The Impact of Foreign Direct Investment on China's Economy - Case Study Example

Foreign Direct Investment (FDI) is defined as the investment outside the boundary of the investing side’s home country. FDI also suggests special type of capital flow, which includes tangible assets, technology transfer, and intangible assets like managerial skills. Hence FDI can also be defined as a form of international inter-firm cooperation controlling host country enterprises (Michi, Cagatay & Koska, 2004). Foreign investments can be in three forms – foreign direct investments, indirect foreign investments and official loans. FDI includes investments in physical assets such as plant and machinery and it is based on an equity ownership of at least ten percent (Forfas, 2002). The main types of FDI are acquisition of a subsidiary or production facility or participation in joint venture, licensing and establishing of Greenfield operations. FDI has been growing faster than the world GDP and is now a major component of foreign investment (Razin & Sadka, 2005). The effect of FDI on GDP is higher than the effect of other forms of foreign investment. Studies suggest that FDI triggers technology spillovers, assist human capital formation, creates a competitive business environment and enhances enterprise development (Tusiad & Yased, 2004). The FDI inflow in China had mixed impact which ranged from increase in GDP, expansion of foreign trade, increase in fixed investment, reduction in unemployment, technology transfer, while creating disparities in income across different regions within the nation. The sudden emergence of China as the FDI recipient has gained importance. From an isolated economy in 1979, China has become the largest recipient of FDI in the developing world and globally the second, only next to the United States (Zhang, 2001) because of its proactive policies towards FDI (Fung, Iizaka & Tong, 2002). China’s distinction is its enormous population and its huge size. China experienced an FDI boom for seven years from 1992-1998 and the factors that contributed to it included further liberalization of FDI regime in China coupled with the explosive growth of the domestic economy. Another interesting feature was that most of the FDI came from Hong Kong, Taiwan and other Asian countries and not from the western nations. The Asian FDI concentrated on labor-intensive low-technology goods like garments, toys and shoes meant for the international market. The western-FDI placed emphasis on capital-intensive goods like machinery, chemicals and services. FDI in China was concentrated in the coastal region which has been associated with regional differences within China and the historical cultural links with foreign investors. Much of the literature on FDI in China suggests that although bulk of FDI came from Asia (excluding Japan), most of it was from Hong Kong and that too by the domestic Chinese who routed it through Hong Kong. The table demonstrates the inflow from different countries: Cited from Fung, Iizaka & Tong (2002). Gradual reforms took place over two decades and FDI came into China in five different forms: equity joint ventures (EJVs), cooperative operation enterprises or contractual joint ventures (CJVs), wholly foreign-owned enterprises (WFOs), foreign sharing-holding enterprises (SH) and joint exploration (JE). Initially FDI was in the form of contractual joint ventures where the risk of foreign participants is lower. As further reforms measures were adopted and the business environment improved, and the government concentrated on promoting high-tech capital intensive projects, WFOs increased (Fung, Iizaka & Tong, 2002). China FDI consisted mainly of Greenfield investments (Graham & Wada, 2001). FDI poured in from countries all over the world and the annual rate of increase in FDI averaged more than 40% over the early 1990s which peaked to 175% in 1993 (Berkun, 2001). The industries that the foreign firms concentrated upon were garments, textiles, fur, leather and machinery. Chain’s economy was transformed from a Soviet style planning system and international isolation system to a market-oriented economy with increasing interdependence with the world economy. The impact of FDI on China’s economy came in different ways. The table below gives the actual FDI utilization: Cited from: Fung, Iizaka & Tong (2002). Between 1979 and 2000 China’s GDP grew by 9.5% annually on an average from RMB 36 billion to RMB 882 billion (Fung, Iizaka & Tong). GDP per capita also increased at an annual rate of 8.3%. The direct contribution of the FDI to GDP growth was in the provinces that attracted the highest foreign investment and ranged almost 4 percentage points per year in Guangdong to negligible amounts in most inland provinces (Tseng & Zebregs, 2002). The southern coastal provinces registered the highest growth while the western inland provinces had the minimum growth. FDI also raised the total factor productivity (TFP) growth in China by 2.5 percentage points per year during the 1990s. This too was the strongest in the provinces that received the highest FDI. The per capita income in the poorest provinces of China grew faster than the rich provinces during the early 1980s (Graham & Wada, 2001). At that time FDI was a not an important factor of growth as it stands today. The process was reversed when foreign investment started pouring into the coastal areas. The areas which had state-owned enterprises registered much less growth and the reason could be that foreign investors were not too keen to invest in such areas. As FDI to the nation increased, economic opportunities increased, which led to higher growth and consequently attracted higher FDI. This implies that FDI inflow and the economic growth were interrelated. FDI has a direct benefit that it leads to capital accumulation. As the FDI increased the total fixed investment also increased (Tseng & Zebregs). By late 1990s the total fixed investment had crossed over 10% but after the Asian financial crisis broke, the investment on fixed assets from foreign sources decreased. By 2000 the foreign investment had come down to 7% of the total investment in fixed assets. The foreign funded enterprises (FFEs) were the most dynamic and productive firms in China’s economy. Their labor productivity was double that of the public enterprises (Tseng & Zebregs). The FFEs introduced new technology and management skills. This led to increased demand and productivity which led to higher sales and positive spillovers on the domestic firms. This led to increased growth in all sectors. Increased flow of FDI in China led to its trade expansion with other nations. Fung, Iizaka & Tong point out that by early 1980s both Taiwan and Hong Kong were established exporters and their domestic costs were rising. They were looking for alternative production sites and found the environment and the labor costs suitable especially in China’s Southwest region. Finding a favorable policy environment and social and cultural compatibility, China became the preferred destination. Chinas total trade increased from US$ 38 billion in 1980 to more than US$ 474 billion in 2000 (Fung, Iizaka & Tong). China featured 26th in the list of exports from any nation but it came up to the 7th position in 2000. The growth of China’s trade since 1978 was phenomenal. Its share of world trade quadrupled from 0.9 percent in 1978 to 3.7 percent in 2000. Again the FFEs had a major role to play. The share of exports grew by 45% between 1985 and 1999 (Tseng & Zebregs). The FFEs accounted fro half of overall export growth from China. The growth in foreign trade came from non-Japanese Asian source FDI that flowed into labor-intensive export processing units. Thus the exports from China mainly comprised of electrical and electronic goods, apparel, toys, footwear, instrument and furniture. FDI that came in from the western countries was invested to serve the local markets and not for exports as in the case of FDI from the Asian countries. Most of the investment was in the areas of import-substitution. One of the important reasons that countries want foreign investment is that it brings with it latest technology. China benefited immensely by such FDI flow as the local subsidiaries would have access to technology. FDI also leads to indirect productivity gains for host country firms as they also provide training in labor and management. China allowed several benefits to the foreign firms as an incentive to attract technology and expertise in management (Fung, Iizaka & Tong). With increased FDI came technology transfer and technology transfer accelerated the growth of the TFP. General Motors (GM) brought R&D functions into China at the request of the government. When other automobile companies were reluctant to drain technology and quality control, and confined themselves to assembly of finished cars, GM took the bold initiative to tie up with the government for R&D functions. GM’s PATAC, a joint venture R&D centre is an independent automotive research development company (Hara & Nakanishi, 2004). Today GM has local production, has established an R&D function, as well as developed its own sales channels to create a local sales function. China thus benefited immensely from the technology transfer. With the growth of FFEs in China, employment in the urban areas quadrupled between 1991 and 1999 to a total of 6 million accounting for 3 percent of China’s urban employment. The state-owned enterprises were undergoing reform and this led to unemployment but the presence of FFEs helped to ameliorate this unemployment to a large extent. In the coastal provinces the FFEs accounted for ten percent of the urban employment (Tseng & Zebregs). As stated above, the provinces that received high amount of foreign investment had higher growth than the inland areas. As such the income disparities became evident and this has made the Chinese government improve the infrastructure in the western inlands so that they become equally feasible in attracting FDI (Tseng & Zebregs). While some see this as a negative impact of FDI, it has in fact created a circumstance by which the entire nation could experience the same pace of growth. This move by the government is intended to reduce the income disparities across the nation. The foreign firms had the liberty to import or export on their own account and they also enjoy tax exemptions and concessionary tax rates (Fung, Iizaka & Tong). They were also allowed to import raw materials and machinery duty-free the only condition being that they were engaged in exports. The income tax laws differ for domestic enterprises and the foreign funded enterprises. China’s system of enterprise income tax incentives has become increasingly complex and non-transparent in addition to causing revenue loss for the government (Tseng & Zebregs). As China gained accession to WTO, this problem was further aggravated s some of the fiscal incentives do not conform to the WTO principles of national treatment. The most significant transformation that FDI brought to China was that economy hitherto state dominated now became a market-oriented economy. FDI was responsible for ownership restructuring in China’s industry. In 1995 about 12% of the firms were state-owned which dropped to about 6% in 1999 (Fung, Iizaka & Tong). The increased FDI flow intensified competition in the domestic market which sent wake-up signals to the state-owned enterprises. This helped to amend the laws towards a market-oriented economy. Because of the trade reforms and liberalization which attracted huge amount of FDI, China gained accession to WTO which helped the economy further. The manufacturing units that were set up the foreign firms were known as export processing units because intermediate goods were received in semi-finished condition which was then processed and exported. The growth of foreign firms that were mainly engaged in exports did help the economy to create jobs but not much of technology inflow was necessary as goods came into China in semi-finished state. It thus helped little in the integration of the domestic firms and did not cause them to grow. At the same time, the FFEs used very little input from the domestic sources compared to the domestic firms and hence very little value was added to the finished products which were subsequently exported. While some companies benefited by the reforms in China, not all gained success. Whirlpool had to discontinue when they found that domestic companies could manufacture similar products and charge less (Berkun, 2001). The later entrants did a thorough research before entering China. Kodak entered through acquisition of ailing Chinese film manufacturers and invested huge amount. Motorola too was successful. The FFEs investment was heavy in transport and food processing sectors, and was concentrated in serving the local markets. There was no domestic competition in these areas and hence the government measure to stimulate technology transfer or better performance from the FFEs were futile efforts (Tseng & Zebregs). Due to lack of competition there is no incentive to introduce the latest technology. This was especially true in the case of joint ventures where a local supplier was involved over which the foreign investor has little control. The foreign firm would not be too keen to divulge much of technology in case of joint ventures. The domestic firms could have taken advantage of the situation and Chinese government could have encouraged competition. This could raise the standard of the domestic firms while keeping the FFEs cautions not to slack in their efforts. In general manufacturing sectors however, the state-owned enterprises had to revise their policies and compete with the foreign firms. They also benefited because they too could improve performance, which helped in the growth of the overall economy of China. Although FDI brings with it technology transfer, in the case of China initial and most FDI came from Hong Kong and Taiwan and that too in labor intensive industries. So there was not much of technology benefit that China gained initially but it did benefit from “soft” managerial and marketing skills as the markets in Hong Kong and Taiwan were already mature (Fung, Iizaka & Tong). The evolution of FDI in China has been described as setting up a friendly environment for foreign business including physical infrastructure and administration, with the aim to attract FDI. The process of liberalization and consequently the opening up of the economy took place in stages. At each stage as reforms were adopted, more FDI inflow took place. In the late 1990s the target was to gain accession to WTO which too was achieved. After the accession, the concentration is on the service sector, banking, insurance and allied areas. The benefits that foreign investment gained were overall development of the nation once the economic disparities were identified. Despite different arguments and disagreements, China has gained by opening up the economy and attracting FDI. Although it happened in stages, the country benefited in different ways. What to some appeared to be drawbacks was actually an indirect benefit. For instance, regional disparities or increased competition for the state-owned enterprises all ultimately served to benefit the overall growth of the country and brought it to the position where it is today. China gained in technology, gained in utilization of resources, could reduce employment, and improve the manufacturing sector and later the service sector. All these ultimately helped the nation gain access to WTO for which it had been trying for several years. The increases in FDI at every stage gave it a boost to proceed to the next stage which it has been able to successfully achieve. References: Berkun, S., (2001), Foreign Direct Investment in China, 21 Oct 2007 Forfas (2002), World Trade Organisation Negotiating Objectives for Irish Enterprise Policy, The National Policy and Advisory Board for Enterprise, Trade, Science, technology and Innovation, 21 Oct 2007 Fung, K. C., Iizaka, H., & Tong, S., (2002), Foreign Direct Investment in China: Policy, Trend and Impact, 21 Oct 2007 Graham, E. M., & Wada, E., (2001), FOREIGN DIRECT INVESTMENT IN CHINA: Effects on Growth and Economic Performance, 21 Oct 2007 Hara S & Nakanishi K (2004), AT10 Research Conference, The Asia Strategies of Japanese Corporations, 21 Oct 2007 Michi, H., Cagatay, S., & Koska, O., (2004), THE IMPACT OF ENVIRONMENTAL REGULATIONS ON TRADE AND FOREIGN DIRECT INVESTMENTS, 21 Oct 2007 Razin, A., & Sadka, E., (2005), Corporate Transparency, Cream-Skimming and FDI, 21 Oct 2007 Tseng, W., & Zebregs, H., (2002), Foreign Direct Investment in China: some lessons for other countries, IMF Policy Discussion Paper, 21 Oct 2007 Tusiad & Yased, (2004), FDI attractiveness of Turkey, 21 Oct 2007 Zhang, K. H., (2001), What attracts foreign multinational corporations to China? Contemporary Economic Policy, Vol. 19 No. 3 pp 336-346 Read More