5 Foreign Direct Investment in China: Some Lessons for Other Countries (2024)

Key Trends and Characteristics

FDI inflows to China have surged from almost nil at the start of reform in the late 1970s to between $40 billion and $45 billion a year (nearly 5 percent of GDP) in the second half of the 1990s (Table 5.1; Figure 5.1). The surge occurred in the early 1990s, following Deng Xiaoping’s tour of the southern coastal areas, where he reaffirmed China’s continued commitment to reforms and to opening the economy to the outside world. His tour ushered in an era of renewed confidence and entrepreneurship. Although FDI inflows declined slightly during the Asian financial crisis, they picked up again in 2000, partly in anticipation of China’s accession to the World Trade Organization (WTO). By the 1990s China had become the second-largest FDI recipient in the world, after the United States, and by far the largest recipient among developing countries, accounting for about 25-30 percent of FDI flows to all developing countries.

However, part of China’s success in attracting FDI may be exaggerated because of misreporting and round-tripping. The latter refers to capital originating in China that is sent to other economies and then returns disguised as FDI to take advantage of tax, tariff, and other benefits accorded to foreign but not domestic investment. The extent of this round-tripping is difficult to assess; estimates range from 7 percent of inflows in 1996 to almost 25 percent in 1992.1 Some FDI is actually better characterized as foreign borrowing, because the inflows in question (mainly for infrastructure) were guaranteed a specified rate of return. Misreporting may also be a problem, because local officials have an incentive to exaggerate their ability to attract FDI, and foreign investors have an incentive to overstate their actual investment in order to report lower taxable income.

Hong Kong SAR and Taiwan Province of China have traditionally been important sources of FDI in China (Table 5.2). Their importance diminished somewhat in the 1990s as multinationals from Europe, Japan, and the United States entered China, but these two economies still account for almost half of FDI inflows.

The largest share of FDI is destined for manufacturing, which took up almost 60 percent of total contracted FDI in 1998 (Figure 5.2). Next is real estate at 24 percent, followed by distribution (transport, wholesale, and retailing) at 6 percent. Among manufacturing industries, about half of FDI has been directed toward labor-intensive products such as textiles and clothing, food processing, and furniture. Technology-intensive manufacturing (for example, medical goods and pharmaceuticals, electrical machinery and equipment, and electronics) and physical capital-intensive manufacturing (for example, petroleum refining and chemical materials) share almost equally in the remainder. This suggests that an important motivation for foreign companies has been to take advantage of China’s low labor costs.

The geographic pattern of FDI in China shows a huge disparity among regions. The eastern region accounts for 64 percent of GDP but took up nearly 88 percent of FDI entering China from 1983 to 1998, while the central region (with 29 percent of GDP) took up 9 percent and the western region (with 23 percent of GDP) attracted only 3 percent (Figure 5.3). This pattern stems from the FDI policies pursued by the Chinese authorities and reflects the incremental nature of the reform process in China. Much of the early reforms consisted of experiments in selected regions and sectors; this allowed the authorities to assess the results of these experiments before extending them to other parts of the country. The “open door” policy started with the creation of the special economic zones (SEZs; see below) in the southern provinces of Guangdong and Fujian at the outset of the reforms in the late 1970s, followed by the opening of another SEZ in Hainan and the designation of 14 cities in China’s coastal regions as “open coastal cities” in the 1980s. This has resulted in an overwhelming concentration of FDI in the eastern part of the country. When the authorities adopted more broadly based economic reforms and open-door policies for FDI in the 1990s, FDI started to spread to other provinces.

Equity joint venture companies, cooperative joint venture companies, and wholly foreign-owned enterprises have been the main forms of FDI entering China.2 Early in the reform period, China allowed FDI only in the form of joint ventures (except in the SEZs), for ideological reasons and because the authorities thought this form was better suited to tapping advanced foreign technology. It was not until 1986 that wholly foreign-owned enterprises were permitted outside the SEZs. Accordingly, equity and cooperative joint ventures accounted for the lion’s share of FDI in 1990 (Figure 5.4). Recent trends, however, show that FDI is increasingly directed into wholly foreign-owned enterprises, which accounted for more than half of total commitments in 1999.

At the start of the reform process in 1978, China was not evidently better placed to attract large amounts of FDI than, for example, India, which at the time shared a number of characteristics with China. Both countries had relatively closed economies, with low average incomes and a large share of the population dependent on agriculture. Neither China nor India was then receiving significant amounts of FDI. This picture has since changed dramatically. India remains a fairly closed economy while China has become more integrated into the global economy. And as India’s GDP per capita more than doubled between 1978 and 2000, China’s GDP per capita quadrupled (in constant dollar terms).

China’s increasing openness to the outside world can be seen in the rapid growth of its foreign trade. Exports and imports as a share of GDP rose from negligible amounts to about 25 percent in 2000. The average tariff rate in China fell from well over 50 percent in the early 1980s to about 15 percent now, less than half that in India. Equally important, because China exempts so many goods entirely from import duties, and because a significant share of imports of goods subject to high tariffs are imported illegally, actual tariff collection as a percentage of total import value has been much lower. The effective tariff rate—that is, tariff revenue as a percentage of total imports—is only 3 percent in China, compared with 23 percent in India (Table 5.3). As a percent of GDP, net FDI inflows into China in 2000 were more than seven times those in India.

Main Determinants

Studies of FDI in China have shown that the determinants of FDI in China are not unique to China but have also been important in attracting FDI to other emerging market economies.3 Two types of FDI flows can be considered: domestic market-oriented flows and export-oriented flows. Domestic market-oriented FDI is motivated mostly by the size and growth rate of the host country. Export-oriented FDI mainly looks for cost competitiveness. The factors that have been most important in influencing FDI in China can be grouped into three categories: economic structure, liberalization and preferential policies, and cultural and legal environment.

Impact of FDI

FDI flows to China have contributed to GDP growth in at least two ways (see Chapter 6):

• Increased capital formation. This effect is estimated to have contributed about 0.4 percentage point to annual GDP growth in the 1990s. The direct contribution of FDI to GDP growth has been highest in those provinces that have attracted the most foreign investment: it has ranged from almost 4 percentage points a year in Guangdong to negligible amounts in most inland provinces.

• Higher total factor productivity (TFP). Empirical research suggests that FDI raised TFP growth in China by 2.5 percentage points a year during the 1990s. Again, this effect was found to be strongest in the provinces that have received the most FDI. Thus, in sum, FDI has contributed nearly 3 percentage points to potential GDP growth for China.

FDI has contributed to GDP growth both directly, through the establishment of FFEs, and indirectly, by creating positive spillover effects from FFEs to domestic enterprises. FFEs tend to be the most dynamic and productive firms in China’s economy. Their output in the industrial sector expanded at four times the rate of other industrial enterprises during 1994–97, and labor productivity in FFEs is almost double that in public sector enterprises. In addition, empirical research has found that domestic enterprises appear to have benefited from the presence of FFEs, through both increased sales and positive spillovers. Such spillovers come about when FFEs introduce new technologies and management skills. They are thought to have become progressively more important as more links began to develop between FFEs and domestic enterprises in the 1990s.

The creation of employment opportunities—either directly or indirectly—has been one of the most prominent impacts of FDI in China. Employment in FFEs in urban areas quadrupled between 1991 and 1999, to a total of 6 million, accounting for 3 percent of China’s urban employment.13 This has been particularly important in ameliorating unemployment pressures stemming from ongoing reforms of state-owned enterprises. FFEs are particularly important employers in the coastal provinces, accounting for over 10 percent of urban employment in Guangdong, Fujian, Shanghai, and Tianjin as of 1999.

FDI has built a highly competitive and dynamic manufacturing sector for exports. The growth of China’s trade since 1978 has been four and a half times that of world trade, and China’s share of world trade quadrupled from 0.9 percent in 1978 to 3.7 percent in 2000—an achievement not matched by any other country.14 FFEs played a key role in this achievement. Between 1985 and 1999 the share of exports accounted for by FFEs grew from 1 percent to 45 percent; FFEs accounted for half of overall export growth and one-third of import growth during this period.

Conclusions

Although more work is needed to flesh out the lessons from China’s experience with FDI, some tentative conclusions may be drawn. Factors important in attracting FDI to other countries have also been key to China’s success. China’s large domestic market, low wage costs, and improved infrastructure, complemented by open FDI policies (especially the establishment of OEZs), seem to have been major factors in attracting FDI. But China could probably attract even more FDI if governance improved and if China’s legal system became more effective in enforcing contracts.

A unique factor in China’s success is the large presence of investors from two of the most dynamic economies in the region: Hong Kong SAR and Taiwan Province of China. Although part of the FDI flows from these economies may be induced by distortions, the fact remains that, together with Singapore, they have accounted for more than half of FDI flows to China.

Apart from the economic environment, political commitment is an important ingredient in attracting FDI. For example, India shares with China many of the structural factors that have been important determinants of FDI: a large market, abundant labor, and a large diaspora. So, a priori, there seems to be no reason why India could not become an attractive destination for FDI. There are, of course, important differences in how the two countries have made political choices. In China the political leadership imposed a vision of the country’s path of growth and development. Nevertheless, these leaders had to overcome obstacles to FDI rooted in history and ideology. They did so by limiting the opening to a few localities initially, but even then a great deal of autonomy in economic decision making was given to the localities, allowing a market-based economy to develop alongside a centrally planned system. Although this decentralization created some problems, it also gave local authorities strong incentives to grow and develop their economies. The success of the initial experiments created strong demonstration effects, which induced broad support for further reforms and opening of the economy. This created a virtuous cycle: as the reforms produced economic fruits, support for reforms became more widespread, allowing more reforms to be implemented.

China’s experience shows that FDI contributes to GDP growth. The effect is likely to be strongest if foreign enterprises develop close links with domestic enterprises, so that the impact of FDI on productivity growth spreads beyond the firms receiving FDI.

FDI will continue to contribute to China’s economic development. WTO accession should lead to a continuation of these contributions, as FDI can be expected to increase, particularly in the services sector, in activities such as finance, telecommunications, and wholesale and retail commerce. FDI will remain an important source of growth and will help offset potential output losses and create employment opportunities for workers whom state enterprise and banking reforms have made redundant. It is noteworthy that the Chinese authorities have invited foreign participation in the restructuring of state-owned enterprises and the resolution of the nonperforming loan problems in the banking sector. In sum, FDI can be expected to continue to play an important role in China’s reform process for some time to come.

Some pitfalls in China’s FDI experience also provide lessons for other countries. In particular:

• China remains burdened by an increasingly complex and biased tax incentive system. The system is heavily targeted at FFEs, favoring them over domestic enterprises. Indeed, two different enterprise income tax laws apply to FFEs and domestic enterprises. With the proliferation of OEZs and the widening of the range of eligible activities, China’s system of enterprise income tax incentives has become increasingly complex and nontransparent, and it continues to impose revenue losses on the government. The problem has taken on greater salience with China’s accession to the WTO, because some of China’s fiscal incentives do not conform with the WTO principles of national treatment and prohibition of export and import replacement subsidies. China is in the process of amending various laws to meet its WTO commitments.

• Growing regional inequalities also remain a problem. By focusing on specific regions, China’s FDI policy has contributed to the growing income disparity between coastal and inland provinces. The Chinese authorities are giving priority to reducing regional income disparities by developing the western and central regions of the country, among other things by attracting FDI to these regions through increased investment in infrastructure.