Foreign Direct Investment in China
Released: 2003-02-14T00:00:00

Background

China, as any other developing country, has needed foreign technology for its economicdevelopment. For the first two post-revolution decades, China remained suspicious of foreigncapital and hoped that by importing foreign capital goods and using reverse engineering it could meetits technological needs. Such a policy had limited success even after the opening of China followingPresident Nixon's visit to Beijing in 1972 and the gradual of normalization relations with the UnitedStates and other nations. Between 1972 and 1978, China imported equipment and a number of newplants from the industrialized West but found only limited success in developing indigenoustechnology through the reverse engineering route. Under Deng Xiaoping's economic reforms,attitudes toward foreign capital began to change. During the first stage (1979-83), foreign investment was restricted to four Special Economic Zones (Shenzhen, Zhuhai, and Shantou inGuangdong Province and Xiamen in Fujian Province). In spite of the incentives provided, the inflowof FDI remained low - an average of only $360 million annually over the five-year period. Duringthe second stage (1984-91), Hainan Island and fourteen coastal cities in ten provinces were opened to foreign capital. (11)

In 1990, the government eliminated time restrictions on the establishment of joint ventures, provided some assurances against nationalization, and allowed foreign partners to become chairs ofjoint venture boards. In 1991, China granted more preferential tax treatment for whollyforeign-owned businesses and contractual ventures and also for foreign companies that invested inselected economic zones or in projects encouraged by the state (such as energy, communications,and transportation). In 2000 and 2001, China revised significantly its laws on foreign-ownedenterprises and joint ventures. It eased export performance and domestic content requirements,attempted to make the legal framework more transparent, and ensured thatforeign-investment-related enterprises would not be nationalized except under special circumstances. China's entry into the World Trade Organization in December 2001 also stimulated FDI flows intothe country.

Financial incentives also are used by the central and regional governments to attract foreign investment. These include reductions in or exemption from central and local taxes and lowering ofimport duties on foreign-made equipment and construction materials. (12) In its designated priorityareas, the government also gives preferential treatment to foreign investors. Currently such areasinclude agriculture, resource development, infrastructure, and export-oriented and high technologyindustries. (13) On the negative side, widespreadcorruption and bureaucratic hurdles continue to deterforeign investment, but the government is trying to remedy the situation by imposing harshpunishments on corrupt officials who are caught.

General aspects of China's market also have added to the attraction for foreign investment. With its 1.28 billion people and rapidly rising incomes and purchasing power, China presents a hugepotential market. Per capita incomes around Shanghai and in Guangdong province already havereached an estimated US$5,000. China also possesses a comparatively well-developed socialinfrastructure, including a compulsory nine-year education system that has helped provide a supplyof reasonably literate workers with some technical competence. Labor is abundant, wages low,strikes uncommon, and discipline problems are rare. The eastern and coastal regions of China,moreover, include sufficient transport and communications facilities for foreign investors to exportgoods or distribute them within China.

In its 2002 FDI Confidence Index survey of top corporate decision-makers, A.T. Kearney (a business consulting firm) found that "confidence in China is booming." For the first time since thesurvey began, in 2002 China surpassed the United States to become the destination most likely toattract investment. More than any other country, investors held a more positive outlook towardChina, with 46% more optimistic about the Chinese market then than in the previous year. They arealso expected to commit more first-time investments to China than to any other country. (14)

The surge in FDI into China coincided with a similar trends worldwide. The second half of 1990s saw an unprecedented increase in the world outflow of foreign capital - a more than six-foldincrease from an annual average of $225 billion during 1990-95 to $1,492 billion in 2000. According to the World Investment Report (WIR), there were three forces at work - all related toglobalization. First, many governments liberalized capital flows into their national economies. Thisallowed foreign investment to enter more freely. The process was further accelerated by theprivatization of government-owned enterprises in both developed and developing countries. Second,increasing costs of production and various technological developments induced enterprises to spreadtheir operations and risks internationally. Concurrently, the cost of transportation andcommunications fell, thereby enabling firms to locate their production processes in different partsof the world and to supply products, parts, and accessories from long distances. Finally, increasingcompetition forced enterprises to enter new markets at an early stage and to transfer someproduction there to "nationalize the product" and to reduce production costs. These forces also wereat work for FDI in China.

As shown in Figure 2, after averaging around $2 billion per year during1984-88, FDI flows intoChina rose dramatically in the 1990s to $46.9 billion in 2001 and further to $52.7 billion in 2002(according to Chinese statistics). In 2001, FDI inflows to China accounted for 6% of the world totaland 22% of inflows into developing economies. (See Appendix A.) These FDI flows have beenincreasing in recent years despite global recessionary conditions that caused total world FDI flowsto drop nearly by half in 2001.

Chinese statistics on FDI, however, differ considerably from those of other nations. For example (as discussed later in this report), the U.S. Department of Commerce shows American directinvestment in China at less than a third of the level that Beijing reports.

Sources of FDI Inflow into China

Most FDI into China comes from either "Greater China" or from the three major industrializedmarkets: the United States, Japan, and the European Union. Hong Kong continues to be the numberone source. (Even though Hong Kong reverted to Chinese sovereignty in 1991, it still is counted asa "foreign" entity for trade and capital flows.) In 2001, Hong Kong provided $16.7 billion or 36%of China's total of $46.9 billion of actually utilized FDI. Much of Hong Kong's investment inChina, however, actually is Chinese capital doing a "round trip" to take advantage of investmentincentives and protections for foreign investors. (15) Taiwan provided another 6.4% of the FDI andMacao 0.6%. Some of Taiwan's FDI in China also flows through Hong Kong or offshore taxhavens. Singapore provided 4.6%. Hence, nearly 47% of the officially tabulated FDI inflows intoChina originated in areas sometimes designated as the Greater China region. Other major investorsin 2001, were the United States with 9.4%, Japan with 9.2%, and the EU with 9.0%. The offshoretax havens account for nearly 15% of total FDI flows into China, but this FDI actually originatesfrom countries such as the United States, the EU, Japan, Taiwan, or even the PRC, but for variousreasons was routed through tax havens such as the Bahamas, Virgin Islands, Cayman Islands,Bermuda, and Western and Eastern Samoa.

FDI by Enterprise Type

In the early stages in which foreign capital was allowed to enter China, the main vehicles of entry were joint (equity) ventures, cooperative joint ventures, and wholly foreign-owned enterprises. In joint ventures, capital was provided by two or more parties who managed the enterprise andshared in the risk according to their contributions to the capital. In the cooperative joint ventures,much of the capital was provided by the foreign partner, while land, building, and workable assets were provided by the domestic side. The nature and degree of participation and the sharing of riskwere established in the contract. On the stipulated date of termination of the contract, all the assetsbecame the property of the Chinese side. In wholly owned ventures, the foreign firm put up all thecapital.

In the 1980s, 42% of all FDI into China was invested in cooperative joint ventures and 39% in joint (equity) ventures. Hence, 80% of all FDI inflows came into joint ventures of one or the othertype. Investments into wholly foreign-owned enterprises accounted for only 10% of the FDI inflows. Another 10% entered in other forms such as compensation trade or international leasing, etc. (SeeTable 1).

Table 1. Foreign Direct Investment in China by Type, 1979-2002 (in percentage)

Source: China. Ministry of Foreign Trade and Economic Cooperation. Statistics About Utilizationof Foreign Investment in China. Various years.

During the 1990s, the relative importance of cooperative joint ventures declined significantly. In 2002, they accounted for less than 10% of FDI inflows. The share of joint equity enterprises wentup during the first half of the 1990s reaching around half of total inflows in 1991 after which theydeclined, initially slowly, but by 2002 were only 28%. Typically in joint enterprises, the Chinesepartner was able to contribute expertise on land and labor acquisitions and political connectionsnecessary to navigate the Chinese bureaucratic system. As the enterprise developed, however, suchskills became less and less important relative to management and operational skills provided by theforeign partner. Currently, more and more foreign companies are opting to establish wholly-ownedenterprises over which they have complete control. On the other hand, Chinese authorities, with theirgrowing experience in dealing with foreign enterprises, have become more confident in allowingthem to operate without a native partner. In addition, the authorities in Beijing - first, keen to enterthe World Trade Organization (WTO) and, then, required by WTO rules - have been changing theirregulatory regime to make it more consistent with their WTO commitments. The share of whollyowned enterprises in FDI rose to 60% by 2002 and is likely to continue to rise.

FDI Utilization by Sector

By far the largest share of FDI inflows into China - almost two-thirds - has been invested in manufacturing. Foreign investment has moved into China not only to take advantage of the rapidlygrowing domestic market for consumer goods but also to take advantage of the resources in Chinato manufacture and assemble products - particularly parts and accessories - to be exported to worldmarkets. Japanese, South Korean, and Taiwanese corporations, for example, which were facingrising costs for labor and production in their home markets and elsewhere in Asia have relocatedsome of their production to China.

The sectoral mix of FDI, moreover, is shifting away from traditional labor-intensive industries. In the 1980s, textiles and footwear were dominant destinations for FDI, but as shown in Table 2, in2001, less than 5% went into textiles. Pharmaceuticals accounted for three times as much - 15%. Electrical machinery, transport equipment, as well a telecommunications industries are nowbecoming much more important. Real estate received nearly 11% of total FDI inflow in 2001. Theproduction and supply of electricity and water received nearly 5%, and social services, including thehotel industry, accounted for another 5%.

Table 2. Foreign Direct Investment into China by Sector, 2001

Source: China Ministry of Foreign Trade and Economic Cooperation.

Geographical Distribution of FDI Into China

Following the pattern of China's industrialization, most of the foreign investment is concentrated in the coastal regions in the east. As much as 88% has been invested into China'seastern region, while only 9% has gone into the Central region, and 3% into the Western region. (16) (See Table 3) Initially, China's official policy was to allow foreign capital mainly in the SpecialEconomic Zones in Guangdong (bordering Hong Kong) and Fujian (north of Guangdong facingTaiwan) provinces. During the 1980s, Guangdong province had absorbed almost half of the FDIin China, and even in 1990s its share remained at a quarter of the total FDI stock.

Table 3. Geographical Distribution of Foreign Direct Investment in China, 1980s and 1990s (in percent)

Source: Taube, Markus and Mehmet ÃgÃ¼tÃ§Ã¼, Main Issues on Foreign Investment in China'sRegional Development: Prospects and Policy Challenges (Paris: OECD, 2000), Table 3, p. 7.

While the government initially directed FDI into the east coastal areas, economic forces also played a key role in determining the destination of FDI flows. China's eastern coastal regions havethe largest concentrations of population with major cities such as Beijing, Shanghai, and Guangzhou. Rates of growth there have been the most rapid, and they have well-developed roads and railnetworks as well as access to major ports and shipping routes. Many people in these regions alsohave close connections with overseas Chinese, since vast numbers of these emigrant Chinese cantrace their ancestry to the coastal areas. One study indicates that three-quarters or more of the totalFDI in China had come from overseas Chinese. (17)

In Guangdong province, for example, proximity to Hong Kong played a large role in attracting FDI. Economic reform in China virtually coincided with a substantial rise in wage levels, rents, andoverhead costs in Hong Kong. This motivated Hong Kong industries to relocate to the neighboringGuangdong province with its plentiful supply of labor, land, and electricity. Also historically, thetwo areas have had close relationships. When China was more closed, Hong Kong wasGuangdong's window to the world and provided technology, capital, and management skills forcompanies there. Many of the Chinese in Hong Kong came from Guangdong province. Bothpopulations speak Cantonese (rather than Beijing's Mandarin). In preparation for Hong Kong'sreversion to China in 1997, moreover, the policy of Beijing was to open its territory bordering HongKong to foreign investment and trade in order to reduce the economic gap between Guangdong andHong Kong and stem pressures to emigrate there. (18) The same is true of Fujian province. Many inTaiwan came from that province, speak the same Chinese dialect, and share business methods andculture.

The boom in economic development and modernization in the eastern coastal regions of China, however, has generated huge disparities in income, standards of living, and opportunities betweenthe eastern regions and those in the middle and west. For Beijing, this is a potentially explosivesituation partly because more ethnic minorities (e.g., Muslims in the Xinjiang Uighur AutonomousRegion and Tibetans)

live in the non-coastal regions and because the promise of higher-paying jobs in the east is luringmigrants by the millions from other parts of China. The state-owned enterprises in the non-coastalregions and the rust-belt Northeast, moreover, often are losing in the competitive battle with moreefficient plants along the middle and southern coast. This is causing considerable labor unrest.

In partial response to the regional disparities, Beijing's policy on attracting foreign investment now emphasizes the lagging middle and western Chinese regions. These currently are given priorityin selecting industries from China's Master List of desirable industries, in procuring domesticfinancing, and in offering higher levels of allowable foreign participation in joint ventures. Thecentral government, moreover, is providing a cut of 15% in business income taxes and is givingpriority to the funding of infrastructure projects for FDI in these regions. (19)

U.S. Direct Investment In China

U.S. multinational corporations have joined with those from other nations in investing directlyin affiliated companies in China. A huge gap exists, however, between U.S. and Chinese data. According to U.S. data, at the end of 2001, the United States had $10.53 billion (historical cost basis)in direct investment in China. According to Chinese data, since 1990, utilized FDI (as opposed tocontracted FDI) from the United States totaled $33.97 billion.

Table 4. U.S. Direct Investment in China, 1990-2001 (billion dollars)

Sources: China, Ministry of Foreign Trade and Economic Cooperation. U.S. Bureau of EconomicAnalysis.

a Data not linked to post-1993 data that was adjusted by the 1994 Benchmark Survey.

b The 1994 Benchmark Survey picked up investments with assets or sales between $3million and$15 million that had not been reported in previous annual surveys.

The differences between the two sets of figures have not been reconciled, but they likely can be traced to: differences in reporting criteria; U.S. investments originating in or going throughoffshore U.S. affiliated companies (particularly in Hong Kong); investments that fell under the U.S.threshold for counting; more complete data gathered by the U.S. Department of Commerce on repaidloans and other data internal to companies that are not generally accounted for by the Chineseministry that approves foreign investments; changes in exchange rates; and overstatements ofinvestment amounts by local Chinese officials and foreign investors. Both sets of data, however,indicate that U.S. FDI in China has been increasing. According to Chinese figures, in 1990, the flowof American FDI into China was only about $456 million; by 2000, it had reached $4.4 billion; andin 2001 it rose to almost $ 4.7 billion. In a similar manner, U.S. figures show an increase from a fewhundred million per year in the early 1990s to nearly $2 billion in 2000.

The United States has been the second largest source of FDI for China (next only to Hong Kong) and during 1999-2001 accounted for an average of about 10.5% of China's total inflows(using China's figures). China, however, is not a major location for all U.S. FDI. In 2001, U.S. FDIthere amounted to only 0.76% of U.S. FDI worldwide. U.S. FDI in Hong Kong accounted foranother 2.1% of total U.S. FDI abroad for a total for both China and Hong Kong of only 3%. MostU.S. FDI goes to other developed economies in Europe, Japan, and Canada.

The United States collects data on the operations of its multinational corporations that includes affiliated companies in China. For 2000, the value of total assets of nonbank foreign affiliates ofU.S. companies in China (10% or more American owned) was $32.12 billion, up from $18.59 billionin 1997. Of these amounts, the total for majority owned (50% or more U.S. owned) foreign affiliateswas $28.69 billion in 2000, up from $14.36 billion in 1997. (20) These values for total assets includeinvestments by the non-U.S. partner and exclude the value of banks in China affiliated with U.S.companies. The U.S. affiliated companies reported 252,400 employees (0.03% of China's laborforce) earning an average of US$6,846 per year. They produced $3.94 billion in gross product (valueadded) which accounted for 0.4% of China's nominal gross domestic product. In terms of totalChinese employment and output, therefore, U.S. affiliated firms are still but a dot on the largeChinese landscape.

Major U.S. Corporations in China

Source: Caravel, Inc., American Business in China, 2002-2003.

The U.S. companies with affiliates in China include many of the large multinational corporations in the United States. The U.S.-China Business Council has 220 members. The Caravelcompany's list of U.S. firms operating in China in 2002 totaled 1,466 companies (up from 1,383 in2000) with 570 in Beijing, 448 in Shanghai, and 223 in Guangdong province across the border fromHong Kong. The American states in which the headquarters of the parent company investing directlyin China were concentrated in the West Coast, industrialized mid-West, Mid-Atlantic, and Texas. As shown in Figure 3, the greatest number of U.S. companies were headquartered in California(255), New York (243), New Jersey (102), Illinois (100), Texas (77), Pennsylvania (67),Massachusetts (65), Ohio (63), and Connecticut (62). (21)

American companies have established affiliates in China for a number of different reasons. Ina 2002 U.S. General Accounting Office survey of 551 American companies, the highest percentageof respondents indicated that establishing a presence in China was an important goal (103respondents), with increasing exports to China (79 respondents) and taking advantage of low laborcosts (76 respondents) also important. Other goals were expanding a regional base in China andexpanding or establishing a distribution network there. (22) (See Table 5)

The U.S. corporations interviewed for the GAO Survey, while expressing their mild optimism regarding China's willingness or ability to implement its WTO commitments, also highlighted whatthey felt were their main concerns. These included five commitment areas related to the rule of lawreforms and implementation: (1) the consistent application of laws, regulations, and practices; (2)protection of intellectual property rights; (3) enforcement of contracts and judgement settlement ofdisputes; (4) independence of judicial bodies; and (5) equal treatment between Chinese and foreignentities. Other areas of concern were the transparency of laws, regulations, and practices - a reformwhich the respondents felt that China might find difficult to implement - and all aspects ofinteraction between government and business, including subsidies to Chinese firms, non-tariffbarriers, as well as China's application of safeguards against U.S. exports.

Table 5. U.S. Company Goals in China,2002

Source: U.S. General Accounting Office, World Trade Organization: Selected U.S. CompanyViews about China's Membership, September 2002, Table 3, p. 15.

The respondents were more hopeful that WTO-related reforms would be implemented reasonably successfully at the national level (and in major cities) but felt that implementation at locallevels would be much more difficult. Local officials are often more interested in protecting localbusinesses and jobs and reportedly often either evade laws or circumvent them. For example, inintellectual property rights enforcement, China has already enacted reforms aimed at an overallimprovement in IPR protection, but local companies, even when owned by local governments, areknow to have copied foreign products and packaging. With respect to copyright violations,enforcement by local officials often is imperfect even after a foreign company wins a case in thecourts. (23)

U.S. FDI Position by Industrial Sector

According to U.S. data, as much as two-thirds of the stock of U.S. FDI in China is invested in manufacturing - more than 50% of which is in the electronic and electrical equipment sector. Another 12% is invested in petroleum, 8% in banking and finance, and 5% in wholesale trade. (SeeAppendix B). Worldwide, manufacturing accounts for about 27% of U.S. foreign direct investment. The reason for the high percentage of U.S. FDI in China in manufacturing is to take advantage ofthe large and rapidly growing domestic market combined with the abundant supply of low-cost labor. U.S. retailers also are locating to China to service the expanding consumer market. Wal-Mart, forexample, has 20 joint-venture stores there including 16 supermarket centers and three Sam's Clubwarehouse sales operations. (24)

Effects of U.S. FDI in China on U.S. Trade

One of the criticisms of foreign investment in China and other countries is that it "exports U.S. jobs" and worsens the U.S. balance of trade. One study found that U.S. investment in Chinabroadens China's production base for exporting goods back to the United States and will result inan even greater U.S. trade deficit with that country. (25) U.S. companies in China do export some oftheir output back to the American market, but most is sold in China. According to the U.S. Bureauof Economic Analysis, in 1998, of the $20 billion in total sales by U.S. majority-owned affiliates inChina, 14% went to the United States, 69% was sold in China, and 17% went to other markets. Ofthe $1.1 billion in electrical and electrical equipment produced by these majority-owned affiliates,however, 44% was sold to the United States. Also of the $7.6 billion in computer and electricalproducts manufactured, 23% was exported to the United States. (See Table 6)

In terms of the question of how much U.S. and foreign firms in China are contributing to the growing U.S. merchandise trade deficit with that country, this deficit has grown from $10 billionin 1990 to $61 billion in 1998 and to $83 billion in 2001 (a projected $100 billion in 2002 based onJanuary-November data). The $83 billion deficit in 2001 accounted for 20% of the overall U.S. tradedeficit of $411.9 billion. In 2001, the largest sectoral deficits with China were $16.3 billion inelectrical machinery (including $2.1 billion in radio receivers), $12.2 billion in toys and sportsequipment, $9.7 billion in footwear, $9.7 billion in machinery, and $7.4 billion infurniture/bedding. (26) The deficits in these fivesectors totaled $55.3 billion or 66% of the total U.S.deficit with China for that year. The rapid growth of some of these sectoral deficits is remarkable. The U.S. trade balance with China in electrical machinery went from a surplus of $16.0 billion in1990 to a deficit of $16.3 billion in 2001. This industry is highly dependent on foreign inputs fordesign, marketing, and research and development. (27) Likewise, in machinery, a surplus of $11.0billion 1990 dropped to a deficit of $9.7 billion in 2001.

Table 6. Sales of Majority Owned Affiliates of U.S. Corporations in China by Industry, 1998 (billion dollars and percent)

Source: U.S. Bureau of Economic Analysis. Operations of U.S. Multinational Companies. Preliminary Results from the 1999 Benchmark Survey. Survey of Current Business , March 2002,and supplementary tables.

As noted earlier in this report, foreign affiliated firms account for the vast proportion of electronics-related and other high-technology exports from China. U.S. majority owned firms there,however, do not appear to have contributed directly to this rising bilateral trade deficit through theirproduction. According to U.S. data on the operations of majority owned American affiliated firmsin China, in 1998, they shipped $1.96 billion in product to the United States. At the same time, U.S.companies shipped $1.95 billion in product to them for a rough balance in the two-way trade. (28) Much of the rise in Chinese exports to the United States, therefore, has originated from foreignaffiliates from other countries and from Chinese-owned companies. U.S. investment in China,however, can displace potential U.S. exports to China, as affiliates are established to manufactureand sell U.S. brand name products that traditionally have been made at home.

Some of the rising U.S. trade deficit with China also is being transferred from other economies in Asia. Foreign-owned firms from Hong Kong, South Korea, Taiwan, Japan, and other marketsthat traditionally have accounted for much of the U.S. overall trade deficit also have been investingin production facilities in China. Nike, for example, contracts the production of its footwear madein China from assembly plants owned by companies from South Korea and other Asian nations. Many of these companies have moved factories there from their home markets in order to lowerproduction costs. For example, U.S. imports of footwear from China rose from $1.48 billion in 1990to $9.77 billion in 2001. Over the same period, imports of footwear from South Korea dropped from$2.56 billion to $0.10 billion. Likewise for furniture, U.S. imports from China rose from $0.14billion in 1990 to $5.02 billion in 2001, while over the same period, those from Taiwan fell from$1.01 billion to $0.76 billion.

U.S. Multinationals and Chinese Labor

A concern of U.S. labor interests has been that workers in China are subject to substandard conditions in the workplace. Such activity not only may violate basic labor and human rights, butit may provide Chinese exports a competitive edge in world markets or violate U.S. trade laws. Thegeneral picture of labor conditions in China is mixed. Beijing has passed some labor laws, butenforcement seems lax. Independent unions are not allowed, and some labor leaders have beenjailed.

In general, those who study labor conditions in China note that relatively good working conditions exist in American-operated manufacturing facilities. Much of the production forAmerican subsidiaries in China, however, is contracted to East Asian affiliated companies there. Some of the worst cases of worker exploitation reportedly have occurred in those plants. The typesof abuse reported physical punishment, verbal humiliation, severe restrictions on movement, lackof rest, limited and short breaks, long working days without overtime pay, poor health and safetyconditions, and lack of compensation for injury. Companies also may use financial leverage tocompel workers not to quit. In some cases, employers have required workers to pay a deposit thatis not refunded if they leave, or they may extend loans that must be repaid through a long period ofpayroll deductions. (29)

Some U.S. companies have addressed the problem of labor conditions in contracting factories by adopting codes of conduct, codes of ethics, or corporate conduct guidelines for their affiliates,suppliers, or subcontractors in China. These include Levi Strauss, Mattel, Nike, Reebok, Avon, DoleFood, and Toys R Us. Still, working conditions in China are difficult to monitor - when productionis subcontracted - and enforcement always is a problem - particularly when workers are heavilydependent on their employers. (30)

Some organizations have investigated factories in China producing for export. Among the investigating organizations, the National Labor Committee (NLC) located in New York and somenon-governmental organizations in Hong Kong (such as the Hong Kong Christian IndustrialCommittee and the Asia Monitor Resource Center), claim to have found numerous violations ofbasic worker rights and poor working conditions. (31) The cited factories, however, tended not to beU.S.-owned but often contracted with U.S. companies to manufacture brand-name products.

Effects of Foreign Direct Investment on China's Domestic Economy

FDI (including reinvested earnings of affiliates) has come to play an important role in theChinese economy. The problem in determining the precise role of FDI in recent Chinese economicdevelopment, however, is that it has been part of the general opening of the economy to the worldand a more market-based economic system. In terms of quantifiable indicators, foreign affiliatesnow account for nearly a quarter of industrial value-added, nearly a fifth of the tax revenue, andalmost half of all exports from China. (32) FDIinflows account for 10 to 15% of China's total grossfixed capital formation. Several econometric studies have attempted to estimate how much FDI hascontributed to Chinese economic growth. Since FDI still accounts for a relatively small percentageof total investment in fixed capital, it naturally will have a small quantifiable effect on grossdomestic product. A recent study concluded that about 13% of the changes in China's output canbe traced to changes in FDI. levels. The same study found that FDI had a larger effect on China'sexports - a finding that would be expected given the large role of foreign affiliated firms in exports. (33)

Foreign affiliates are, by far, the largest source of China's exports of high-technology products. In 2000, 93% of all exports of electronic circuits came from foreign affiliated companies. In dataprocessing, office machines, and related products, the share of foreign affiliates was as high as 85%and in mobile phones (transmitter-receiver apparatus) as high as 96%. (34) FDI also played a major rolein the drastic change in the composition of Chinese exports. In 1985, primary products andresources-based manufactures accounted for 49% of all exports. By 2000, their share had droppedto 12%, while the share of high-technology exports grew from 3% in 1985 to 22% in 2000. (35) (SeeTable 7) This structural change in China's exports toward higher technology, more dynamic, andhigher value added products played a role in the increase in China's share of world trade, which rosefrom 1.6% in 1985 to 6% in 2000. (See Appendix B)

Table 7. China's Export Structure, 1985-2000 (Percent Share)

Source: U.N. Conference on Trade and Development, World Investment Report, 2002 , Annex TableVI.5, pp. 162.

From a macroeconomic perspective, FDI plays a dual role in easing the foreign exchange constraint faced by most developing nations. This constraint is the lack of foreign exchange to payfor imports and repay past borrowing that places bounds on the rate of economic growth and hasbeen at the heart of financial crises that have occurred in Latin American, Asian, and African nations. A nation generates foreign exchange by exporting more than it imports and by attracting capital fordirect and portfolio investment. In 2001, China added $43 billion to its foreign exchange reserves(a total of $286 billion at the end of 2002). This $43 billion was generated primarily by a $17.4billion current account surplus (including a $34 billion merchandise trade surplus) and a $37.4billion net direct investment inflow (inflows minus outflows of $9.7 billion) that offset a $19.4billion deficit in portfolio investment. (36) FDIcontributed both to China's surplus in investmentinflows and to its surplus in trade. Without FDI, China would probably have faced a severe shortageof foreign exchange and likely would have had to curtail its rapid growth. This creates a dependencyby Beijing on foreign investors who play a critical role in breaking China's foreign exchangeconstraint and in modernizing Chinese industries and export structure.

Another effect of FDI in China and the price competitiveness of Chinese exports has been the possibility that China is exporting deflation to the world economy. Currently, Hong Kong, Japan,Singapore and, to a lesser extent, the United States and Europe have been grappling with the effectson deflation on their economies. The theory is that China's low-priced exports of products alsomanufactured in other nations is driving down prices and causing weakness in consumption anddepressing profits. (37) The low prices for China'sexports can be maintained primarily becauseChina's currency is pegged to the dollar, and this peg can be sustained because of China's surplusin trade, inflows of FDI, and the government's accumulation of foreign exchange. Some analystshave cast doubts on the ability of China to export deflation, but on a microeconomic basis, theundercutting of prices by imports from China is being observed in many countries in manyindustries. (38) Between January 1, 1995 and June30, 2002, 23 nations had initiated 278 anti-dumpingcases against imports from China. These included India with 51 cases, the European Union with 38,the United States with 37 , Argentina with 27, and Australia with 14 cases. (39)

Security Concerns

Foreign direct investment in China affects security primarily through three avenues: itscontribution to economic growth which funds China's military, technology transfers, and economicinterests.

With FDI contributing to rising economic power, China can devote more resources to its military, although in view of growing domestic needs, military spending has been taking secondplace to economic expansion and modernization. In March 2002, China announced a 17.6% or $3billion increase in military spending, bringing the publicly reported total to $20 billion. Accordingto the U.S. Department of Defense, China's total military spending is closer to $65 billion, andannual spending could increase in real terms over three- to four-fold by 2020. (40) FDI, however,contributes only about 10 to 15% of the growth in GDP underlying this projected rise in militaryexpenditures.

An important rationale for multinational corporations to invest abroad is that they hold technology, intellectual property, or manufacturing processes that can generate more potential profitsby establishing an affiliated firm in a foreign country than at home. Virtually all foreign directinvestments involve some transfer of technology - whether embodied in machinery and parts or usedto develop processes in the host country. The technology also may leak to other companies in thehost country who then may become competitors in world markets. In the case of China, the questionis whether foreign direct investment is enhancing the competitiveness of Chinese exports to the pointwhere U.S. firms and American security are being threatened.

A 1998 study conducted by the U.S. Department of Commerce (Bureau of Industry and Security) investigated how technology transfers to China have affected U.S. commercialcompetitiveness and U.S. security. The report concludes that, generally speaking, "China at presentposes no direct threat to U.S. economic competitiveness in high-tech industries. However, if currentprojections by Chinese and international financial institutions are correct, China will be a majorcompetitor and world economic power in a decade or two." The report also concludes that theUnited States is paying the "most for the privilege of access to China's market in terms of lostpotential exports and job opportunities." (41) Inshort, U.S. firms producing in China could be sellingproducts there from their Chinese factories rather than from sources in the United States.

The report further states that in the automobile sector, technology transfers (by companies such as Daimler Chrysler and General Motors) have upgraded Chinese domestic capabilities, yet theindustry or its future spin-offs are not likely to undermine U.S. security interests in the near future. In the case of aircraft manufacturing know-how, the report concludes that the Chinese are learningmore from the joint ventures with European Union companies than from American firms. Apotential risk of military spin-offs exists because the same Chinese firms that have co-productionagreements with foreign firms also produce military aircraft. Air traffic control or global positioningsystems developed for the civilian aviation sector also may assist in upgrading military capabilities. However, as the Commerce Department report points out, "China's abilities and reputation in termsof military aircraft manufacturing and reverse engineering capabilities are notoriously poor and donot seem to have improved." The report also points out that foreign technology transfers would dolittle to alleviate the chronic problems of China's existing antiquated military aircraft, limitedtraining, and combat experience, or the Chinese military's bureaucratic and logistic problems. (42)

In the case of satellite technology, China has made some progress and has 8% of the market for international commercial satellite launches. U.S. exports of satellite technology, as is the case withother sensitive, dual-use technologies, are controlled by U.S. export laws. Those American firmsaccused of providing space technology to China (Hughes Electronics, Boeing Satellite Systems, andLoral Space & Communications) allegedly provided assistance directly to the Chinese company thatlaunched satellites rather than by transferring technology to subsidiaries in China. (43)

In the electronics and telecommunication sectors, technology transfers have enabled China to catch up in some electronics-related sectors, but in most cases the technology transfers are in formof co-production and assembly and in terms of access to "soft" technologies. In the electronic sectorChina still mostly produces "relatively low-tech electrical or electronic products such as televisions,refrigerators, radios, and electric fans. In semiconductors, China has made considerable progress butit still lags behind world leaders in producing the latest generation of computer chips. China'scapabilities are the most developed in computer hardware, particularly assembly. (44)

A 2000 Aston University (Birmingham, UK) Asian Business Research Institute study arrives at similar conclusions. It found that even where technological capability is being transferred mostof the EU companies interviewed felt that it would take more than three years, and in some casesmore than ten years, before China could replicate the technologies. These companies, therefore, feltshielded from the immediate threat of Chinese competition. In the meantime, European companiesstated that they intend to stay ahead mainly through their own investment in research anddevelopment. (45) This accords with England'sexperience during the Industrial Revolution when itattempted to prohibit the export of its technologies. Such efforts were futile. Flows could only beslowed - not stopped.

A related concern is whether the United States is developing a dependency on Chinese imports that might undermine the U.S. defense industrial base. (46) Also, some U.S. businesses are assessingtheir risk of relying on China for such a large proportion of their supply of final and intermediateproducts. Could political turmoil in China, hostilities along the Taiwan Strait, or other disruptionthreaten their corporate operations? Some U.S. businesses reportedly are curtailing their investmentsin China to limit risk and diversify supply. (47) Asshown in Table 8, however, for broad categories ofhigh-technology products and parts, China provides no more than 17% of U.S. imports. It is thenumber two supplier for electronic apparatus for line telephones, office machines, and computers,but numerous other suppliers are available. In semiconductors, integrated circuits, and cathode raytubes, it ranks even lower among import suppliers and accounts for less than 7% of total imports ofthose products. A major disruption in supplies from China, however, could cause severe shortagesof toys and footwear. China provides 82% of U.S. imports of miscellaneous toys, scale models, andpuzzles (HS9503) and 57% of U.S. imports of footwear with leather uppers (HS6403). The retailoperations of Payless Shoes, for example, could be severely hampered, since it relies on China for80% of its supply of shoes. (48)

Table 8. U.S. Dependence on China for Certain Defense-related Products, 2001

Source: Ranking from World Trade Atlas. Data from U.S. Department of Commerce.

The second security-related issue that stems from the growing FDI in China relates to the vested economic interests of U.S. and other foreign companies there. If hostilities with China should breakout, the factories and other physical plant in the Chinese economy could serve not only as "hostages"for Beijing but also a source of expertise, employment, and foreign exchange that Beijing couldscarcely afford to lose. The foreign affiliated firms also can become a strong interest group that maypressure Beijing and their respective home governments to avoid political or military actions thatcould disrupt their businesses. The continued growth of FDI in China depends heavily on theconfidence of investors that China will remain stable, will institute reforms, and will comply withthe conditions of its accession to the World Trade Organization. This is seen by many to place anincentive on Beijing to seek peaceful solutions to foreign policy issues but, at times, also places U.S.businesses in a position of attempting to protect their investments by siding with Beijing on certainissues (such as opposing economic sanctions).

One likely place that hostilities might occur involving China is along the Taiwan Strait. Investment relations between the PRC and Taiwan, therefore, are playing an increasingly importantrole in maintaining stability on both sides. Taiwanese businesses have invested an officiallyrecognized $68.8 billion in the mainland since 1990, primarily in the coastal provinces of Fujian andGuangzhou and in Shanghai. Private estimates place the figure at as high as $100 billion. (49) Mostof this investment was routed through Hong Kong or tax havens both to avoid politicalcomplications and to secure incentives and protection accorded foreign investors. The Taiwanesegovernment estimates that more than 400,000 Taiwanese business-related persons and their familiesare now residing in China. There are about 3 million visits by Taiwanese to the mainland each year. Thousands of businessmen have married women from the PRC. According to a prominentTaiwanese politician, the strategy of China has been to facilitate this investment and to allowTaiwanese companies to earn higher profits than comparable investments from other nations. Taiwan's ruling Democratic People's Party is concerned over the security implications of thisinvestment. It also worries that some of the investment is zero sum - it displaces investment thatwould have occurred at home. While the mainland is growing at 7 to 8%, Taiwan's growth rate hasdropped in half to about 3%. China's development, on the other hand, appears to be giving Beijingmore confidence and less incentive to use the Taiwan issue to generate nationalism (and politicalsupport) at home. (50)

The growing investment, trade, and business relations between Taiwan and the mainland have compelled the two governments to open ties further. In 2003, one-way air charters betweenShanghai and Taipei for the Chinese New Year were initiated. (Taiwan still requires the charters tostop briefly in Macao or Hong Kong.) Businesses are pressuring the governments to expand theso-called three mini-links in transportation, direct mail, and trade currently between the Mainlandand the offshore islands of Kinmen, Matsu, and Penghu. Most observers foresee such economic tiesgrowing over time.

In summary, foreign direct investment is hastening two processes in China: its integration into the global economy and the modernization of its industries. FDI contributes to both these processesby providing technology, management skills, and marketing while also easing constraints on foreignexchange by boosting exports and inflows of capital. FDI contributes to economic growth. Thisprovides the means for China to modernize in various respects - including its military. Meanwhile,FDI provides captive foreign entities for Beijing should hostilities break out but also creates strongpressure groups both within China and in other nations of the world. These groups have directfinancial interest in maintaining stability, amicable Sino-foreign relations, and liberalized trade. FDIby Taiwan's businesses, in particular, may be changing the calculus for hostilities along the TaiwanStrait. As the Taiwanese economy becomes more integrated with that of the mainland, pressures riseto ease restrictions on interaction between them and to reach an amicable solution to the currentstalemate.

Appendix A. Foreign Direct Investment Inflows by Recipient Region and Economy, 1990-2001 (in billion dollars)

Source: U.N. Conference on Trade and Development, World Investment Report, 2002 , Annex TableB.1, pp. 303-6.

* Preliminary data.

** Estimates.

Appendix B. China's Competitiveness in World Trade as Indicated by Market Shares, 1985-2000 (in percent)

Source: U.N. Conference on Trade and Development, World Investment Report, 2002 , Annex TableVI.5, pp. 162.

Appendix C. U.S. Foreign Direct Investment Position in China by Industry, 2001 (in billion dollars and percent)

Source: U.S. Department of Commerce

Note: Data are on a historical cost basis.

Appendix D. U.S. And Total Foreign Direct Investment in China, 1990-2001 (billion dollars)

Source: U.S.-China Business Council based on data from China, Ministry of Foreign Trade andEconomic Cooperation.