According to last September’s World Investment Report 2004: The Shift Towards Services, China topped the global FDI inflows with a realised total value of $54bn in 2003. Luxembourg may have registered an astonishing $87bn inflow but that figure is driven by so-called trans-shipment, a transfer of funds between affiliates within the same group located in different countries.

China has constantly ranked among the top five destination countries since 2001. This reflects its overall strength in attracting the relocation of global production bases and its relentless efforts to bring in multinational companies (MNCs). However, it needs to refine its FDI strategy to sustain its lead and leverage FDI to promote economic growth.

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The fundamental factor driving large amounts of FDI to China is no secret: fast GDP growth with stability and a large, open domestic market. Despite all the potential statistical imperfections, China is growing fast with tremendous improvements in human resources and infrastructure.

For those who feel threatened by China’s growth, the immediate response can be summed up by the eloquent remark recently made by Rubens Ricupero, former secretary-general of the UN Conference on Trade and Development (Unctad): “The problem was not that there is too much growth in China, but that there is too little in other developed countries, in the least develop countries, in Africa, Latin America, Europe and Japan.”

If most countries can do well in their home markets, they will help each other generate more investment and growth. That said, China’s FDI policies and specific locational advantages cannot be ignored. Examining these can lead to a better understanding of China’s success and its future direction.

Dual drivers

There are two sets of factors driving China’s efforts in attracting FDI. The first set is common to all countries, namely introducing technology, acquiring management know-how and expanding export markets. The second set is unique to China. Institutional barriers exist that prevent state-owned enterprises (SOEs) from operating on a market mechanism-based model. Setting up joint ventures thus becomes a way to enjoy both preferential treatments and economic freedom.

These two sets of factors will evolve in different ways and have different implications for FDI flows to China.

The first set will remain essentially intact but the realisaton method will change. In recent years, China has accelerated the opening up of industries that were previously closed to foreign investors. Meanwhile, it has also tried to channel FDI to desired industries, emphasising high technology, export orientation and environmental friendliness.

However, World Trade Organization accession commitments mean that China needs to abide by the national treatment principle. Various performance requirements, such as local content, technology transfer and export performance, need to be gradually eliminated. In other words, the investment regime will be further liberalised, not just in the sense of market access, but also the overall investment policies.

Removal of entry barriers will bring in more FDI especially in services, which will be market-seeking in nature. This will not generate more pressure on other economies because market-seeking FDI is not a zero-sum game. If there are more open, profitable markets, global capital flows to them can increase simultaneously. Introduction of national treatment and elimination of performance requirements will reduce the cost of investing in China, thus boosting efficiency-seeking FDI. This may lead MNCs to shift away from the economies that require more stringent performance requirements than China.

Multilateral systems, such as the General Agreement on Trade in Services (GATS), Trade Related Investment Measures (TRIMs) and the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPS), aim to create a comparable market environment for all member states, but there is considerable leeway for national governments to formulate their own policies. The result will depend on how the policies gradually take shape in the process of conforming to the accession rules. This itself closely relates to the other set of factors and China’s domestic reform agenda.

New environment

The second set of factors, relating to SOEs, will change significantly and alter the market environment that foreign firms will face in China. Many, if not the majority, of China’s best SOEs in industries accessible to foreign investors have set up joint ventures with foreign companies. In the foreseeable future, as the number of SOEs in the national economy continues to shrink, China will facilitate the entry of private domestic firms. MNCs will tend to build up their own affiliates rather than look for Chinese domestic partners. At the same time, they will face more competition from private Chinese firms as their numbers increase. All of these will become attractive features of the Chinese market.

Foreign invested enterprises (FIEs) have provided an alternative to private entrepreneurship because private Chinese firms have been largely discriminated against. In the past 20 years, the highly efficient FIEs have contributed a great deal to the Chinese economy. In 2002, even though FDI accounted for only one 10th of the gross fixed capital formation, FIEs contributed one third of the industrial output, one quarter of the value added, more than half of the exports, and nearly three quarters of the foreign exchange balances held in Chinese banks by corporations.

FIEs also generated nearly one fifth of the total tax revenues and 23.5 million job opportunities, employing about one 10th of urban workers. These numbers suggest FDI has contributed nearly one quarter to one third of China’s GDP growth.

Distorted view

Despite these positive aspects, the numbers also suggest that FDI has created some distortions in China’s economic picture. Most domestic capital is inefficient, and SOEs and private firms cannot compete with FIEs in many manufacturing industries. As entry barriers are further broken down in services, FIEs will play a more dominant role in a broad array of industries.

Though FIEs generate income, tax and jobs as domestic firms do, a nation’s long-term competitiveness arguably depends on its own entrepreneurship and the capabilities of enterprises built up by its citizens to compete in the global market. In this sense, China needs to offer less preferential treatment to foreign firms.

More broadly, the country must shift its FDI strategy by steadily removing the distortions created by FDI and alleviating the reliance of its GDP growth on FIEs. It needs to complement this shift with an active domestic investment promotion strategy – facilitating market entry for domestic non-SOEs and improving the competitive environment so that domestic entrepreneurship can grow faster.

The right direction

If the aim of attracting FDI to China is to introduce advanced technology, improve management and expand markets, it would appear to be working. More and more private Chinese-owned spin-offs of the FIEs are capable of competing with these FIEs in China as well as in the global markets.

China needs to learn from post-World War II Germany and avoid the experiences of Botswana. The former encouraged foreign investments but was not dominated by them – instead, it succeeded in strengthening its own innovation capacities. By contrast, foreign companies have to a large extent dominated the economy of Botswana, with daunting social and political consequences, even though FDI has contributed to the economic growth of the country.

To many foreign investors with market-seeking motivations, preferential treatment is not the determining factor in their investment decisions anyway. Thus it is not a sustainable strategy for attracting efficiency-seeking FDI. China must create an open and fair competitive environment for all firms, domestic and foreign alike, to cultivate the growth of national champions.

As it strives to build up a rule-based market economy that respects policy transparency, protects intellectual property rights and upholds fair competition, China will increase its advantages in attracting FDI. But FDI structures will be shaped by the new instruments, and round-tripping FDI is likely to decline and disappear eventually, reducing China’s FDI figures statistically. That in itself may relieve other countries’ concerns, though the magnitude of this change may be hard to detect in the short term.

Asian co-operation

In addition, China needs to make more of an effort to deepen Asian production integration, which is transforming the FDI structure of the region. If Asian countries all compete for similar types of FDI projects, they will only end up hurting each other and themselves. Competition itself is not necessarily detrimental because it can compel countries to improve their investment climates. However, too much competition, especially in granting preferential treatments to FIEs, may have distortional effects on the competing countries’ domestic economies.

As manufacturing constitutes two thirds of FDI into Asia, it is dangerous for Asian countries to compete too heavily with each other on this front. To curb unhelpful intra-regional competition and experience the benefits of regional integration, China and other Asian countries should consider creating a division of labour among themselves.

The Association of Southeast Asian Nations (ASEAN) investment framework encourages Japanese companies to build regional production networks, with individual member states playing different roles at different stages of production. This may increase economies of scale and improve regional competitiveness.

Similar initiatives should be actively pursued throughout the region. Through them, individual Asian countries may concentrate on nurturing specific advantages and encouraging bilateral investments.

For instance, Hong Kong, Singapore and Shanghai along with Tokyo can become the financial centres of the region. Production bases for garments, textiles and toys – as well as hubs for software development – can be established in China and India. Electronic parts and components can be produced in Thailand, Malaysia and Singapore with electronics assembling and telecoms equipment focused in China and Indonesia. Automobiles can be manufactured in Thailand, South Korea and China.

Countries in the region could deepen their co-operation in information technology infrastructure as well as research and development.

Combined impact

If ASEAN plus China, India and South Korea integrated as a single market, the entity would have the largest population and the third largest GDP in the world. If Japan were included, these economies would form the world’s largest trade union with a market size bigger than the North American Free Trade Agreement and EU combined.

China can remain a leader in attracting FDI and leveraging it for development but only by upgrading its institutional environment, phasing out distortionary preferential policies and deepening integration with its neighbours.

Yong Zhang is a consultant at Unctad. The findings, interpretations and opinions expressed in the article are solely those of the author and do not represent the views of Unctad.