The Hindu Business Line : China’s FDI policy — Changing gears for national interests

In the initial years of reform in China, FDI substituted for bank lending as banks were prohibited from lending to private firms. But since 2005, the thrust has been to use FDI to promote investment in higher-value-added sectors and discourage indiscriminate pursuit of FDI by local governments, says K. SUBRAMANIAN.

For long, China has remained a model for the advocates of globalisation with foreign direct investment (FDI) playing a pivotal role. There are myths and fallacies about FDI in China. China’s FDI policy is not set in stone and its contours have been changing over time.

The creation of special economic zones (SEZs) was a unique step towards integration and ideally suited the overseas Chinese. They identified items for production, partners for joint ventures, invested large amounts and exported them through their networks.

Initially, it was the success of SEZs that attracted other foreign companies. Chinese exporters in the private sector had the skills to produce traditional items such as handcrafts, shoes, toys, etc and did not need any foreign technology. What they needed was capital. If China was flush with a savings rate of over 50 per cent of national income, why were Chinese firms capital starved?

Until 1998, government-owned banks were prohibited from lending to private firms and could lend only to state-owned-enterprises (SOEs). Private firms had to depend on retained earnings for working capital and expansion. When FDI was thrown open in 1994, they rushed headlong into it. Truly, FDI substituted for bank lending. Foreign equity financed imports of equipment, components, technology services, etc regardless of their intrinsic value. Countless joint ventures (JVs) or foreign-invested enterprises (FIEs) were established by township-village enterprises (TVEs), SOEs, etc.

FDI operations

There is a myth about the freedom for FDI operations in China. In contrast to the freedom given to them in coastal areas, the Chinese were paranoid about their operations elsewhere. There were concerns over national enterprises, especially SOEs, and economic security. JVs and FIEs were subject to severe regulations and were required to achieve industrial and plan targets along side performance requirements such as local procurement.

Many academics have narrated the distortions created by the differential treatment accorded to exporters. While the coastal regions grew extra-ordinarily rich, other regions, especially the western, remained backward. Unemployment was rising and included those leaving farms and others retrenched by SOEs. Migrant labour had crossed 110 million. They could turn politically violent unless gainfully absorbed in other jobs. China had to grow and unless it grew, it would be unstable. Excessive concern over growth and creation of jobs led to over reliance on FDI.

As Premier Wen Jiabao cautioned at the National People’s Congress in March this year, “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable.”

A recent World Bank Report (Foreign Capital Utilization in China: Prospects and Future Strategy, World Bank Beijing Office, September 28, 2007) shows that 90 per cent of FDI investment was in coastal provinces and less than 2 per cent in western provinces. In 2004, around 75 per cent of FDI was in manufacturing.

The aggregate size of FDI flowing into China dazzles many analysts and prevents them from having a closer look at the overall impact of the FDI on its economy. Though the aggregate figure is large, the FDI’s relative size in total investment is rather low. Against the estimated investment of 45 per cent of GDP, FDI accounts for less than 5 per cent. Another disturbing feature is that much of the FDI is round-tripping and estimates vary from 25 to 50 per cent.

There are doubts about the technological contribution made by FDI. Indeed, China’s openness led to the creation of production networks which linked it with the rest of East Asia. As the Economic Intelligence Unit described, “Quite a lot of new trade that Asean is generating……new exports are going to China in a triangular relationship, often between Asean and China, rather than East-West axis developing within Asean itself,” (November 16). Indeed, FDI brokered this process, but did not contribute to China’s own technology upgradation.

A World Bank study (Trade Integration in East Asia: The role of China and Production Networks, WPS4160, March 2007) describes it at length. Though China’s trade suggests higher technological content, it is derived mostly from imports. Half of China’s high-tech imports are used for export processing activities. Moreover, trade is concentrated in a limited number of products like radio, TV, office machinery and precision instruments. Foreign affiliates handle around 80 per cent them. One consequence is that it has limited impact on domestic innovative capacity.

Another NBER Research paper (Facts and Fallacies about US FDI in China, W.P.13470, October 2007) suggests that US affiliates conduct very little R&D in China and are quite dependent on their parent companies back home.

Yet another myth is that under an authoritarian regime there is consensus over FDI policies. Deng faced his critics when he unveiled his vision. His critics were silenced when his experiment succeeded in integrating China with Hong Kong initially and, later, with East Asia. Even so, there have been continuing battles between the government and the old guards.

The debate seems to have turned contentious since the turn of 21st century and more so with the beginning of the currency war with the US since 2002. It was evident that the honeymoon with the US was over and China came to be seen as a rival or a threat. Doubts crept in over dependence on the US market as a long-term policy for growth.

Researchers with the Chinese Academy of Social Sciences began to worry that the rapid increase of FDI would make China’s economy too dependent on foreign trade which could decrease the country’s ability to withstand global economic fluctuations and political stability. (People’s Daily, November 16, 2004.) They drew the parallel of Latin American economies.

Nationalist sentiments

Nationalist currents have been on the rise and protests voiced over the take over of core industries by foreign firms. Washington Post reported, “There are certain sectors China believes are vital to economic security, and there is a fear of high level of foreign intrusion.” (China gets cold feet for foreign investment, February 2, 2007.)

There was such fierce opposition to Carlyle taking 85 per cent equity in Xugong Construction Machinery, a market leader, that after several months, Carlyle had to settle for 50 per cent. There was a similar backlash over foreign investments in banking. These instances do suggest that policy-makers pay heed to public perception.

By 2005, China had decided to shift gear. In November 2006, its National Development and Reform Commission (NDRC), the top economic planning agency, released a blueprint on FDI, outlining the policy intentions of the government for the next five years. It highlighted the need to shift to a “quality, not quantity” approach in attracting FDI.

It was a policy for 11th Five-Year Plan and explicitly linked FDI with the Plan objectives. Indeed, it is a departure from the gung ho approach to FDI. The revised thrust is to use FDI to promote investment in higher-value-added sectors, discourage indiscriminate pursuit of FDI by local governments and apply stricter environmental standards to FDI proposals. It was a signal to move away from low-value export-processing and assembly-type manufacturing which was the bane of earlier FDI. While some western analysts are sceptical, there is evidence that China is determined to change course. In March, the National People’s Congress passed the new Enterprise Income Tax law unifying the income tax rates for all enterprises at 25 per cent and adjust preferential tax policies to reflect the government’s focus on technology development, environmental protection, and balanced socioeconomic and regional development. It has withdrawn all tax holidays on FDI. This will eliminate round-tripping by Chinese residents. FDI incentives are only for newer policy directions.

On November 7, the NDRC released new guidelines on FDI. These hark back to the earlier decisions and redefine the scope of FDI. It is a 28-page guide stating China’s position of “upholding the opening-up policy and safeguarding national economic security” as approved by the State Council.

Foreign investors are invited to join efforts to promote recycling economy, clean production, renewable energy utilisation and ecological environment protection. Manufacturing is open to FDI in high technology and is not allowed in traditional industries. The idea is to access FDI to spur innovation, industrial restructuring and redress regional imbalances.

Moment of departure

The new policy marks a total departure from the earlier one holding fort for 28 years. China will no longer give blanket encouragement to exports. There is a banned list which includes strategic minerals and “strategic and sensitive” relating to national economic security which have not been specified.

What China seeks to achieve is to rebalance its economy to ensure sustainable growth. There is less reliance on exports and investment and more on consumption. In that process, they do not hesitate to give new direction to FDI. Unlike the reform lobby in India which thinks that FDI is a tender plant which will wither under regulations, China does not hesitate to do it to serve its national goals. It has an FDI policy with changing contours.

(The author is a former Finance Ministry official with extensive experience in international, trade and financial affairs.)

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