FOREIGN DIRECT INVESTMENT IN CHINA

CHINA

Over the past few years the world has experienced a tremendous growth in Foreign

Direct Investment (FDI), that has even exceeded the growth of both world output and

world trade( Ali &Guo 2005). China is by far one of the world‟s largest recipients of FDI

and in 2004 surpassed the USA as host destination. FDI inflows to China rose from

nothing at the beginning of the reforms in the 1970s to between US$40-45 Billion per

year in the second half of the 1990s (Tseng and Zebregs 2002). FDI started increasing

rapidly from 1991 especially after the „southern journey‟ supporting rapid growth and

reforms for opening China up to the rest of the world made by the late Deng Xiapong in

1992. This tour brought about an era of renewed confidence and entrepreneurship.

China experienced a slight reduction in FDI inflow during the Asian Crisis but was back

at an increase soon after; due to its participation in the WTO. The main sources of FDI

inflow in China were officially Hong Kong (SAR) and Taiwan Province of China. The

importance of these countries as the main sources of FDI diminished in the 90s as

multinational companies from Europe, Japan and the United States entered China, but

even so Hong Kong and Taiwan Province of China still account for almost half of the

FDI in China. Foreign Investors in China fall under two main categories; those using its

cheap labour for an export platform and those who are there to target the Chinese

market itself (Henly, Kirkpatrick and Wilde 1999). Small scale investment firms, often

originating from Hong Kong fall into the first category while transnational and

multinational companies from Europe, Japan and the United States fall into the second

category. Looking at sectored distribution of FDI the largest amount of FDI is generated

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from manufacturing, this accounted for almost 60 percent of total FDI in the year 2000.

Next following manufacturing was real estate at 24 percent, followed by distribution

(which consists of transport, wholesale, and retail) at 6 percent. (Tseng and Zebregs

2002). The manufacturing sector is made up of labour intensive manufacturing

(examples are textiles and clothing, food processing and furniture), technology intensive

manufacturing (examples are medical and pharmaceuticals, electrical machinery and

equipment), and capital intensive manufacturing (examples are petroleum refining,

chemical machinery). These propose that to majority of the companies, the motivation

to invest in China is to enable them take advantage of the low labour costs that it has to

offer.

Geographical distribution of FDI in China shows a great amount of inequality among the

regions. The eastern region accounts for the majority of the FDI flow into China. The

inequality of distribution of FDI originates from the FDI policies implemented by the

Chinese government during the early reform times. Much of the early reforms where

experiments on selected regions and industries; this was for the purpose of allowing the

authorities to assess the results of allowing FDI before permitting it to other regions and

sectors. The Open door policy started with the creation of the Special Economic Zones
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(SEZs) in the southern provinces of Guangdong and Fujian at the start of the reforms in

the late 1970s, which were later followed by the opening of another SEZ in Hainan and

14 coastal cities in 10 provinces in the 1980s. This resulted in the overwhelming

concentration of FDI in the eastern part of China. Looking at the main vehicles of FDI in

China, equity joint venture companies (EJV), Cooperative Joint Companies (CJV), and

Wholly foreign owned Ventures (WFO) have been the main ways of obtaining FDI in

China. At the beginning of the reform period China allowed only EJVs as a form of

entry; this was because authorities believed that this form of entry would better benefit

them in terms of gaining advanced technology. Equity joined ventures and Wholly

Foreign Owned Ventures were permitted at a later stage but looking a later data WFO

have become a more popular form of entry because the reassurance provided by

having a Chinese Joint venture partner is viewed as less necessary than it was in the

earlier days of FDI.

Studies done through cross-country regression analysis or interviews with investors in

host countries have illustrated that that characteristics like economic development ( this

includes market size, labour costs etc.) and FDI policy factors (these include tax

incentives, free tax zones etc.) have direct influence on the destination of flows of

capital across national borders. These factors that are part of the location advantage

factors have been important in determining China as an attractive investment area.

Below we look at the different determinants of FDI that have resulted in China being an

attractive place to invest.

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Market Size

Market size has been an important determinant of FDI worldwide, in the case of China

this has been important for countries like Europe and the United States than for FDI

from Hong Kong and Taiwan Province of China; this is because the former are

domestic market-orientated investors and the latter are mainly export-orientated

investors. Gross National Product (GNP) is used to reflect the economic development of

a country. It shows the potential demand of a country and therefore gives a good

estimate of the countries market size. Investors therefore use it as an indicator of a

countries market size. FDI has been attracted to China due to the enormous market

potential that China has to offer. The table below shows the GNP of China between the

years of 1989 and 1999; showing the gradual increase in GNP therefore the increase in

market size which has resulted in China being an attractive Investment area.

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Supply of Cheap Labour

Foreign Investors seek to take advantage of the host countries‟ cheaper factor inputs

compared to their home countries; the cost of labour is often considered as one of the

most important factors. In other words, foreign investors display sensitivity to inter-

country variations in labour costs when making their location decision(Broadman and

Sun 1997).Low wage costs have played a big role in attracting FDI towards China and

in the distribution of FDI flow across it provinces. Analysts have suggested that these

low wage costs have been an important factor in attracting the export-orientated FDI

from Hong Kong and Taiwan Province of China due to the rising wage costs in their

countries and the economies in the region. This has resulted in China‟s emergence as

one the important global competitors in the labour intensive manufacturing. Another

factor that FDI investors look at is the quality of labour, over the years China has been

less attractive to FDI because of this factor but due to the governments‟ continuous

efforts to improve the quality of education it has been improving (for example they are in

negotiations to open a second campus for The University Of Nottingham in Shangai).

We can view the progress of quality of education by looking at literacy rates over the

years. As we can identify in the charts below over the years the literacy rates of both

youth and adults have increased making China not only favourable because of its

quantity of labour but also its quality.

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Infrastructure

Infrastructure development in an area is also important to investors when making

location decisions. It covers many dimensions, from highways to railroads to

telecommunication systems and institutional developments. Studies have shown that

provinces in China with more developed infrastructure receive more FDI (Tseng and

Zebregs 2002). FDI in China is concentrated on the eastern coastal areas, these areas

have superior infrastructure and transport links to external markets. In these areas

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which are mainly Open Economic Zones (OEZs) the government delegated investment

decisions to the local government which allowed them to develop the infrastructure and

has therefore attracted investors. Another important factor which attracts investors is the

geographical location of a place in the case of China the provinces located on the

coastal areas attract FDI; not only because of its accessibility to ports and other markets

but also because of the government FDI policy regimes in these areas. These

improvements can be viewed in the following table sourced from the World Bank (IMF

Policy Discussion Paper Pg 10).

Scale Effects

Studies have analysed looking at the flow of FDI that not only in China but with FDI

everywhere, that once a country or a province has attracted a critical mass of FDI, it will

continue to receive FDI as investors perceive the presence of other investors as a

positive signal (Cheng and Kwan 2000). Economies of Scale also make it more efficient
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for foreign multinationals to locate in the same area because it allows them to share

information and facilities. Coastal Provinces especially in the southern Province of

Guagdong and Fujian, which are close to Hong Kong and Taiwan Province of China,

have been the largest attracters of Foreign Investors. With investors already present in

the area it makes the area an attractive location to invest because most companies are

followers.

Reduced Barriers and Preferential Policies

The reduction of barrier to investment and improvement of polices in the investment

environment have played a major role in attracting FDI into China. The Chinese

government starting from the reforms era after having considered attracting FDI an

important goal to achieve as it would introduce new technologies know-how and capital

and also help in developing the export sector which would increase income. The

government was afraid of the risks posed with opening up their economy but overtime

clarified the legal environment for FDI by relaxing government controls, and improving

and providing practical assistance, as well as political and legal assurances (Tseng and

Zebregs 2002). This started out with experiments limited to a few locations and sectors

at the beginning of the reforms and later on resulted in more regions and economic

sectors being opened up by the 90s. These actions taken by the government of China

to make China a more open economy has made it an attractive location for investment

by many investors.

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The preferential policies set up to attract FDI by the government have been tax

concessions and special privileges for foreign investors, and the establishment of OEZs.

The tax incentives for Foreign Funded Enterprises (FFEs) are mostly in the form of

reduced enterprise income tax rates and tax holidays. These incentives are available to

all FFEs and domestic enterprises in the OEZs and to export orientated and advanced

technology FFEs outside the OEZs. In addition to these incentives firms in the OEZs

enjoy high level of autonomy in managing operations, this is because the experience

very little control on goods movements, and are allowed to export almost freely. These

firms also benefit from more flexible labour relations and more liberal land use. There

are also additional benefits for export orientated and advantage-technology FFEs, these

include tax exemption on profit remittance, additional tax benefits for re-invested profits,

and larger reduction in land use fees. Governments have the ability to influence the way

investors view their economy, China has been successful in fulfilling the requirements in

making China an attractive investment spot. (View the appendix for detailed

document on government laws and policies for FDI)

To sum it all up over the years from the beginning of the reform era China has been

successfully establishing itself as a hot spot in Asia to invest. It has gained its position

as not only one of the largest FDI recipient in the world but also the largest recipient of

FDI in Asia. Factors that have contributed to making China the most attractive place in

Asia to invest includes the large market that China has to offer, Cheap Labour for

reduction of total production costs, well developed infrastructure that has a range, scale

effect resulting from investors‟ perception and reduced barriers to FDI and preferential

policies. Even with the risks that government‟s fear FDI can bring, the government of
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China has been able to successfully open up China to the rest of the world and have in

return gained a lot. FDI inflows have been more than sufficient to finance periodic

current account deficit on the balance of payment, it has made significant contribution to

investment and industrial output, and increased employment rates among many other

benefits.

APPENDICES

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