Is China’s FDI glass half empty or half full? Is the rate of FDI into China slowing to its dismay, or are government efforts to slow inflationary and currency-appreciation pressures bearing fruit? Where is all that money coming from – and where is it going?

China’s GDP grew by 11.4% in 2007 compared to 10.7% in 2006. Despite this phenomenal growth – or perhaps in part because of it – some observers have wondered whether FDI into China is slowing and shifting to greener pastures, with India, Vietnam and Brazil frequently mentioned as alternative destinations, each of which offers its own compelling reasons for investment. But China’s story is not so much about becoming unattractive for FDI as it is about its leaders’ concern that the country could be loved to excess.

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Years of growth

The past few years have seen strong growth in China’s FDI. In 2006, it increased about 9% on 2005 figures. At the end of 2007, FDI totalled $82.66bn, an increase of 18.94% on 2006.

FDI has been the key driver in China’s economic reform effort for the past three decades. By 2007, however, certain adverse effects of China’s astonishing economic growth had become increasingly evident. Food prices were rising – pork, a key staple, rose by 57.7% in 2007. Energy demand soared, leading to brownouts and an increased drain on resources, a tendency exacerbated by pricing restrictions limiting increases in fuel prices as a way to avoid inflation. And real estate values in major cities continued to escalate; despite measures adopted in 2005 to cool investment in the real estate sector, average housing prices in Shanghai rose 11.3% in 2007.

Faced with these strains on the social fabric, the government started to take steps to reduce the rate of economic growth. It tightened credit policy by raising the bank reserve rate five times between September 2007 and March 2008. The State Administration of Foreign Exchange (SAFE) – the agency charged with overseeing renminbi (RMB) exchanges into and from foreign currencies – started to examine foreign currency inflows more closely, particularly foreign-denominated debt. Anecdotal evidence from investors suggests currency exchanges of sizeable amounts had become quite difficult. SAFE now demands supporting documentation for remittances of more than $200,000 and converted RMBs must be deposited directly into the stated third-party recipient’s account (for example, payments to suppliers).

In December 2007, China’s revised Foreign Investment Catalogue took effect. The catalogue classifies industries for potential investment as prohibited (such as tobacco distribution), restricted (for example, conditionally permitted, such as through a joint venture with a China-based partner) and encouraged (investments the government wants to support, sometimes with incentives). Investment that does not fit into one of these three categories is considered permissible but there are no policy incentives applicable to it. Various changes to the catalogue include removing from the encouraged category certain kinds of basic manufacturing that China clearly has mastered (this foreign investment is now permitted but not encouraged) and limiting foreign investment in certain kinds of real estate activities. Even so, FDI in the first half of 2008 was estimated to have increased by 45.55% compared to growth in the same period in 2007.

So where has all this money flowing into China been coming from? Given media coverage of US-China trade and business ties, one might suppose a significant portion of it comes from the US, perhaps followed closely by EU member countries. In fact, less than 7% of China’s FDI in 2007 came from the US and only 6.3% came from EU countries. The vast majority – 72.5% – came from other countries and regions in Asia, such as Taiwan.

Sectoral investment

And in which industries is the money being invested? The top five sectors receiving FDI in 2007 were manufacturing (49.43%), real estate (20.68%), leasing and business services (4.86%), wholesale and retail distribution (3.24%), and information communications, computer services and software (1.8%).

Manufacturing is king when it comes to FDI in China. But given the country’s changed Foreign Investment Catalogue and other considerations, is that where the government wants FDI to flow? What is China’s wish list when it dreams of ideal FDI distribution? According to the State Administration of Industry and Commerce – which is charged with regulating business conduct by both domestically invested and foreign-invested companies in China – the five most highly desired types of investment projects are:

  • New agricultural technologies, resources and raw materials.
  • Advanced or new technologies that improve product function, energy savings and raw material use, as well as technologies that increase economic benefits for production of equipment or products that China needs but currently cannot produce on its own.
  • Projects adapted for international market requirements that can raise product standards, help to open new markets, expand product sales or increase their export.
  • Technology and equipment that facilitate energy savings and renewable energy and protect against environmental pollution.
  • Projects that draw on the strength of the people and resources in China’s central and western regions, in conformity with the nation’s industrial policy.

 

Contrast this wish list with where China’s FDI went in 2007 and a gap can quickly be seen: real estate is nowhere on the list, yet more than 20% of FDI in 2007 went into real estate. China seeks energy conservation and environmental protection-related investment, but 0.36% of FDI in 2007 went into this field.

Manufacturing is still desired but China wants to move up the value chain in terms of the projects it attracts. This might partly explain why, despite the fact that only quite small percentages of FDI come from the US and the EU, China still wants to attract companies from these areas because they are home to the kind of top-notch, leading-edge companies it wants to emulate in its quest to advance its economic capabilities.

The story about China’s FDI is not so much about declining FDI as it is about the challenge of attracting the desired type of FDI. And in that regard, the glass looks half empty. It remains to be seen whether or not 2009 will bring an improvement. n

Amy Sommers, a partner in the Shanghai office of international law firm Squire, Sanders & Dempsey.