Foreign Direct Investment into Chinese Economy - Essay Example

1.0 Introduction Since the policy reform process began in 1979, China’s economy has undergone rapid growth and structural change (Wang et al 2002). If ever there was any doubt that “policy matters,” China’s experience over the past 25 years should dispel it once and for all (Dunning, 1994, Sadka, & Rasin, 2002). China is now the largest recipient of foreign direct investment (FDI) in the developing world. According to Wang et al., (2002), recent years have witnessed the emergence of China as one of the most important destinations for foreign direct investment (FDI), with the country receiving about US$403.98 billion by the end of 1999. The emergence of many studies on Chinas’ FDI shows the importance of FDIs to the Chinese economy. The importance of FDI for China’s economy has been demonstrated by empirical research (Kueh, 1992; Zhan, 1993). At the micro level, studies examine technology transfer by multinational enterprises (MNEs) and linkages between foreign subsidiaries and Chinese local firms (Li and Yeung, 1999). Previous studies within these dimensions were generally qualitative and support the view that the entry and operation of MNEs promote the development of Chinese indigenous firms. Research on Foreign Direct Investment (FDI) in the past has attracted much attention from the field of international finance and international marketing. FDI refers to a situation where, a firm invests directly in facilities to produce or market product in another country (Hill 2007:238, Sumulong et al., 2003, Buckley 2004, Shen et al., 2006). Once a corporation or firm undertakes a foreign direct investment, it becomes a Multinational Enterprise (MNE). Examples of foreign direct investment initiatives include: CEMEX a Mexican corporation operating in more than fifty countries; British petroleum, Texaco, ASDA, TESCO (Hill 2007). Hill (2007) contends that FDI takes on two main forms: Greenfield investment, mergers and acquisitions. Hill (2007) went further and argues that, in Greenfield investment, the firm in question establishes a new operation in a foreign country while the later involves acquiring or merging with an existing firm in the country. Acquisition however is usually hostile, because this is usually done against the wish of management (e.g. CEMEX’s acquisition of RMC of Britain and Southland in the United States (Hill 2007, Buckley 2004). In the years that follow after the Second World War, trade and investment have become increasingly intertwined. Within the first few decades after the war, most countries from Asia and Africa viewed Foreign Direct Investment (FDI) with suspicion, and wariness and the flow of FDI towards these areas has been relatively slower (Buckley 2004, Sumelong et al., 2003). To most of these countries, the presence of Multinational Enterprises (MNEs) was seen as an impeachment to their national sovereignty. The situation was further aggravated with previous colonial experience and the fact that to some, FDI was a modern form of economic colonialism (Sumulong, Fan & Brooks 2003). According to the World Trade Organisation (WTO), the flow of FDI has substantially changed the international economic landscape. From1980 it has been argued by a handful of researchers (e.g. Hill 2007, Sumelong et al 2003, Buckley 2004, and Reis & Head 2005) that FDI outflow has overtaken the growth of world exports. The expansion in FDI became relatively pronounced during the period 1985-2000, a period characterized with scores of mergers and acquisitions, the Asian financial crises, the oil boom and privatization programs in Latin America (Hill 2007, Sumelong et al., 2003). In the year 2000, FDI outflow stood at $1.4 trillion (Hill 2007, Sumelong et al., 2003). Figure 1 below gives a summary of FDI and export growth between 1980-2000. Sources: Exports: IMF 2003; FDI Outflows: UNCTAD 2002 Having said this, in the remaining part of the paper I will discuss the causes of FDI inflow into the Chinese economy in the first section, positive effect of FDI inflow and potential benefits of FDI to the Chinese economy, and finally the negative effect of FDI inflow will be presented. There after, I will present in brief some contemporary issues of FDI and finally my conclusion will be presented. 1.1 Causes of Foreign Direct Investment into the Chinese Economy Economic liberalisation is seen as a major way of tackling corruption and prompting economic growth. The liberalisation of the Chinese economy has been cited by numerous researchers as the pillar behind the inflow of FDI into the Chinese economy. Liberalisation according to Aitiken (1997) involves redefining the role of government and the relationship between the government and the economy. Corruption can be explained in terms of the abuse of state power (Hill 2007, Sumelong et al., 2003). A large state machine, which intervenes and regulates intensively and extensively, offers fertile territory for corruption. Politicians and officials will have a great deal of individual power which many are likely to use for personal gains (Hill 2007, Sumelong et al., 2003). Liu et al (2001) states that, China offers an interesting case. According to Liu et al. (2001), in 1978, when China began to open its economy to the outside world, there was little inward FDI and China ranked 32nd in the world league table for international trade (Liu et al 2007).By the end of 2000, however, China had already approved more than 364,345 foreign invested firms, and pledged FDI reached US$676.7 billion (Liu et al. 2001) Liu et al. (2001) went forward and states that China is now among the world’s largest hosts of FDI inflows and in 2000, China’s total international trade reached US$474.3 billion (Liu et al.2001). In 1999, China became the ninth largest trading country in the world. Hill (2007) postulates that, FDI is widely believed to be an essential and important ingredient of economic growth that, in turn, is seen as vital to poverty reduction. FDI adds to total investment in a country and provides a means of transferring production technology, skills, innovation and best practice to the recipient country.Liu et al. (2001) found out that, a virtuous procedure of development for China: the growth of China’s imports causes the growth in inward FDI from a home country/region, which, in turn, causes the growth of exports from China to the home country/region. The Chinese “open door policy” adopted twenty years ago has also contributed to this recently. Hill (2007) since it launched the economic reforms and called for foreign capital participation in its economy in 1979, China has received a large part of international direct investment flows. Hill (2007) further postulates that, China has become the second largest FDI recipient in the world, after the United States, and the largest host country among developing countries. China’s position as a host to FDI is in fact too far removed from any other developing country – and most developed countries – to be equaled. According to Aitiken (1997) in practice, FDI has been a mixed blessing. It can deliver some benefits but it can also undermine local businesses and financial institutions. In some cases, foreign investors use illegitimate means to ‘persuade’ governments to allow them to invest. Bribery is also common when foreign companies are only prepared to invest if they can secure special privileges. In China, this kind of opportunity has been exploited by most FDIs. FDI often flourishes only because of the special privileges extracted from the government and frequently these privileges are the result of corruption. In this sense, FDI sometimes comes at the high price of undermining democratic processes (Hill 2007). Apart from the traditional reason for circumventing tariff barriers, the market size, prospects for market growth, and the degree of development of host countries are very important location factors for market-oriented FDI especially in China (Liu et al 2001). China economic reforms that took place after the collapse of communism have been largely applauded for the massive flow of FDI into the Chinese economy in recent years. China’s experience over the past 25 years should dispel it once and for all. According to Aitiken (1997), the reforms themselves did not, however, cause growth and structural change, but rather created incentives and institutions, absent in the socialist planned economy, that were a necessary precondition for growth and structural change to occur. Liberalization of the foreign trade and investment regimes proceeded incrementally, gradually replacing administrative controls on imports and exports with tariffs and quotas and then subsequently reducing tariff rates and abolishing quotas Aitiken (1997). Thus, the shift in the orientation of the reform process in the early 1990s had a dramatic impact on the volume and destination of FDI inflows to China. foreign direct investment has, therefore, not only contributed to growth and industrialization, but also to changing the ownership and production structure of the economy (Hill 2007). Aitiken (1997) states that, foreign direct investment flourished in the 1990s in part because domestic private companies were constrained, by lack of access to credit and ambiguities about their legal status, from taking up the investment opportunities that were opened for foreign investors Large multinationals such as Microsoft, IBM, Lucent Technologies, Intel, have recently established laboratories in China to benefit from employing the most promising Chinese scientists and technologists available at low cost. In the process of generating research results that are proprietary to the multinational, cooperation with local companies and research institutes supported the development of Chinas high-tech sector (Hill 2007). Thus, here it should be noted that, the recent flow of FDI into the Chinese economy is largely due to the availability of cheap labour, cheap capital and a ready market. Most researchers have argued that, China has a population of 1.2 billion, with a vast potential for consumption. Liu et al (2001) for example states that investors regard the Chinese market as the last enormous market that has not been developed in the whole world (Liu et al. 2007). Over the past decades or more, the scale of Chinas economic reconstruction has been expanding increasingly, with the purchasing power of the people strengthening rapidly and markets becoming increasingly brisk. Although China’s per capita GDP is still very low, its rapid economic growth and continuously increased purchasing power has made China attractive to market oriented FDI, such as in the fields of basic chemicals, drinks, household electrical appliances, automobiles, electronics, and pharmaceutical industries (Liu et al. 2001, Aitiken 1997). The tables below present a summary of FDI inflow into China in the past years. 1.2 Positive effect of FDI flow into China The integration of FDI and trade theories is still at its infant stage. As a result, though the importance of FDI or international trade as individual variables in economic growth has been widely documented, their possible linkages are relatively understudied (UNCTAD), 2002) With respect to China, some researchers have concluded that concludes that foreign MNEs have played a significant role in China’s export growth. In 1994, foreign MNEs accounted for 41 per cent of China’s overall exports (Aitken et al1997). This may be primarily due to the growth in export-oriented FDI. Learning from their foreign counterparts may stimulate exports by local Chinese firms (Sumelong et al 2004). In finance, it is a common practice to view mergers and acquisitions as manifestations of the market for corporate control. Much of foreign direct investments usually take the form of mergers and acquisition and according to Reis & Head (2005), two-third of FDI that took place between the periods of 1987-2001 was in the form of mergers and acquisition. With their relative advantage of capital, technology, and managerial resources that would otherwise not be available to the host country or other domestic firms, FDIs are often seen as monopoly because of their economic, technology and managerial advantage they posses. Subsequently, host countries enjoy these benefits and costs that otherwise is unavailable to domestic firm. This is because of the monopolistic position enjoyed by FDIs (MNEs) with respect to these resources (Weigel &Miller 1972, Hill 2007, Sumelong et al., 2003). These monopolistic advantages come from, superior knowledge; production capabilities not accessible to other local firms; technological advancement and superiority not open to other firms (Hill 2007, Sumelong et al., 2003, Aitken & Harrison 1997). These benefits to host countries include: flow of resources, employment, Balance of Payment, economies of scale and scope, technological and managerial transfer. The above benefits accrue to the host country because of the imbalance of resources between local firms and the FDIs or advantages enjoyed by FDIs or not available to local firms at the same costs within the host countries. According to Aitken & Harrison (1997), a Foreign Direct Investment is often seen as a monopoly because, FDI only operates in situation where they are monopoly in host countries or hold some supremacy over similar companies in countries of interest. The monopolistic position results from the foreign company ownership of some resources, patents that are unavailable at the same price or terms to the local companies (Hill 2007, Wigel & Miller 1972, Sumelong et al 2003). Some other important benefits of FDI to the host country are the transfer of capital, technology, managerial skills, and economies of scale. These benefits come as a result of the monopolistic position of MNEs. Multinational companies by virtue of their large size and financial strength have access to financial resources not available to host country firms (Hill 2007). These funds might be available from internal company sources, or because of their goodwill they may find it easier to borrow, or acquire recent and modern technology. Local firms on their part because of the size of their activities and unknown reputation cannot access these same resources. Thus MNEs become monopolies within the host countries as these resources are open just to MNEs and the competitive table is tilted in their favour. The resulting benefits to host country (e.g. Capital, technology transfer, managerial skills, jobs that would otherwise not be created) are as a result of the monopolistic position of FDIs relative to local firms. In addition, a number of researchers (e.g. Hill 2007, Sumelong et al., 2003, Buckley 2004, Reis & Head 2005) have argue that, FDIs tend to increase their employment rate faster than domestic rivals. This benefit again comes in as a result of their monopolistic position pertaining to managerial skills and scope. These same researchers argue that, foreign firms tended to pay higher wages, and their condition of employment was better. This benefit again comes as a result of economies of scale these companies enjoy because of their monopolistic resources, capabilities and know-how within host countries. Another benefit to host country as a result of FDIs monopolistic advantage can be seen at the level of the host country balance of payments account (BOP). This account is a net of a countries receipt and payments (Hill 2007, Sumelong et al 2003, and Buckley 2004). When and FDI opens a foreign office the capital account of the host country benefit through a receipt because of double entry bookkeeping accounting. The host country again benefit from receipts once part of the goods produced in the host country are being exported. This benefit however is as a result of a pool of financial opportunities open to FDIs and unavailable to local firms (Hill 2007, Reis & Head 2005). Appropriability theory states that companies are reluctant to transfer vital resources, capital, patents, trademarks and management know how to other organisations that can make its decisions independently because the company receiving these resources can use them to undermine the competitive position of foreign company transferring them. These foreign companies through greenfield or mergers and acquisition open up a new enterprise through which consumer choice is increased. Thus the level of competition is increased an economic growth is achieved in the long run, economic growth is stimulated, through product and process innovation (Hill 2007,Reis & Head 2005, Sumelong et al., 2003). Though, this point is a long run benefits it can be argued to be a by product of the monopolistic advantage quality exhibited by FDIs at the beginning. 1.3Negative Effect and Potential costs of FDI to Chinese Economy In the current climate of enthusiasm for FDI and in the current state of events a number of risks and costs associated with FDI at the host country tend to be overlooked. In view of these economic costs associated with the activities of FDIs to host countries many observers (e.g. the radical view) have argue that FDIs because of their inherent monopolistic advantages absent to local firms are an instrument of imperialist domination to host countries. Because of their capital, technology and capabilities and skills a substantial cost is being incurred on the host nation such as over dependency by host country for jobs, investments and technology there by keeping the host countries backward (Hill 2007, Dunning 1994, Sumelong et al., 2003). No wonder the extreme version of the radical view postulates that, “no country should ever permit foreign corporations to undertake FDI, since they can never be instruments of economic development, but of economic domination because of their size and other monopolistic advantages” (Hill 2007:264). Dunning (1994) postulates that because of the opportunities open to FDIs which are unavailable to other local firms, FDIs take advantage to incur a substantial cost to the host economy that of a perceive loss of national sovereignty and autonomy. This same argument has been supported by Hill (2007) and Sumelong et al., (2003) when they argue that in the host country, key decisions are often made by the parent company of the FDI that has no real commitment to the host country, and over which the host country government has no real control (Hill 2007). FDI incur substantial costs to the host nation with respect to the BOP. Once the activities of foreign companies are settled in the host countries, most of its other transactions with the parent company take place in the form of outflow (Dunning 1994). These outflows are reflected in a country’s BOP as a debit (e.g. royalties, dividends, payments for input and a host of MNEs manipulation) and thus, these consequently offset the net payments against the receipt of the host country (Hill 2007). Earnings must be paid back to home country. Though most host country have responded by restricting the amount of earnings and resources to be gotten or transferred to parent company, FDIs because of their monopolistic position always evade taxes through transfer pricing and other accounting manipulations. This offset the host country BOP unfavorably (Hill 2007, Reis & Head 2005, French 1998, Sumelong et al 2003, 1994). Another costs incur on the host country due to the monopolistic position enjoyed by FDIs can be seen at the level of competition. Because of their monopolistic advantage, MNEs have greater economic power than indigenous competitors and consequently competition is tilted to their advantage. These companies might get funds elsewhere to subsidize their cost and consequently local firms will be pushed out of the market resulting to hardship, lost of jobs, over dependency and a host of other costs (Hill 2007, Dunning 1994). FDI with their monopolistic advantage of technological spill-over to host countries, could push a host country into a substantial cost as FDI position could discourage the development of technological know how by and in local firms and institutions to the detriment of growth of domestic producers and the national economy (Sumelong et al., 2003, Eichengreen & Tong 2007). Other costs to host country due to the monopolistic advantage of FDI include: transfer pricing which in most cases reduces the tax revenue going to host country, the brand names attached to the goods of the subsidiaries. Eichengreen & Tong (2007 argue that sometimes the associated advertising with the brand name may give rise to economically and socially distorting consumption. Sumelong et al., (2003) went further and supported this same argument when they contend that such distortions can have a far-reaching detrimental impact, such as when more costly foreign foods are produced. In addition most FDIs because of their position, tend to be capital intensive these may result to social costs in the form of unemployment, when local firms which are labour intensive close down, and there is a net loss of jobs (Hill 2007, Sumelong et al 2003). Effect to host country culture and environment are other areas of FDIs cost to host country. Natural resources are often being exploited by most FDIs out of the sustainable rate and because of weaker environmental laws in host country and the monopolistic advantage; FDIs take advantage and pollute the environment. Through influx of tourists the local culture is destroyed. Sumelong et al., (2003) argue that a widely recognised example concerns the detrimental socio-cultural and environmental impact resulting from FDI which brings in substantial numbers of tourists, some of whom abuse local culture and traditions. Guariglia & Basu (2007) in their study of what impact does foreign direct investment have on indigenous technological efforts, contend that lack of access to modern technology is one of the main reasons why poor countries remain poor. These researchers went further and echo that today FDI has become a much sing-song amplified tool of economic growth until most developing countries are made to believe that through FDI the technological gap with developed countries will be bridged. However, this is not often the case as FDI technology often comes with a cost. Technology transfer by FDI often substitutes domestic technologies in production (Guariglia & Basu 2007). This is so because, in situation where a domestic firm investment in R&D cannot only improve its own technology but that of the country as well. 1.4 The Way Forward The linkages between FDI and trade are complex. It is very difficult, if not possible, to predict whether FDI and trade are substitutes or complements. Gray (1998) suggests that market-seeking production affiliates can displace international trade and efficiency-seeking production affiliates will increase the volume of trade. Heckscher–Ohlin–Samuelson model suggests that international trade can substitute for international movement of factors of production including FDI. According to the model, international commodity trade involves an indirect exchange of factors between countries (Liu et al.2001). For instance Liu et al. (2001) contend that, by exporting capital-intensive commodities in exchange for labour-intensive commodities, the capital-abundant country indirectly exports a net amount of capital in exchange for a net amount of labour (Liu et al2001). According to Heckscher–Ohlin–Samuelson model, even under the assumption that factors are perfectly immobile between countries, factors do migrate between countries indirectly through exports and imports of commodities. In the Mundell (1957) model, production functions are assumed to be identical in all countries and regions (Liu etal.2001). International trade and the international mobility of factors of production, which includes FDI, are considered as substitutes rather than compliments for each other where there are barriers to trade 2.1 Conclusion This paper was initiated to evaluate the costs and benefits of Foreign Direct Investment to the host country as a result of the monopolistic advantages enjoyed by MNEs unavailable to local firms. As mentioned earlier, the economic literature of FDI fully recognizes that, from the stand point of the host countries, there are both important benefits and costs that accrue to host countries as a result of FDIs monopolistic advantages. The benefits include the spill-over effect of the transfer of technology, increased efficiency due to competition, positive effect on the BOP due to inflow of resources, employment and in all consumers may benefit from higher quality and lower costs of goods. These benefits are as a result of the economic potentials available to MNEs and absent or more expensive to local firms. Among the widely accepted and debated costs is the possible negative effect on the environment, culture due to influx of tourists, transfer pricing, manipulation of amount due to host government as taxes, closure of domestic institutions due to competition, negative effects on the BOP. However, in order not to be parochial in our argument it is important to note that the ultimate objective of any enterprise is the creation of shareholders value. This is the rational underlying the theory of investment. There are some other costs and benefits that host countries enjoy not as a result of the monopolistic position (e.g. the establishment of auxiliary and ancillary industry, cooperation with home country etc. Today, most host governments worry that with the inflow of FDI economic independence is loss. Though today, this is a problem to most developing countries, Hill (2007) argue that a quarter of a century ago several European countries expressed concern about United States FDIs as threatening their national sovereignty, this same concern surface in the United States around the 80s with regard to European and Japanese FDIs (Hill 2007). References Aitken, B., Hanson, G. H., and A. E. Harrison, 1997. Spillovers, Foreign Investment and Export Behavior. 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