially in areas like Shanghai where the authorities have greater experience of foreign investment. Foreign investors still complain that the process is too cumbersome and involves the submission of forms to an excessively large number of official bodies. The application and approval process could be streamlined and made more transparent. It would be easier if an investor could obtain automatic approval within a set period, for example two weeks, after ascertaining and fulfilling all approval criteria, unless the authorities could show due cause for not allowing it. For this to happen, all internal (neibu) regulations operated by local authorities would have to be published and, if not in conformity with national regulations, abolished.
China is committed to improving the transparency of government policy and regulation as a result of its WTO accession. China can achieve greater transparency by ensuring regular publication and updates of policy decisions, laws, and regulations relating to FDI in both Chinese and English. The Chinese government is increasingly using the Internet for this purpose and is working with the OECD to perfect a single site that will eventually contain most of the information needed by a potential foreign investor.
The rule of law
Another essential component of an enabling environment for foreign investment (and for domestic investment) is the rule of law. The legal system has made great strides since it was reestablished under Deng Xiaoping in the 1980s, but China's courts still lack qualified lawyers and judges and are not yet independent of political influence. The Chinese authorities are to be commended for their efforts to train more lawyers and encouraged to strengthen the robustness of the courts in the face of pressure from local officials to issue biased judgments.
One area in which domestic as well as foreign investors will benefit from stronger implementation of existing laws is in the field of the protection of intellectual property rights (IPR). A start has been made in the establishment of specialized tribunals to try cases involving trademarks, copyright, and patents, but flagrant violations of the law in this area persist. Stronger IPR protection can foster greater creativity and encourage more foreign investors to bring high technology to China.
Untapped potential
The vast majority of FDI flows among OECD member countries (which account for more than 90 percent of global FDI flows) are now in the form of cross-border M&A. By contrast, cross-border M&A accounts for a negligible proportion of China's FDI inflows, which come mainly in the form of joint-venture partnerships or greenfield investments. Yet M&A offers a tremendous potential for foreign investors to participate in the restructuring of China's state-owned enterprises, many of which are inefficient and could benefit from new management techniques at least as much as from imported, new technology. One reason for the lack of M&A activity is the uncertain legal status of cross-border M&A in China (see A Roadmap for China's Mergers and Acquistions). A consistent, coherent, and transparent competitive environment would encourage foreign investors to play a fuller role in state-owned enterprise restructuring.
China's capital markets are largely closed to direct foreign involvement. Foreigners have not, in the past, officially been able to purchase A shares, which constitute the majority of shares on the Shanghai and Shenzhen stock markets. FIEs are not permitted to issue bonds in China; only a handful of FIEs are likely to be allowed to issue shares. Allowing foreign investors to participate in China's capital markets on the same basis as domestic investors would help create depth and liquidity in those markets; it would also allow foreign investors greater flexibility in financing their operations in China and engaging in M&A.
Policy options that will enhance the enabling environment for foreign investors will also be good for domestic investors. A rules-based system can create the transparency and predictability that all businesses need if they are to make large-scale, long-term investments. And China's experience over the past two decades demonstrates that opening sectors to FDI is a surer way of strengthening domestic Chinese companies than protectionism.
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