China is a huge sucking machine for world capital.
Huge consumer market, massive cheap labour and large pool of talents serve as a gravity for world capital into China.
China well positioned for foreign direct investment
By Richard Daniel Ewing
(18 December 2001) Global foreign direct investment has plunged this year to its lowest levels since 1997, reducing capital flows to developing nations around the world, but China seems immune to the global drop—at least for the moment.
Although the potential for China to suffer reduced investment exists, several factors suggest that the country will maintain high levels of investment despite dire global economic conditions.
The foreign direct investment boom that began in the early 1990s and peaked last year at well over US$1 trillion has slowed dramatically this year. The United Nations Conference on Trade and Development (UNCTAD) estimates that FDI will decline 40 percent, reaching just over US$700 billion for 2001.
This would represent the first reduction in FDI flows since 1991 and the biggest fall over the past three decades.
From the United States to Brazil, this investment decline is reducing capital flows to countries around the world. Except for Mexico and China, all of the 25 largest recipients of FDI in 2000 will see decreased inflows this year.
Since the early 1990s, China has been the developing world’s perennial leader in attracting FDI. Compared with the same 10-month period last year, contracted foreign direct investment in China has risen by 27 percent to over US$55 billion. Actual FDI inflows of approximately US$41 billion last year are expected to top US$44 billion in 2001.
However, Hong Kong overtook the mainland last year as its inflows leapt from US$24 billion to over US$64 billion in 2000.
Amazing as that appears, UNCTAD believes that much of this investment is "transit FDI" temporarily parked in Hong Kong before being reinvested in other East Asian locations. Indeed, given US$63 billion in investment outflows, Hong Kong’s net FDI inflows were only US$1.4 billion.
Asian financial crisis
Although its 2001 investment levels are expected to grow somewhat, China could certainly suffer decreases in FDI. Following the 1997 Asian financial crisis, foreign direct investment to China fell by over 10 percent.
The current war in Afghanistan and instability in India, Pakistan and Central Asia may thwart the government’s efforts to attract foreign investors into China’s poor western regions. Also, China appears ready to scrap the preferential tax treatment given to foreign enterprises in "special economic zones." It’s possible that corporate tax rates may double to 30 percent, deterring some foreign investors.
Given these factors and the bleak world economy, China could become the next foreign-investment victim.
Foreign direct investment is the largest and most stable source of private capital for the developing world, and it is extremely important for China. These inflows complement local savings and investment and help fuel economic growth.
Productivity is raised as FDI often brings effective foreign-management techniques, new technology and sophisticated marketing. The spillover effects can boost the productivity of other local firms, expanding the benefits of FDI.
More immediately, capital inflows are helping China restructure some of its stagnant industries. Indeed, the international initial public offerings of China’s largest petroleum companies—PetroChina, Sinopec and CNOOC—raised billions of dollars that will help streamline operations, cut costs and raise efficiency before these firms have to compete directly with foreign multinationals.
Inefficient banking system
Further, for countries like China with inefficient banking systems, foreign investment is a relatively efficient means of distributing capital. China’s banking sector does not allocate capital resources efficiently to the most productive firms.
Policy loans to failing state enterprises are a waste of potentially productive capital that might have otherwise gone to a Chinese Henry Ford or Bill Gates. Unburdened by political considerations, foreign investors can select the firms with the best potential, helping raise overall productivity in the economy.
China’s domestic economy needs a stimulus over the next few years to carry reforms forward, but two traditional sources have been falling flat. First, the slump in global demand for Chinese exports has muted that productive force.
Second, the government’s massive fiscal spending program will help keep economic growth high for the short-term, but this program has already been operating for a few years and cannot be sustained indefinitely. In light of the limited contributions of these two factors, foreign investment is becoming even more important to the economy.
If foreign investment in China declines significantly, domestic firms will be starved for productive capital and corporations will postpone or cancel reforms. Given the limited performance of exports and temporary fiscal stimulus, foreign investment is crucial for restructuring and growth. But, the question remains: How vulnerable is China to declining global FDI flows?
Despite China’s clear dependence on foreign investment and factors that may dampen those inflows, there are several reasons why China may be able to maintain high levels of inflows.
To understand the effect of falling global FDI on the Chinese economy, one must look at the composition of those flows. The giddy heights of the late 1990s foreign-investment boom were largely produced by a staggering increase in the number and size of cross-border mergers and acquisitions (M&A).
The recent contraction in global FDI is due mainly to a dearth of cross-border M&A mega-deals.
Inflated global FDI flows
Huge mergers, like the US$161 billion Vodafone-Mannesmann deal, Daimler’s acquisition of Chrysler and the US$48 billion BP Amoco merger inflated global FDI flows. But this year, mega-deals have become fewer and farther between.
The M&A portion of global FDI has declined for two reasons. First, after the frenzied past few years, many of the most attractive companies have been acquired. Second, the depression of stock prices and equity markets around the world makes it an inopportune time to acquire companies, as potential acquirers are less able to raise funds.
However, the majority of these deals occurred in the developed world. Thus, unaffected by major swings in cross-border mergers, FDI flows in the developing world have remained fairly constant – growing at an annual average of about 10 percent and totaling US$265 billion in 2000.
Given China’s minimal participation in cross-border mergers, the majority of its FDI inflows are in the form of relatively stable greenfield investments, joint ventures and other flows.
In addition to the overall composition of FDI flows and China’s relative immunity to volatile M&A swings, there are several reasons why China can expect to maintain high levels of foreign investment.
Labor, consumption and growth
First, with a seemingly limitless supply of cheap, productive labor, China has become an export-processing hub for Asia and is attracting vast amounts of foreign investment into this sector. Japanese, Taiwanese and European firms have poured investment into the coastal region, building manufacturing centers and fueling the export boom.
Indeed, from 1990 to 2000, China’s exports grew by 15 percent annually—making an astounding jump from US$62 billion in exports to US$250 billion in 10 years.
Second, although China is the world’s ninth-largest trading nation, the vast majority of its economy is based on domestic consumption. Thus, even though China’s trade growth has stalled this year, foreign firms are directing more investment at local consumers.
Indeed, the reason most frequently cited by foreigners for investing in China is the size and potential of the domestic market. World Trade Organization membership will provide a major boost to foreign firms seeking to enter the market, opening previously closed sections of the economy and bringing in billions of investment dollars.
Carrefour, Starbucks and GM are just a few of the global corporations already peddling to local residents, and U.S. retailing giant Wal-Mart recently secured permission to open its first Beijing locations.
Given Wal-Mart’s ability to draw customers from smaller local stores, Beijing’s local retailers and investment companies have reportedly come together to pool resources to meet the competitive threat.
Third, as India demonstrates, size alone is not sufficient to compel investors to commit capital. But the Chinese market is not only vast, it is also rapidly deepening.
Unlike the sluggish Indian economy, China’s high rates of growth over the next several years will lift the disposable income of tens of millions of Chinese. These consumers will then be able to make substantial purchases of consumer goods like refrigerators, cars and electronics.
Diversity of foreign-investment portfolio
Another factor suggesting China’s continued FDI performance is the diversity of its foreign-investment portfolio. In addition to attracting investment in labor-intensive and capital-intensive sectors, China has increasingly attracted investment to technology-intensive industries.
Fueled by a need to adapt products to the local Chinese market and drawn by well-educated Chinese researchers, Motorola, Microsoft and Samsung all have established research-and-development centers in China. This trend has opened a new source of foreign investment.
Unlike some other developing nations, China has enormous amounts of state-owned assets to privatize. Some developing countries, such as Brazil, have all but depleted the stock of government companies. China has only begun to sell off state firms to private ownership.
Foreigners buying into these enterprises gain access to previously restricted industries. Thus, BP’s major acquisition of PetroChina’s shares last year was intended to gain leverage in China’s petroleum industry.
Moreover, China is scheduled to conduct its first auction of government assets to foreigners. If this occurs, it would be the largest liquidation of Chinese state assets since 1949.
Another source of future FDI is Taiwan.
Taipei’s recent repeal of its ban on investments of US$50 million or more on the mainland will also help keep FDI levels high. Even with limits, Taiwan has been one of the leading sources of investment on the mainland.
Cheaper mainland factories
Taiwan, one of the world’s largest producers of semiconductors, has already transferred many production facilities to cheaper mainland factories. Taiwan also will be formally admitted to the WTO, promising a further integration of the two economies.
Finally, according to A.T. Kearney’s October "FDI Confidence Index Flash Survey," which gauges the foreign-investment intentions of corporate leaders worldwide, among the world’s major economies, only China has experienced a positive swing in investor outlook.
This finding suggests that China will remain a favored investment destination in the near term.
Given its well-diversified export, consumer and research-and-development FDI portfolio, as well as its rapid domestic consumer growth, untapped state companies and confidence among foreign investors, China should weather the current economic downturn well.
Despite falling worldwide levels for foreign investment that are constricting growth in other developing nations, FDI flows into China are likely to remain high over the medium term. Although not sufficient in itself, these capital inflows will enhance China’s ability to restructure.
This foreign investment will also help the Chinese economy meet the competitive challenges that WTO entry will surely bring.
About the author:
Richard Daniel Ewing wrote this commentary for ChinaOnline. Ewing is assistant director and research fellow in Chinese studies at the Nixon Center in Washington, D.C. He is a graduate of both the Johns Hopkins School of Advanced International Studies (SAIS) and the Hopkins-Nanjing Center in Nanjing. He can be reached at dewing@nixoncenter.org.
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