As Wanda Tseng, IMF Deputy Director of the Asia and Pacific Department, noted in her opening remarks, two decades of economic reforms and resilience in the face of regional crises have paid off handsomely for China in terms of “spectacular growth, substantial inroads in reducing poverty, and the development of a very vibrant nonstate sector.” Clearly, a key element in this transformation was an early decision to progressively open the country to the outside world through trade and foreign investment. This Economic Forum, Tseng explained, is taking a closer look at what drove those flows, what impact they have had on China’s economic performance, and what the future implications for FDI are from further liberalization and the convertibility of the renminbi.
First, the big picture
But before FDI’s role—past or future—was discussed, Markus Rodlauer, Assistant Director for the IMF’s China Division, outlined the larger picture, examining developments in China’s balance of payments and exploring how external flows related to the domestic economy in terms of the savings-investment balance. In recent years, he said, China’s current account surplus has averaged about $25 billion (about 2.5 percent of GDP) and FDI net inflows, about $40 billion (roughly 4 percent of GDP).
As Rodlauer and other panelists noted, however, China did not “need” FDI in that it had huge amounts of domestic savings (averaging 40 percent of GDP—a level sharply higher even than other Asian economies) and an “equally astounding aggregate level of domestic investment” (35–40 percent of GDP). What is to be made of this puzzle—huge inflows of FDI amid very strong domestic savings and investment? Rodlauer argued that FDI’s substantive contribution was not so much in filling any balance of payments gap but rather in dramatically improving the productivity of investment and boosting growth.
Drivers of FDI
Why, indeed, did China want FDI? Harvard Business Professor Yasheng Huang, summarizing the thesis of his forthcoming book, Selling China, had a story to tell. Jettison some of your stereotypes about FDI in China, he said, because a lot of conventional explanations are at least partially wrong. FDI may have improved the productivity of China’s investment, but it did so within an institutional context that kept efficient private domestic entrepreneurs from making these same contributions.
On the face of it, Huang noted, FDI’s role looks large and direct. China’s exports surged over the course of the past decade, and the role of foreign-invested enterprises (joint and wholly owned ventures) expanded dramatically, accounting for 15 percent of exports in 1990 and 48 percent in 2000. But look more closely, he added, and you also find a “switching effect.” More than two-thirds of this boost in exports is accounted for by well-financed foreign firms (often from Hong Kong SAR, Taiwan Province of China, and Macao SAR) supplanting credit-strapped private domestic firms.
A truer picture of FDI’s role, Huang also suggested, can be gained from subtracting the investments of the dominant state-owned enterprise sector and comparing FDI with nonstate firm investment. In that context, the annual average share of FDI is the equivalent of 28 percent of nonstate domestic capital formation—remarkably close to highly FDI-dependent Singapore (30 percent) and Malaysia (24 percent). All three countries, he argued, systematically suppressed local entrepreneurs (albeit for different reasons) and substituted foreign know-how. In China, he said, the motivation was ideological—until the late 1990s, the government was leery of the power of private firms.
Huang cited further evidence of this suppression in the regional and sectoral distribution of FDI. Unlike the regionally and sectorally concentrated FDI found elsewhere, China’s FDI has flowed to many provinces and many industries. There is some evidence, he said, that domestic capital mobility may actually have declined over the reform period and that provinces that could meet their investment needs from local sources had to turn to FDI for capital.
Typically, a growing market with good fundamentals attracts domestic as well as foreign investment. But in China, the FDI component of investment grew much more strongly than domestic investment until 1996–97, when government policies began to treat domestic entrepreneurs much better, which in turn spurred greater domestic investment.
Also look carefully, Huang said, at the large presence of FDI in the export sector. In labor-intensive industries such as garments and footwear, FDI accounted for about 61 percent of the exports. In comparable industries in Indonesia and Taiwan Province of China, the foreign involvement was dramatically lower (33 percent and 5.7 percent, respectively). In Taiwan Province of China, the export success story was the product of local entrepreneurs. In China? “Essentially,” he explained, “foreign entrepreneurs are playing the role of venture capitalists, providing seed capital to businesses that are discriminated against by the banks.”
China’s FDI has a similarly unusual role in privatization. Huang found numerous instances of state-owned enterprises contributing their brand names, customer bases, and operating assets to finance an equity claim on a newly created joint venture. In the process, however, the state-owned joint-venture partner became a shareholding company with no operating assets. The FDI story, he emphasized, is really a de facto privatization story—one in which the government has not allowed domestic private companies to acquire the same state-owned enterprise assets that foreigners can.
But there was also a case to be made for the more traditional drivers of FDI. Summarizing his recent IMF Policy Discussion Paper (02/3), Harm Zebregs, an economist in the IMF’s China Division, suggested that market size, abundant cheap labor, and adequate infrastructure did play a role in attracting investment to China. So, too, did reduced barriers and preferential policies that took the form of tax concessions and special privileges and that allowed open economic zones to play a crucial role in the gradual liberalization of the economy. Other elements, such as cultural, bureaucratic, and legal environments, helped attract FDI from the Chinese diaspora, and the lack of familiarity with these same elements prompted European and U.S. investors to seek local counterparts.
Nicholas Lardy, a Senior Fellow at the Brookings Institution, found merit in both arguments. Distortions in China’s financial system were a very important reason why China relied on the external sector, he said, but traditional determinants were also influential. Lardy added two further drivers of FDI that he felt had been insufficiently acknowledged: China’s processing program, which allows foreign firms to import, duty free, capital goods and components and assemblies that will be used for export processing (“an enormous driver of China’s trade growth”) and the convertibility of the current account, in 1996, which has allowed foreign-invested firms to repatriate declared dividends from joint ventures.
FDI’s impact and lessons
What did FDI do for China, and indeed for the firms investing in China? Zebregs found FDI had a relatively small effect on growth through higher capital accumulation but a more significant effect through higher productivity growth—an impact estimated at 2–2.5 percent of GDP growth in the 1990s. Foreign-invested enterprises, he added, had labor productivity twice as high as state-owned enterprises; created job opportunities (and currently account for 3 percent of urban employment); and played a key role in China’s impressive trade growth.
Lardy dismissed the fairly widespread myth that processing activity and the foreign firms operating in enclaves had little impact on the domestic economy. He preferred the productivity argument. Look at what’s happening in the processing sector, he said. While the rate of value added was relatively low in the early 1990s, “value added as a percentage of output in the processing sector roughly doubled.” This means, he added, that as more and more foreign firms operate, they create demand. A lot of domestic firms are producing more parts and components.
Lardy also tackled the increasingly common myth that foreign investors aren’t turning a profit. Examine systematic data rather than anecdotes, he suggested, and you find profitability in the second half of the 1990s at about 14 percent—that same profit margin investors are finding in Brazil and Turkey.
Does China’s success, then, hold lessons for other countries? Zebregs suggested the most important lesson is that China’s success is not unique. Its recipe was a standard one: large domestic markets, low wage costs, and improved infrastructure, complemented by open FDI policies and the establishment of open economic zones. Less common, but no less important, was China’s decision to pursue a gradual, persistent reform strategy that built on the success of market-based reforms in a few locations to develop, over time, broader interest in, and support for, wider reforms.
Of course, that’s not to say that the strategy didn’t have its pitfalls. Zebregs pointed, in particular, to an increasingly complex and biased tax incentive system (something the authorities are now attempting to rectify with unified tax rates for foreign-invested and domestic firms) and growing income disparities between coastal and inland provinces (a problem abetted by FDI concentrations and now hoped to be redressed through a redirection of FDI to western and central provinces).
Though much has changed in China, much more change seems to loom on the horizon. One pressing question is what effect China’s WTO commitments will have on the volume and composition of FDI inflows. Lardy cited several WTO commitments that will make investment in manufacturing more attractive, and he saw China and foreign investors poised to take advantage of the phaseout of textile and apparel quotas. Overall, though, Lardy was convinced that the truly significant changes would occur in areas previously closed to FDI, notably telecommunications, financial services, and distribution. On balance, he looked for moderate growth in overall FDI, with a significant shift, over time, in its composition.
Trade-related changes, however, are not the only reforms in prospect, and Rodlauer closed the panel discussion by examining the likely implications of further liberalizing the capital account (including FDI) and pursuing the convertibility of the renminbi.
On the capital account, Rodlauer reminded the audience that, despite steps to liberalize the trade and FDI regimes, China still employs extensive capital controls to retain scope for independent monetary policy and maintain a stable exchange rate, as well as to limit vulnerability to capital flow reversals and protect certain domestic industries. FDI, while fairly open, is nonetheless tightly regulated on an individual basis. Portfolio equity and loans are also strictly controlled, with entirely separate systems for foreigners and residents.
Eventual opening up of the capital account and full convertibility are likely to be unavoidable, Rodlauer said, and China itself has stated this as an explicit and long-term goal. The authorities are aware of the well-known benefits of opening the capital account and similarly aware of the equally well-known risks. It is in view of these risks—overheating, sudden reversals, and contagion—that the authorities have opted for a very deliberate and gradual path to capital account liberalization. They have specifically mentioned, Rodlauer said, their desire to reform their enterprise and banking sectors first and have tight budget constraints in place. And they are particularly concerned about the sort of excessive borrowing that has characterized other transition countries and the very large volatility that could occur in their still fairly narrow capital markets.
How then to proceed? The keys, as country experience makes clear, are strong macroeconomic policies and a strong financial system. On the macroeconomic side, Rodlauer observed, China’s balance of payments position is very strong, but work remains to be done on sustainable public finances and on the exchange rate and monetary policy side (where at some point China will have to move gradually from its current exchange rate regime to greater flexibility). In the financial sector, state-owned banks and enterprises will need to be rehabilitated, he said, and a strong prudential system put in place.
This is a large work program, Rodlauer conceded, and opening up and liberalizing is always a complex and interconnected process. Uncertainties are a given, he observed, but you have to start somewhere, monitor very carefully, and be very flexible. China has gotten the sequencing “quite right” thus far—opening with FDI, moving to portfolio equity flows, and leaving short-term debt-creating flows until the end. Now that the authorities have adopted convertibility as a long-term goal, he concluded, the next step is very carefully phasing it in and supporting it with appropriate reforms and macroeconomic policies.
The full text of the May 2 Economic Forum on FDI in China is available on the IMF’s website (www.imf.org).
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