China, which traditionally has been described as a slumbering dragon, is one of the most

popular investment destinations in the world, attracting Foreign Direct Investments (FDI)

at a most astonishing rate. This inevitably has created a myriad of questions regarding

this phenomenon, to which this paper attempts to answer, with regards to how China

actively liberalized FDI ,the characteristics of FDI in China, the challenges of investing

in China, which will be amply illustrated through case studies, the impact of this large

inflow of FDI, and lastly, how we think China can do to rectify some of its existing

problems with regards to FDI.

Liberalization and Characteristics of FDI in China

Since late 1978, China has carried out massive economic reforms in an effort to

restructure their economy to be more market-oriented, with FDI being one of the pillars

of this reform. The government has gradually liberalized its restrictions on FDI in order

to reap to reap the benefits of foreign investments, such as technology transfer, modern

management skills, and foreign exchange. The results of these reforms have been

extraordinary, with thousands of multinational companies (MNCs) having invested in

China, brining with them billion of dollars in FDI (Appendix A). By the 1990s, China has

become the second largest FDI recipient in the world.

China revised their laws and regulations in order to allow FDI and to entice MNCs to

invest. China’s first move to open up its economy to FDI was taken with the

implementation of the Sino-Foreign Equity Joint Venture Law. This allowed the legal

entry of FDIs into China and provided a statutory basis for the establishment of joint
ventures with China. Foreign companies seeking investments in China will have to set up

a “joint venture” with a local Chinese partner, in which the profit and risk sharing of

equity joint ventures is proportionate to the equity of each partner. An equity joint venture

is usually structured as a limited liability company with the foreign partner contributing a

minimum of 25% of the registered capital, subjected to the approval of the Chinese

Ministry of Commerce. Investments were only allowed in designated Special Economic

Zones (SEZs). These SEZs were located in Guangdong Province, Fujian Province,

Hainan Province, Hunchun and the Pudong Development Zone (Shanghai). The benefits

of investing in a SEZ come mainly by tax incentives. A typical example of the tax

concessions offered to a manufacturing startup typically looks like:

• No tax during start-up years before making a profit

• The first year that your company makes a profit starts the "Tax Clock" and is year

one

• The first and second year after the tax clock starts, there is no tax.

• For years three and four, there is 1/2 of the normal tax rate.

• In the fifth year, the company pays the full normal tax rate.

Hong Kong and Taiwan remain are the two main sources of FDI to China (Appendix B).

However, the importance of these 2 economies diminished somewhat in the 1990s as

MNCs from Europe, Japan and the United States entered China. However, these 2

economies still account for almost half of FDI in China. In terms of sectoral distribution

of FDI, manufacturing makes up the largest portion (Appendix C), contributing up to

60% of FDI, followed by real estate with 24 %. Within the manufacturing sector, almost
half of it is directed towards labor-intensive manufacturing, suggesting foreign

companies’ motivation to tap into China’s low labor costs.

Challenges of FDI in China

Foreign firms who are weighing a decision to invest in China, as well as those who

already have engaged in FDI, face a number of potential problems. The challenges listed

in this paper are by no means exhaustive. The complex bureaucratic structure of China’s

government brings about certain problems. A potential problem is misreporting, which

makes it difficult for companies to assess rates of returns due to the questionable nature

of China’s official macroeconomic data. Because of China’s large population, coupled

with the complex governmental structure from village level all the way to the national

level, collating data is highly inefficient and inaccurate. Moreover, local authorities tend

to exaggerate their achievements and conceal their losses in a bid to impress their

superiors. The many layers of government also gives birth to a lot of red tape, among

which is a rather complicated application process for new investments, which hinders

prospective investors. Also, China, being a large country with a population of 1.3 billion

people, has a very diverse culture. Commonly, people often cite Chinese as emphasizing

on guanxi, or interpersonal connections, as a way to do business. However, the truth is

that there are many different interpretations to that among all the different provinces, due

to differences in lifestyle, upbringing and circumstance. Investors must take note of these

differences in demographics as they can have a profound influence on businesses. There

is also a lack of infrastructure and industrial tradition in some areas, which, inevitably,

leads to problems in the daily running of the business, such as, lack of utilities (water,
electricity). These disruptions in basic amenities can be costly as the productivity lost can

be significant. Corruption, for example bribery, is also an obstacle that potential investors

have to grapple with. China was ranked 59 out of 150 countries in the World Democracy

Audit for 2003. A high perception of widespread corruption will scare away potential

investors, and hinder businesses already in operation there. The cases below further

illustrate, and add on, to the challenges as discussed.

Case Study 1: Chinese Car Makers Set Sights Overseas

For many years, China has been the main breeding grounds for many models of

automobiles. These companies formed lucrative partnerships with foreign companies who

set up plants in China and tapped on the cheap labor resources there.

However, after serving as apprentice to foreign automobile makers for the past decade or

so, some big state-owned Chinese car companies are trying to expand their diminutive

stature overseas and building their own brands.

The years of service to the big names in automobile business have taught the Chinese

invaluable experience and path a more smooth-sailing way forward for them. From

technology behind the assembly plants to management of the different sectors, Chinese

companies have learnt their lesson well and are now venturing into their own hands-on

session.

The sole aim of the companies is to build their brands overseas and help China claim

more than a few familiar brands to foreigners. After all, being a country that has enjoyed

two decades of near-double-digit growth, China’s policy makers are eager to take the step

in this highly competitive world and source for their own share in the market.
One company, Shanghai Automobile Industry Corp, has made bold plans to make 50,000

of its own brand of vehicles and clench a seat in the world’s top 10 auto makers by 2010.

This may not be a dream come true for the company as they have been gained deep

pockets by selling the brands of VW and GM. A spokesperson from SAIC also mentioned

the likelihood of acquiring Ssangyang Motor which has the licensed car technology from

Mercedes. All such actions points directly to the company’s goals to build up its own

brand name and beef up its expertise.

Unfortunately, such series of actions could alarmingly disturb the intricate balance of

relationships built up between Chinese auto companies and their foreign counterparts.

The course of actions could upset the lucrative partnerships and ending several years of

marriage in divorce. In actual sense, foreign companies are breeding their own

competitors in this automobile chase. Needless to say, if the Chinese automobile makers

inched their way into the global market, we would expect much fiercer competition

between the once friends.

Case study 2: Sponsors Set Stage for 2008

VISA has been one of the world’s preferred credit card companies when traveling and not

wanting to carry large amounts of cash. This Athens 2004, officials from the Bank of

China were invited to take a tour of the historic city and witness for themselves, not the

beauty of the architecture and landscaping, but rather the convenience and popularity of

VISA cards when purchasing items. This is an act to try to encourage Chinese banks to

get local restaurants and stores wired to their cards. China has 3 million VISA cards that

are allowed to be used abroad and VISA is hoping that the number would increase to 50
million by 2008. However, with only about 10% of merchants utilizing this mode of

payment now, VISA has a long great wall to climb to its target.

Case Study 3: China’s Retailers Feel the Heat

This year, China’s surging power shortage problem in summer has forced restaurants,

shops and even hotels to survive the long and dreadful sauna-like temperatures without

24 hour air cons and even blackouts during peak periods. Many restaurants have to turn

away the lunch-time crowd as they lack the electricity to produce food catered for the

needs of the consumers. Even factories have to delay productions or change to production

at night to cut down costs.

The same luxury is not applicable to retail businesses that cannot shift their businesses to

opening at night. Many customers have to turn away from shops that have been

suspended electricity due to high consumption. Sometimes, customers are not even able

to try on clothes as it is just too hot.

Case study 3: China is Far From Being A Free-Market Economy

China’s economy is controlled by the ruling party who in turn allocates about half of the

fixed-asset investment. Generally, the Chinese business cycle tracks the country’s

political cycle closely. The Communist party convenes its national congress every five

years and each congress determines leadership changes at both at the top and at the

provincial level. The parties derive legitimacy from economic performance and

demonstrate their ability by securing jobs and promoting growth. However, data has

shown that the growth rate in the year when a party congress is convened is significantly

higher than in the preceding year. In 1992, the growth rate was 14.2%-5% higher than the

9.2% registered in 1991.

Political leaders have the power to dramatically increase fixed-asset investments as they

have the access to bank credit and other forms of capital. Although the state owns 4

dominant commercial banks, it is the provincial leaders who dictate their lending

positions. Thus, the provincial leaders have the final say in the pet projects and even the

future of the managers in the provincial branches. Few people would dare deny credit to

these local strongmen for fear of facing a sack.

The typical solution adopted by the Central government is to tighten the reins on these

leaders first without serious warnings. If things continue its spread this way, a few pin

pricks like canceling a project would server as a warning to the leaders. Only when such

tinkering efforts fail does Beijing announce a full procedure to punish the leaders like

stripping them of their titles or even freezing strict limits on investments. These measures

only goes to show that China still has a long way to go before genuinely becoming a free

market as it has to resort to administrative measures and not market forces to slow down

its economy.

Case study 4: China’s Princelings

As suggested by the title, although China has moved forward and tried to clear away the

worry of corruption and path a brighter way for investors, when it comes to high-level

connections, little has changed since the 1980s. Conventionally, one would expect China

not to follow in the type of cronyism similar to Suharto’s footsteps with the opening up of

the market and the more robust roles the media have taken upon. However, a closer look

at the Chinese economy would surprise many people at how much the tie of crony has

jumped by leaps and bounds together with the economy.

Taking Jiang Mianheng, the vice president of the Chinese Academy of Sciences, for

instance, besides from getting a university degree from the America like a lot of other

aspiring Chinese youths, Jiang has something else which none can compare-his father is

Jiang Zemin, the former president and Communist Party chief who still heads the

country’s Central Military Commision.

Due to this very delicate relationship, the projects that he has been involved in have been

enjoying a record of good relations with the authorities. This family tie has made him one

of the most popular people to work with among foreign investors. Citigroup formed an

insurance venture in June with one of Mr. Jiang’s IT companies-the Shanghai Alliance

Investment; Finnish mobile technology firm Nokia sold a 30% stake in its telecoms

factory in Suzhou to Mr. Jiang’s Alliance. IBM has sent a delegation of senior executives

to meet Mr. Jiang in Beijing in February and even Intel has teamed up with Mr. Jiang’s

CAS research arm.

Although these giant names have not commented on the family ties that Mr. Jiang has, it

is quite likely that ‘brands’ are being recognized here and favored when choosing an

investment partner in China. Other examples include the current Party Chief and State

President Hu Jintao’s son Hu Haifeng heading the Qinghua University’s Nutech, an x-ray

technology company that has been granted major deals for China’s customs checks and

immigration security. His daughter Hu Haiqing married Daniel Mao last year who is the

founder and director of China’s biggest Internet portal Sina.com, which faces an

increasingly competitive and regulated Internet and mobile services industry in China.

Premier Wen Jiabao’s son Winston Wen Yunsong is a founder of mainland IT services
company Unihub, which has a joint venture in China with Hong Kong telecoms giant

PCCW.

Impacts

The influx of FDI due to the market reforms has bought about a plethora of changes into

the Chinese society, many of which is good, and some of which is bad. Here we shall

examine some of these impacts that FDI has brought about.

China has grown very rapidly since the late 1970s (when market reforms were carried out

to allow and attract FDI) and statistics proves it. The average annual GDP growth from

1998 to 2002 is 9.5%, while per capita GDP rose from $300 in 1980 to $1000 in 2002.

FDI has contributed to GDP in various ways. FDI contributes to GDP by adding to capital

formation. This effect is estimated to have contributed as much as 0.4% to average annual

GDP growth in the 1990s. The direct contribution of FDI to GDP is the highest in

provinces such as Guangdong (which is a SEZ) as they attracted the most FDI. FDI has

also contributed to GDP through its positive effect on Total Factor Productivity (TFP).

TFP is the measurement of how well an organization utilizes all of its resources, such as

capital, labor, materials, or energy, to produce its outputs. Empirical research has

suggested that FDI has raised TFP growth by 2.5% annually in the 1990s. FDI has also

created employment opportunities, either directly or indirectly, through the establishment

of Foreign Funded Enterprises (FFEs). Employment in the FFEs in the urban areas

quadrupled between 1991 and 1999 to a total of 6 million, accounting for 3% of urban

employment. In the coastal provinces of Guangdong and Shanghai, FFEs account for a
much as 10% of urban employment. This spurt in growth in GDP has bought about a

reduction in poverty in China. An estimated 200-400 million people were lifted out of

poverty from 1980 to 2002, and according to the World Bank, much of the reduction in

global poverty during the last 2 decades was accounted for by China. Thus we see

improvements in the standard of living of the Chinese as a whole.

However, due to fact that FDI has been concentrated on the coastal regions and this hs

created a widening disparity in income. This enlarging income disparity is significant

because it can retard efforts to reduce poverty, and also inhibit economic growth. Also,

large income disparity leads to social problems such as a higher incidence of crime and

political instability.

Analysis

As discussed above, there are some teething problems which have resulted from the

influx of FDI in China, and we shall attempt to provide solutions to these problems.

Income Disparity

The income disparity between the coastal and inland regions is an urgent problem which

has to be dealt with. As the disparity is largely due to the attractiveness of the SEZs in

attracting FDI than the inland regions, we propose that China open up those other areas

too, by providing support for infrastructure and amending the law to allow for FDI to

operate in those regions. Basic infrastructure as such the transport and communication

system should be developed such that businesses can operate there with efficiency.
Empirical studies confirm that provinces in china with more superior infrastructure and transport

links to external markets tend to receive more FDI. Similarly, China can provide tax incentives

for investments in the inland regions too, as this is mostly the main appeal for

investments in the SEZs.

Over-reliance on FDI

As above, manufacturing makes up the bulk of China’s FDI, and this underscores China’s

heavy reliance on this sector. Thus, if this sector is to undergo a recession, China’s

economy could be adversely affected. Thus, China should not rely heavily upon the

manufacturing sector for its prosperity forever. It should diversify its efforts to other

sectors such as R&D and agriculture. China’s competitive advantage is its abundant

supply of natural resources. China is one of the world’s biggest fishery and farming

countries, with its aquatic products accounting for 70% of the world ones. The

agricultural sector deals with providing staple foods for people and thus is able to

command a high profit if it were to export extensively overseas. However, its agricultural

export in the year 2002 was merely . If China were able to step up its production

capacity, it would have been able to earn a lucrative profit from the recent Bird Flu crisis.

Thus, China should make full of this competitive advantage and design methods to

further improve on the agricultural sector. Our group foresees the great potential in

expanding the product export with its first place position in China's agricultural product

exports presently. It might even become the world’s leader in agricultural supply in the

future.
So what is hindering China from speeding up its export volume? We believe that the lack

of advanced technology may be one of the reasons. Instead of its productivity increasing,

it has been showing a downward trend in recent years. Such trend might be owed to the

decreasing number of labor working in this industry. Internal migration of labors from

rural to urban regions has been accelerating ever since the accession to WTO. Thus,

China is now attempting to substitute advanced technology for labor to boost productivity

in this sector. The main tasks are to have a great increase in high-quality breeding and its

product processing, to have an effective control in aquatic and animal diseases and to

have a remarkable increase in the export proportion of agricultural products by attaching

the importance to the three key sectors including product quality and safety, breeding and

fine processing. According to the commitments after China's accession to the WTO, the

average tariff level of China's agricultural products will also be reduced from the present

19.9% to 15.5% in 2005.

China’s over-reliance in FDI might affect the economy negatively if the investors decide

to pull their investments out of the market overnight. Singapore is a good example of this.

Neighboring countries such as India which shares with China many of the structural

factors that have been important determinants of FDI- market size, abundant labor, and a

large Indian Diaspora might become an attractive destination for FDI in the next 10 years

if the Indian government decides to impose a vision for the path of development and

growth of the country. To avoid such crisis from realizing in the future, our group feels

that China could encourage existing high performing Chinese companies to switch their

focus overseas. A recent case would be the Shanghai Automotive Industry Corp., the

invisible spouse for two of the world’s biggest car makers, Volkswagen AG and General
Motors Corp. It has moved its global expansion into high gear. It has entered talks to

partner with Britain’s MG Rover Group Ltd., the sports-car maker. This month, it

announced aims to acquire Ssangyong Motor Co., South Korea’s fourth-biggest car

maker, potentially making it the first Chinese auto maker to take over a foreign

counterpart.

In addition, China could also encourage entrepreneurship among the Chinese citizens.

With the market dominated by mainly the Chinese enterprises, it would not have much

effect on the economy if the FDI moves to other countries.

Presently, many countries such as the United States of America and Japan are

outsourcing their production to China. This creates a great opportunity for the Chinese to

expose to the foreign management styles as well as the standard of quality set by the

foreign companies. Thus, by integrating the valuable knowledge acquired from the

foreign companies into their own expertise, it might create a competitive advantage for

them.

Currently, China is taking an increasingly active view in the formulation of global

technical standards. According to the report, as a world leader for manufacturing and

consumption of high-tech products, China has a strong influence over domestic and

global market standards. As Chinese standards become more widely accepted, Chinese

enterprises will see a rise in standing in the global technological sector. Yan Louyou,

Chinese Chief of the service group for DTT Technologies, Media and

Telecommunications, argues that global technology and telecom firms need to valuate

Chinese standard proposals and, when appropriate, set up technical standards in

conjunction with Chinese enterprises. The report predicts Chinese manufacturers will first
build up a strong business support team in China and then export their technologies to

emerging markets in Southeast Asia and Middle East. China’s formulation of global

technical standards acts as a branding to the products manufactured by the Chinese

companies. This paves a smoother path for future emerging Chinese corporations to

expand their diminutive stature overseas.

Conclusion

China has made great strides in its reforms to open up its market for foreign direct

investment. Among developing countries, China is now the largest recipient of foreign

capital. Foreign direct investment is still concentrated in the southeast and the coastal

areas, even though we see a slow process of diffusion. Foreign-invested firms have

played an increasingly important role in Chinese economic reform. However, there

remains many challenges to investing in China to which it must tackle in order for it

remain an attractive destination for FDIs. FDIs has also resulted in problems to which

China must try to alleviate.

References:

• http://www.qis.net/chinalaw/prclaw11.htm

• http://chinaunique.com/business/sez.htm

• http://www.worldaudit.org/corruption.htm

• Wall Street Journal, 19th August 2004

• http://www.fdi.gov.cn/lteconomy/index.jsp?app=00000000000000000005&language=en
&category=&currentPage=1

• Sizing up FDI in China and India, Shan-Jin Wei, Stanford University, December 2000

• Wall Street Journal, 20th August 2004, front page

• ibid, Page A5, Column 4

• ibid, Page A5, Column 5

• Wall Street Journal, 24th August 2004, front page & page A7, Column 1

• www.WSJ.com

• Wall Street Journal, 25th August 2004, front page

• http://www.weforum.org/site/knowledgenavigator.nsf/Content/Is%20China%20a%20For
eign%20Investment%20Goldmine%20or%20Minefield%3F_2004?the

• Wall Street Journal, 28th August 2004, Page A12, Column 3

• Wall Street Journal, 2nd September 2004, Page M8 Column 1

• ibid, Page M8, Column 2

• ibid, Page M8, Column 2-3

• http://www.wider.unu.edu/publications/pb4.pdf

• China to Become A Major Parameter for Global Technical Standards, 2004-08-18,

http://www.fdi.gov.cn/common/info.jsp?id=ABC00000000000016107
• http://www.fdi.gov.cn/lteconomy/index.jsp?language=en&app=00000000000000000010
&category=01&currentPage=1
• http://www.edu.cn/20020709/3060913.shtml
• The Asian Wall Street Journal, 31/8/04
 • The Asian Wall Street Journal, 24/8/04

Appendix A:
Appendix B:

1979- %
Country/Region 1990 1991 1992 1993 1994 1995 1996 1997
1989 Change
Hong Kong* 20,879 3,833 7,215 40,044 73,939 46,971 40,996 28,002 18,220 -35%
Japan 2,855 457 812 2,173 2,960 4,440 7,592 5,131 3,400 -34%
USA 4,057 358 548 3,121 6,813 6,010 7,471 6,916 4,940 -29%
Taiwan** 1,100 1,000 3,430 5,543 9,965 5,395 5,849 5,141 2,810 -45%
Others 4,569 1,948 3,405 7,241 17,759 19,864 29,374 28,086 22,410 -20%
Total Contracted
32,360 7,596 11,980 58,122 111,436 82,680 91,282 73,276 51,780 -29%
Investment

Graphical Representation:

7%
Appendix C: