Chapter

IV Opening Up and External Policies

Author(s):
Michael Bell, Kalpana Kochhar, and Hoe Khor
Published Date:
June 1993
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A key feature of the Chinese reforms was the gradual opening of the economy to the rest of the world and the concomitant change in the official attitudes to foreign trade and investment. The approach was initially conceived with the relatively modest goals of transferring technology to China and of boosting export earnings to acquire essential imports for industry, while minimizing recourse to foreign borrowing. To this end, a number of limited areas were designated as open economic zones (OEZs)45 in which outward-oriented activity would be promoted.

The OEZs were also used as laboratories for experimenting with market-oriented reforms in a microcosm, on the original presumption that they could be isolated from the rest of the economy. However, their strong performance and growing regional autonomy in government led to pressures for greater integration with the domestic economy and they have emerged as centers of the most dynamic growth in the economy (Tables 7 and 8).

Table 7.Basic Indicators of SEZs and Open Coastal Cities, 1991
Special

Economic Zones1
Open

Coastal Cities
All

China
Population (in millions)2.228.41,143.33
Population as percent of China’s total0.22.5100.00
GDP (in billions of yuan)21.8152.31,768.602
GDP as percent of total1.28.6100.00
GDP/population (in yuan)9,8105,3601,540
Investment in fixed assets (in billions of yuan)8.339.5444.93
Exports (in billions of U.S. dollars)38.832.462.19
Exports/GDP (in percent)31931010.17
Exports as percent of China’s total14.252.1100.00
Actual foreign investment (in millions of U.S. dollars)856.51,973.65,498.8
Actual foreign investment as percent of China’s total15.635.9100.00
Actual foreign investment/total fixed investment492411
Source: China Statistical Yearbook, 1991.

Excluding Hainan.

Reference is to GNP.

Exports from the SEZs and open cities may be overstated because of their status as entrepôts for the surrounding regions.

Source: China Statistical Yearbook, 1991.

Excluding Hainan.

Reference is to GNP.

Exports from the SEZs and open cities may be overstated because of their status as entrepôts for the surrounding regions.

Table 8.Selected Indicators of SEZs and 14 Coastal Open Cities
Annual Industrial

Growth Rate,

1984–911

(In percent)
Exports/GDP,

19912

(In percent)
Foreign Investment, 1991

(In millions of US dollars)
Foreign Investment/

GDP, 1991

(In percent)
China total12.116.710,2902.8
Dalian15.1237.344315.8
Qinhuangdao15.8212.461.0
Tianjin8.586.14818.9
Qingdao9.5161.4623.0
Yantai16.253.5385.1
Lianyungang10.4101.3112.5
Nantong10.846.8345.1
Shanghai6.789.18557.5
Ningbo14.271.0363.0
Wenzhou14.621.561.4
Fuzhou15.159.116715.2
Guangzhou15.7165.62674.5
Zhanjian28.585.7192.5
Beihai21.149.995.3
14 coastal open cities9.9116.82,4347.2
As percent of China total82.2701.324262.1
Shenzhen41.2382.647718.5
Zhuhai45.4186.315713.6
Shantou27.0252.919727.0
Xiamen24.7118.718317.1
4 SEZs34.2273.51,01318.3
As percent of China total282.91,641.610663.5
Sources: China Statistical Yearbook, 1992; and IMF staff estimates.

The national consumer price index was used to deflate industrial output to constant prices.

Trade data for the coastal cities reflect their use as entrepôts for the surrounding region.

Sources: China Statistical Yearbook, 1992; and IMF staff estimates.

The national consumer price index was used to deflate industrial output to constant prices.

Trade data for the coastal cities reflect their use as entrepôts for the surrounding region.

The process of opening the economy inevitably necessitated the reform of policies and institutions in the external sector. China has gradually undertaken an extensive reform of its exchange and trade systems, which nonetheless remain complex, restrictive, and lacking in transparency. Assessing the precise degree of liberalization is complicated in a system in which the implementation of policies has become highly decentralized. Although it is clear that, in principle, China’s exchange and trade systems remain subject to many restrictions and distortions, China’s growing integration into the global economy suggests that the actual application of external policies tends to be relatively liberal, albeit selectively so.

This section reviews the evolution of external economic policies at the national level—specifically the exchange and trade systems—and at the regional level with a focus on the development of the OEZs.

Policies at the National Level

Trade System

Until 1978, China’s foreign trade was conducted through 12 state-owned foreign trade corporations (FTCs) organized along product lines. These corporations procured and traded the quantities directed by the central plan, and all profits and losses were absorbed by the state budget. In turn, production enterprises, which did not have direct access to foreign markets, were given production targets under the plan for supply to the FTCs. Through this system, the tradable goods sector was insulated from the rest of the world, and the balance of payments was controlled through the trade plan.

Under the reforms, the FTCs were progressively given greater autonomy and made more accountable for their operations, while administration of the system was decentralized to the provincial authorities, which were given authority to establish their own FTCs. By 1989, most local branches of national FTCs had become independent entities responsible to the local authorities for their financial results, bringing the number of FTCs to about 4,000. A growing number of enterprises could trade on their own account.

At the same time, the degree of mandatory planning was progressively reduced, guidance planning became more important, and, most significant, the trade conducted by foreign-funded enterprises (FFEs) rose substantially. By 1991 exports and imports subject to mandatory planning had fallen to 30 percent and 20 percent of their respective totals, while the trade of FFEs reached some 20 percent of total exports by 1992.46 As the role of the trade plan has declined, direct control over exports and imports has continued through a licensing system for both.47External trade taxes have also played an increasing role in influencing the quantity and commodity composition of trade flows, and other means have been used to influence the level of external trade, most notably import substitution regulations, which were used (on a nonmandatory basis) to limit imports of about 1,700 goods produced domestically.

Starting in 1991, a number of new measures were taken to liberalize trade, in part stimulated by China’s efforts to make its trade conform with international practices in the context of its application to resume its membership in the General Agreement on Tariffs and Trade (GATT).48 All direct budgetary export subsidies to foreign trade corporations were eliminated from January 1991, and export tariffs on mineral ores were reduced. Import duties were reduced on a number of occasions,49 and China’s customs duty regulations were replaced with the harmonized commodity description and coding system (the average level of duty rates under the new tariff structure is generally equivalent to that under the old structure). In April 1992, the import regulatory duty—established in 1985 as an import surtax—was eliminated, and in October 1992 it was confirmed that the import substitution regulations had been terminated. In addition, under a memorandum of understanding with the United States, China announced its intention to publish the many internal regulations on foreign trade to increase the transparency of the system. Other trade-related measures included a revision of the patent law to bring it into line with international conventions and various steps toward establishing legal conventions and practices for the conduct of external trade.

Looking to the future, China has announced its intention to undertake a number of measures in the context of its negotiations to resume its participation in the GATT, and in the memorandum of understanding with the United States published on October 10, 1992. These include

(1) The removal of two-thirds of import licensing requirements by the end of 1994, and the reduction of other nontariff measures. The memorandum contains a commitment to eliminate all import restrictions, quotas, licensing requirements, and controls on a wide range of products by 1997, with about three-fourths of such restrictions eliminated within two years.

(2) Measures to promote the transparency of the trade system, including the publication of all laws, regulations, and decrees that govern trade, and to establish a central repository for the publication of all trade regulations.

(3) Making the import approval process more transparent by identifying which agencies of the central government can issue directives, bans on imports, quotas, licensing requirements, restrictions, and controls.

Exchange System

During the early stages of reform, various arrangements were tested for sharing foreign exchange with the objective of improving incentives for exports. A retention system evolved, under which exporters surrender their actual foreign exchange and are issued retention quotas by the State Administration for Exchange Control (SAEC) equivalent to a portion of such earnings. Through 1990, a complex set of regulations had developed that allocated foreign exchange differently according to industrial type and provincial location (in general, the coastal provinces were more favored). In 1991, a significant simplification occurred under which a uniform retention rate for enterprises was set throughout the country, and standard formulas were established for sharing foreign exchange between the center and the localities. During the 1990s, experiments with cash retention have been undertaken (notably in Hainan, Shanghai, and Shenzhen).

Until 1980, several exchange rates were used for trade transactions between the FTCs and domestic enterprises with which they were trading. In 1981, a single exchange rate was established for the internal settlement of trade transactions that remained more depreciated than the official exchange rate. Over the succeeding three years the official exchange rate was progressively devalued, and in 1984 the rates were unified.

A dual exchange rate re-emerged in 1986 with the establishment of the foreign exchange adjustment centers (FEACs or swap centers) at which approved enterprises were permitted to buy and sell retention quotas (Box 5). Initially, the system was restrictive because the exchange rate (in fact, the premium paid for the retention quotas) was set by the authorities and participation was limited to foreign-funded enterprises.50 In 1988, as experience was gained, all enterprises with foreign exchange retention quotas were granted access to the centers. At the same time, the authorities lifted control on the swap market exchange rate, allowing it to be determined through negotiations between buyers and sellers. In December 1991, all domestic residents were allowed to sell foreign exchange at the swap rate at designated branches of banks; since then, there has been virtually no restriction on the sale of foreign exchange in the swap centers. However, restrictions remain on purchases, and for about three months in early 1993, the authorities attempted to cap the swap market exchange rate (see Box 5). This effort was abandoned when it became evident that most transactions were being driven into the black market.

Box 5.Foreign Exchange Retention and the Swap Centers

The Post-1991 Retention System

The new rules announced in February 1991 introduced more uniformity into the foreign exchange retention scheme, replacing the previous system of retention that had differentiated on the basis of commodity and location. For general commodities, exporters (other than foreign-funded enterprises, which can retain 100 percent of export earnings if located in a special economic zone) must surrender all foreign exchange earnings to the state at the official rate and receive retention quotas for 80 percent of such earnings—100 percent for mechanical and electrical products. These retention quotas are distributed to the foreign trade corporation (60 percentage points); the supplying enterprise (10 percentage points); and the local government (10 percentage points). The state also has the option to purchase 20 percentage points of the retention quota from the FTC and the 10 percentage points from the supplying enterprise at the prevailing swap market exchange rate. It appears that the state did exercise the option fully in 1991 and 1992, thereby acquiring 50 percent of export earnings for official purposes, compared with an average of 56 percent in the period before the new system.

Criteria for Access to Swap Market Purchases

Access to swap centers to purchase foreign exchange is subject to approval and is restricted mainly to enterprises that need foreign exchange either to import goods that are consistent with the industrial policy of the state or to service their foreign currency debt. Purchases of actual foreign exchange are usually limited to foreign-funded enterprises. Retention quotas may be procured at the swap centers by domestic enterprises that are certified by the Ministry of Foreign Economic Relations and Trade (MOFERT)—now known as the Ministry of Foreign Trade and Economic Cooperation (MOFTEC)—(or its regional counterpart) as eligible to import. These quotas may then be used within a six-month period to acquire foreign exchange from the state reserves at the prevailing official rate.

Authorization to purchase on the swap centers is granted by the SAEC based on two criteria. For licensed imports, if an enterprise has received MOFERT approval, the enterprise is allowed access to the swap center. For those imports that do not require a specific license, SAEC approval is based on a “priority list” of uses of foreign exchange compiled in conformity with the state industrial policy. Priority is given to such goods as fertilizers and other agricultural inputs, imports of foreign-funded enterprises, and the imports of advanced equipment by large and medium-sized state-owned enterprises. Lower priority is given to requests for foreign exchange to finance imports of consumer goods and luxury items. However, in practice, imports of such goods by foreign trade corporations using their own retained foreign exchange earnings are relatively unrestricted. Moreover, there is considerable variation in the degree with which local SAECs enforce the priority list in their regions.

Trading Procedures

An electronic open bidding system is used in 18 of the nearly 100 swap centers in the country, at which authorized dealers and brokers trade openly on a trading floor in retention quotas and U.S. dollars (also Hong Kong dollars in Shenzhen). Prices are allowed to fluctuate freely during each trading session. The People’s Bank of China can intervene to smooth out the trading and to limit the fluctuations, although such interventions are rare. In most other places, the swap center is an office within the SAEC that matches written applications to supply or buy retention quotas where applicants must appear in person with the requisite documentation.

Exchange Rate Developments

After freer trading was permitted in 1988, the premium on the exchange rates in the swap centers rose to about 80 percent, reflecting an increased number of participants at the same time as aggregate demand was surging (Chart 1). In 1989, the premium fell sharply in the wake of a devaluation of the official exchange rate, and thereafter the differential between the two rates narrowed to about 8 percent. Since April 1992, the renminbi has depreciated markedly in the swap market. Despite continued small adjustments of the official rate, the spread between the official rate and the average swap rate had widened to about 45 percent by early 1993, at which point the authorities attempted to cap the premium in the market. As this merely had the effect of driving most transactions out of the swap centers into the black market, the cap was lifted in June 1993. There was an immediate step adjustment, with the premium widening to 80 percent by mid-1993, but the rate moved only gradually thereafter. This depreciation occurred against the background of strong import growth stemming from rapid economic growth, an investment boom, and trade liberalization initiatives.

Chart 1.Exchange Rate Developments

Source: Data provided by the Chinese authorities.

1Downward movement indicates depreciation of the renminbi.

With the new exchange arrangements in 1986, the official exchange rate was in effect pegged to the U.S. dollar.51 There were two devaluations in 1989 (21 percent) and 1990 (9 percent), and in 1991, small frequent adjustments in the official rate were made. By April 1993, the real effective exchange rate of the official exchange rate had depreciated 33 percent more than in 1986 and 70 percent more than in 1980. The authorities have indicated that the ultimate goal is unification of the exchange rates and convertibility of the currency.

Policies at the Regional Level52

In the context of opening the economy, China’s regional policy has centered on developing OEZs, a process that has evolved through four stages broadly in parallel with reforms in the rest of the economy (see Section III). The first stage began with the establishment of four special economic zones (SEZs) in 1979–80. The intention was to replicate the successful experiences of similar zones in some newly industrializing countries in Asia,53 although the SEZs were more ambitious in terms of policies, activities, and geographical coverage than traditional export processing zones.54

During the second stage, these policies were extended to other areas when 14 coastal cities were given authority in 1984 to establish “open zones” within their jurisdictions. The third stage saw the establishment of Hainan as an SEZ in 1988 and the opening of the most ambitious of the OEZs in Shanghai—Pudong New Area in 1990. The most recent stage followed Deng Xiaoping’s initiative in early 1992 that gave priority to an acceleration of economic reforms and further opening of the economy. A number of major cities in inland provinces—particularly along the Yangtze River valley—and on the borders with neighboring countries have also been authorized to offer preferential policies to foreign investors and export-oriented enterprises. See Table 7 for basic data on the SEZs and open coastal cities.

The preferential policies that have been offered to foreign-funded enterprises operating in OEZs since the early 1980s include partial exemptions and holidays from corporate income tax; duty-free imports of goods to be used as inputs for export production; full retention of foreign exchange earned through exports; and free access to foreign exchange adjustment centers (Tables 9 and 10). Although these preferential policies initially varied from zone to zone, there have been recent efforts to harmonize them. Foreign entities have also been entitled to purchase land use rights since 1990 (although these leases were not actively traded until 1992).

Table 9.Income Tax Incentives in Open Economic Zones
RegionIncome Tax Rates1.2Tax Holiday/Exemption
SEZs15 percent income tax1980–83: Exemption for first profit-making year and 50 percent reduction for second and third years for firms with a scheduled duration of over 10 years.
Dec. 1984–: Two years’ tax holiday from the first profit-making year (for services the holiday is 1 year), followed by a 50 percent reduction in the 3 following years for firms with a contract life of 10 years or longer.
HainanDec. 1988: 15 percent income taxMay 1988: Five years’ tax holiday from the first profit-making year, and a 50 percent reduction in the sixth to tenth years, for firms in certain infrastructural and agricultural areas, with a contract life of 15 years or longer.
— Same as other SEZs for projects in industry and other infrastructure.
— Firms producing export goods (70 percent or more of total output value) or with high technology are allowed to deduct 10 percent income tax after the 3-year tax reduction.
Economic and technological development zones of 14 open coastal citiesDec. 1984: 15 percent income taxDec. 1984: Same as SEZs.
Other parts of the 14 open coastal citiesGeneral rate: 24 percent Dec. 1984: 15 percent income tax for technology-intensive investment of $30 million or above.1984–91: 20 percent tax reduction for firms in certain fields.



July 1991: Exemption in first two profit-making years and 3-year 50 percent reduction afterwards.
Pudong New AreaSept. 1990: 15 percent income taxSept. 1990: Basic provisions are the same as SEZs (for business in services the holiday is 1 year).
— Firms producing export goods (70 percent or more of total output value) or with high technology are allowed to deduct 10 percent income tax after the 3-year tax reduction.
— Investment in infrastructure is offered more tax exemptions or deductions.
Inland areasNov. 1981: Progressive marginal rates for CJV and FOV in the range of 20–40 percent.3July 1991: Exemption for first two profit-making years and 3-year 50 percent reduction thereafter. Enterprises exporting more than 70 percent of their production volume are subject to a 50 percent reduction on the income tax for the production year.
Sources: Guide to China’s Foreign Economic Relations and Trade: Cities Newly Opened to Foreign investors; Almanac of China’s Economy, 1981, 1991: Kueh (1987); China’s Investment Guide, 4th ed. 1989; Osborne (1986): An Introduction to China’s Coastal Open Areas. 1991.

In all open economic zones a 10 percent surcharge on profits is imposed by the local government, which has the discretion to grant exemptions.

Until 1991, all open economic zones granted exemptions from a 10 percent withholding tax that was applied throughout China. This tax was abolished in July 1991.

CJV: contractual joint venture; FOV: wholly foreign-owned venture; and EJV: equity joint venture.

Sources: Guide to China’s Foreign Economic Relations and Trade: Cities Newly Opened to Foreign investors; Almanac of China’s Economy, 1981, 1991: Kueh (1987); China’s Investment Guide, 4th ed. 1989; Osborne (1986): An Introduction to China’s Coastal Open Areas. 1991.

In all open economic zones a 10 percent surcharge on profits is imposed by the local government, which has the discretion to grant exemptions.

Until 1991, all open economic zones granted exemptions from a 10 percent withholding tax that was applied throughout China. This tax was abolished in July 1991.

CJV: contractual joint venture; FOV: wholly foreign-owned venture; and EJV: equity joint venture.

Table 10.Incentives in Open Economic Zones
RegionImport and Export Duties and Consolidated Industrial and Commercial Tax (CICT)Other Incentives1
SEZs1980–83: Exemption of import duties for production inputs. Many imported consumer goods are exempted from import duties.Flexible entry visa service.
Dec. 1990: Unified exemption of import duties and CICT for production inputs and export goods.
Hainan Special Economic Zone-May 1988: Exemption of import duties, product tax, and value-added tax for imported inputs for production. Export goods are exempt from the same tax.Flexible entry visa service; land use rights can be transferred to foreign investor for 70 years.
Economic and technological development zones of 14 open coastal citiesDec. 1984: Inputs for exporting production are exempt from import duties. Export goods are exempt from CICT.
Other parts of open coastal citiesDec. 1984: Inputs for exporting production are exempt from import duties. Export goods are exempt from CICT.
Pudong New AreaDec. 1990: Exemption of import duties for production inputs. Export goods are exempt from export duties and CICT.Investment in infrastructure and banking are encouraged.
Inland areasDec. 1990: Inputs for export production are exempt from import duties. Export goods are subject to export duties and CICT.1984: Rebate of 40 percent income tax if the profit is reinvested for joint ventures. July 1991: All foreign-invested enterprises get tax refund for reinvestment.
Source: Guide to China’s Foreign Economic Relations and Trade: Cities Newly Opened to Foreign investors; Almanac of China’s Econamy, 1981, 1991: Kueh (1987); China’s Investment Guide, 4th ed., 1989: Osborne (1986); An Introduction to China’s Coastal Open Areas, 1991.

Experiments with transfers of land use rights became more widespread in many of the open economic zones from 1992.

Source: Guide to China’s Foreign Economic Relations and Trade: Cities Newly Opened to Foreign investors; Almanac of China’s Econamy, 1981, 1991: Kueh (1987); China’s Investment Guide, 4th ed., 1989: Osborne (1986); An Introduction to China’s Coastal Open Areas, 1991.

Experiments with transfers of land use rights became more widespread in many of the open economic zones from 1992.

As regards the taxation of corporate incomes, foreign-funded enterprises operating in the OEZs generally pay, after their tax holidays expire, half of the tax rate they would be expected to pay outside the zones. To be eligible for any of the tax exemptions and reductions, the initial investment to set up a foreign-funded enterprise must be for a contracted period of at least ten years. Other tax exemptions and reductions are available to foreign-funded enterprises in all zones if they bring advanced technology into the country, export at least 70 percent of their output, or are involved in developing infrastructure. In addition to these tax exemptions and reductions, the tax rates applied on enterprises in each zone are sometimes negotiated on an individual enterprise basis. Many domestic enterprises also operate in these zones under policies similar to, but less generous than, those offered to the foreign-funded enterprises.

Special Economic Zones55

The Original SEZs

The application of China’s policy of economic opening to the rest of the world began with the establishment of four SEZs in the two coastal provinces of Guangdong and Fujian in 1979–80. Three of these SEZs are in the southeastern coastal area of Guangdong: Shenzhen (near Hong Kong); Zhuhai (near Macao); and Shantou. The fourth is located in Xiamen in the southeastern part of Fujian across from the Taiwan Province of China. These SEZs, which remained the only OEZs in China through 1984, had the particular advantage of easy access to foreign markets. Otherwise, they were located in regions that had relatively few innate advantages: Guangdong’s level of development was average for China in the late 1970s, whereas Fujian was one of the poorest regions prior to reform.56

Enterprises operating in the zones include (1) state enterprises owned by local authorities or by authorities of other provinces; (2) enterprises that are wholly foreign owned; (3) equity joint ventures; and (4) contractual joint ventures.57 Wholly owned foreign-funded enterprises in the zones generally make their own decisions with respect to their organizational and personnel structure, wage systems, and the recruitment or dismissal of employees. With the authorities’ approval, they can sell part of their output in the domestic market.

One important difference between the SEZs and other areas in China was the administrative decentralization that permits investment decisions in the SEZs to be taken largely outside the state plan. Local authorities in SEZs are allowed to attract foreign investors58 through preferential policies. They are also allowed to undertake their own infrastructural development and other investment as long as they can raise the funds from taxation, from profits of the enterprises they own wholly or partly, or from banks in the zones.59 Enterprises in the zones have the right to make their own investment, production, and marketing decisions. This relative autonomy has been an important factor in attracting investment resources from other areas of China as well as from abroad into the SEZs.

Another important consideration is the tax incentives available to foreign investors. FFEs are subject to 15 percent tax on profits,60 compared with 33 percent paid by those located outside the SEZs. In addition, after a tax holiday in the first two profit-making years, they pay only 7.5 percent tax during the following three years. FFEs located in the SEZs are exempt from import licenses and from customs duties on imports of machinery, equipment, and other inputs, as well as on their exports. These products, excluding cigarettes, liquor, and petroleum products, are also free of indirect taxes if sold within the zones. However, if FFEs sell imported goods that have not been further processed in the SEZs, they must pay 50 percent of the full duty and indirect taxes.61

The four SEZs together have recorded impressive results in terms of their exports, foreign direct investment flows, and industrial output. The value of their exports doubled from 1987 to 1991, reaching $6.6 billion, or about 9 percent of China’s total.62 Contracted foreign investment in 1991 was more than eight times its 1987 level and total real gross industrial output showed strong gains, increasing by over 35 percent in 1991.63 Data for the first half of 1992 and other provisional reports indicate a substantial further increase in activity.

Table 11.Cross-Country Comparison of Tax Rates
Income Taxation
ChinaCorporate income tax: 15 percent in SEZs and open cities; 33 percent on foreign-owned enterprises in other areas.
Hong KongCorporate income tax: 18.5 percent

Other entities: 17 percent

Taxes are levied on profits and interest arising in or derived from Hong Kong
MalaysiaCorporate income tax: 35 percent

Development tax: 5 percent

Excess profit tax: 3 percent
SingaporeCorporate income tax: 31 percent

Withholding tax: 33 percent on dividends earned in Singapore
KoreaCorporate income tax: 0–30 percent
ThailandCorporate income tax: 35 percent

Business tax: 1.5–40 percent

Remittance tax: 20 percent
Source: Grub and Lin (1991), p. 65.
Source: Grub and Lin (1991), p. 65.

The good performance of the SEZs can be illustrated by the success of Shenzhen, the largest of the original four. Shenzhen’s exports, which accounted for more than half of total exports of the four SEZs in 1987–91, increased during that period to $3.5 billion (or $5.8 billion, based on customs data). Contracted value of foreign direct investment attracted into Shenzhen increased from $274 million in 1987 to over $1 billion in 1991. Shenzhen’s industrial output is estimated to have grown by 40 percent in 1992. These developments reflected the activities of some 20,000 enterprises, of which about 5,000 were foreign-funded ventures.

The success of these original SEZs may be attributed to a number of factors: (1) the incentives given to foreign investors that were more generous than those made available in other countries;64 (2) their small initial size coupled with the fact that they were the only areas in China opened to foreign investment before 1984, which enabled them to receive very large amounts of investment; and (3) the large amount of domestic investment that came in the form of joint ventures established by provincial authorities from other coastal and inland provinces. Because of these factors—especially the last—as other regions open to foreign investment, the pace of growth in the original SEZs may moderate somewhat.

Hainan Special Economic Zone

Hainan Island was one of the poorest regions of China through the mid-1980s, with a predominantly agricultural economy and inadequately developed infrastructure. It was designated a “special area open to foreign investment” in 1983, but initially it remained unable to attract foreign investment mainly because of the lack of infrastructure. However, as labor became increasingly expensive in Guangdong, Hainan became an important source of cheap labor in southern China. This development, together with its land and natural resource endowment, gave it some comparative advantage for foreign investment in labor-intensive activities.

In 1988, Hainan was designated as China’s largest SEZ (it was also given the status of a province) and began to focus more on attracting foreign investment and on export production. It benefited from low land prices, cheap labor costs, and the free movement of capital and merchandise, and in some respects its preferential policies were more generous than those of the other SEZs. For instance, to develop its infrastructure (ports, airports, roads, railways, coal mining, and power plants), special income tax incentives were offered. In 1992, the State Council approved measures to develop Yangpu port in Hainan to attract foreign investment into the development of land in the area.65

Hainan was also one of the regions in which experiments with a decentralized and market-oriented approach to economic management—now spreading across China—were carried out, and its need to develop an adequate infrastructure influenced the nature of the measures that it introduced. Its authorities were empowered to approve projects that meet specified conditions and whose total investment is less than $30 million, and it can issue bonds with the approval of the State Council. It was one of the few areas where foreign exchange earnings could be retained in cash regardless of ownership,66 and where foreigners could purchase stocks and bonds before this operation was allowed in other parts of China. Trading in land use rights (for leases of up to 70 years) was also first permitted there. Domestic and foreign investors were allowed to set up companies to develop large tracts of land.

During 1988–91, Hainan’s economic development accelerated and its per capita income caught up with the rest of China. By the end of 1991, it had approved the establishment of more than 2,000 FFEs with investment contracts amounting to $394 million and actual investment of $176 million. Financial resources from other provinces amounted to Y 4.2 billion. Although its trade performance was strong during this period—exports increased from $281 million to $670 million—they remained a relatively small proportion of GDP (less than the national average) and were concentrated in primary products. Although another large increase appears to have occurred in 1992, Hainan has not yet reached the “take-off” point long since achieved by the other SEZs.

Open Coastal Cities

The success of the original four SEZs led to the authorities’ decision in April 1984 to open 14 coastal cities67 to foreign trade and investment. At the time of their selection, the 14 coastal cities had already developed significant industrial bases and adequate infrastructure and possessed technical and managerial expertise. The authorities of the cities were given the power to approve construction and industrial projects involving foreign investment not exceeding $5 million.68 Nonmanufacturing projects involving foreign investment are not subject to upper limits but must be mainly financed by foreign resources.

The open coastal cities are classified into two parts for the purposes of incentives: the economic and technical development zones (ETDZs) and the rest of the cities. The ETDZs are often located near the harbor and are designed to provide the basic infrastructure for the establishment of new enterprises. They enjoy the same tax concessions as those offered in SEZs (for example, a 15 percent income tax rate and tax holidays), although exemptions from import duties apply only to capital equipment and intermediate goods and not to consumer goods. In the other parts of the cities, the corporate income tax is set at an intermediate rate of 24 percent except for high-technology projects and investment projects exceeding $30 million, or projects in the energy, transportation, and port construction sectors, which are eligible for rates as low as 15 percent.

The economic performance of the 14 coastal cities has varied. Although 8 recorded growth rates of industrial output higher than the national average, the average growth rate of the 14 cities taken as a group is estimated to have been well below the national average in 1984–91. This is largely because Shanghai and Tianjin, the two largest industrial cities, grew at relatively low rates—6.7 and 8.5 percent, respectively—compared with the national average of 12.1 percent (Table 8). In these cities preferential policies would have had a more limited impact because the ETDZs were small relative to the overall size of the cities.

Measured by external aggregates, the open coastal cities performed well; for instance, the value of foreign direct investment grew by nearly 35 percent in 1991 and increased threefold in 1992. By the early 1990s, they were absorbing about one-fourth of China’s foreign direct investment, and their export/GDP ratios averaged over 100 percent; although these statistics include trade originating in other provinces, they indicate the importance of the cities in the overall process of opening.69

At first glance, there is a contradiction between the rapid growth of exports and the slow development of industrial production in the 14 open coastal cities. This difference in relative performance reflects the concentration of new activity in export-oriented production, the relatively low base of exports, and the large existing industrial base. It also indicates that the principal objective of the preferential terms offered in the ETDZs has been to increase exports. Finally, the expansion of industrial production in older cities such as Shanghai and Tianjin requires overhauling large and inefficient state-owned enterprises and undertaking extensive renovation of infrastructure. Neither of these could be fully addressed by inflows of foreign direct investment, in part reflecting the ambivalence of the authorities on the extent of foreign involvement in the restructuring of SOEs.

Pudong New Area

A further step in the policy of opening up—the most ambitious single undertaking by far—came in April 1990 with the establishment of the Pudong New Area of Shanghai. It was designated an open economic zone that would enjoy a policy status more flexible than those already applied in the original SEZs and that would from the outset be much more integrated with the surrounding region. Pudong was expected to take the lead in the development and opening of the Yangtze River valley and to be the focal point in China’s development during the 1990s. The authorities envisaged that, by this means, Shanghai would become a major economic, trading, and financial center for China, and indeed for the entire Asian region.

At the time of its selection, Pudong was already different from the original four SEZs in that it was not to be developed from scratch on virgin land. Its development was to be strongly supported by Puxi, the western part of Shanghai. Pudong’s development aims were to establish a finance and trade zone, an export processing zone, a free trade zone, and a high-technology park. Its preferential policies were broader in scope than those of the original SEZs, and the municipality expected strong financial support from both public and private sources in developing the infrastructure of the area.

The distinctive features of activities permitted in Pudong (many of which were subsequently extended to other OEZs) included (1) foreign business was allowed to engage in retail sales; (2) all foreign-owned enterprises could trade their foreign exchange freely; (3) foreign insurance companies could be established; (4) foreign enterprises could build and operate port facilities; (5) authorization was given to establish a free trade zone (Waigao-qiao) in which approved enterprises could engage in foreign trade freely without restriction; and (6) a securities market was opened with the approval of the People’s Bank of China.70 In most other respects, Pudong offered incentives similar to those already available in Hainan and the original SEZs. However, unlike Hainan, where both domestic and foreign-funded enterprises enjoy preferential treatment, Pudong originally offered incentives only to the latter.71

Although still in its infancy, early results from Pudong were encouraging.72 The area attracted numerous foreign and domestic investors, many of whom invested in high-technology industries rather than the more basic light industries that characterized the other open zones. From 1990 to 1992, approvals were given for 704 foreign-funded projects with a total investment of more than $3 billion; projects have included electronics, chemicals, telecommunications, precision and measuring instruments, microbiology, and automobile parts. Eleven branches of foreign banks have been established, and over 30 other banks have applied to open branches in Pudong.

Domestic investment is also on the rise. More than 1,000 enterprises had been set up by the central, provincial, and municipal governments by the end of 1992 involving a commitment of investment of Y 8.5 billion. In 1991, Pudong made its first six land deals, covering an area of 964 hectares.73 Business in other areas also developed quickly in 1990–92. For example, the value of securities transacted on the Shanghai stock exchange was Y 2.4 billion in 1990; it increased to Y 12.6 billion in 1991 and to Y 68 billion in 1992.

Inland Provinces

Foreign investment in inland provinces74 was relatively low from 1978 through 1991. Foreign direct investment projects, which were predominantly resource-based ventures, were concentrated in a few areas including Beijing and a number of cities in Shaanxi and Sichuan.

Although foreign trade from inland provinces developed faster than foreign direct investment, it still lagged far behind that of the coastal provinces, particularly the open coastal cities. In 1990, exports and imports from the inland provinces accounted for about 28 and 10 percent of the national total, respectively. The trade/GNP ratio of the inland provinces was 12.3 percent in 1990, while that of the coastal provinces was close to 40 percent.75

One important factor in keeping foreign direct investment low in inland provinces is that they were at a disadvantage in terms of tax policy. Income tax on net profits of foreign-funded enterprises was unified in 1991 at 30 percent plus a 3 percent local surtax.76 Until that time tax rates for joint ventures had differed from those for wholly foreign-owned enterprises. Other factors that had discouraged foreign investment in inland provinces included local governments’ limited power to approve investment projects;77 poor infrastructure (particularly transportation and communications); and lack of managerial expertise and skilled labor and inadequate research and development.

Despite their dependence on domestic demand, the average annual economic growth in the inland provinces was very close to that of the open coastal areas during 1984–90. Among the many factors that may have contributed was the improvement in the terms of trade of the inland provinces relative to the coastal areas. The domestic prices of energy and raw materials have continued to rise in recent years, exceeding the price increases in manufactured goods. This is to the advantage of the inland provinces, which supply primary products to coastal areas.

In 1992, the authorities embarked on a new phase of the process of opening up. The central government decided to apply preferential policies to ten major cities and to establish six development zones along the Yangtze River valley.78 The Government also gave permission to all provincial capitals and to 13 border cities to adopt similar policies of opening up.79 In the cities along the Yangtze River, the strategy is to integrate their development with that of the Pudong region in Shanghai. Most of the incentives offered in the original SEZs, Hainan, and Pudong are to be applied in the newly opened cities of inland provinces.

In addition to those inland and border areas officially sanctioned by the central authorities, many localities have announced plans to set up development zones without awaiting approval from the central authorities. As well as the existing packages of incentives offered by the central government, provinces have further devolved their powers to local authorities under their jurisdiction to approve foreign investment projects in their respective areas. Some of the areas have adopted more generous policies than those applied in SEZs and Pudong without approval from the central government. Such terms include a five-year tax exemption and a 50 percent reduction of corporate income tax over the next five years and exemption from the energy transportation tax to foreign-funded enterprises.

Review of Progress

There have been two broad strata of policies—at the national level and at the regional level—through which China has gradually opened its economy to the rest of the world. Each contains transitional elements that indicate that lasting reform will require further substantial changes in policy orientation.

At the national level, there has clearly been substantial progress in liberalizing the trade and exchange regimes, but they remain distorted and lacking in transparency. The swap market has provided a market-oriented mechanism of allocating foreign exchange for imports that are outside the foreign exchange plan. It has also relaxed the foreign exchange constraint for foreign investors wishing to invest in China because they can now satisfy their foreign exchange requirements through the swap market. This has facilitated the large inflows of foreign capital into the service sector during the past year.

However, exchange rate developments in 1993 underscore the need to extend market-based mechanisms for determining the exchange rate to all transactions. The authorities have announced their intention to reform the foreign exchange system to achieve eventual convertibility of the currency. Their plans include establishing an integrated national swap market: replacing retention in quotas with cash retention; and unifying the official and swap rates.

Box 6.The Impact on the Economy of Opening Up: Selected Features

This box reviews selected facets of developments in the Chinese economy resulting from the policy of opening up: from an overall perspective, from the perspective of the province most affected (Guangdong), and from the perspective of the most dynamic sector of the economy.

National

The impact of the more rapid opening up in 1992 had a tangible effect on a number of key statistics for China as a whole. The value of exports in 1992 increased by over 18 percent to $85 billion, with the proportion of manufactured goods rising to 80 percent of total exports. Of this total, the exports by FFEs rose from 17 percent in 1991 to about 20 percent in 1992. Contracted foreign direct investment actually used was $11.2 billion, an increase of 150 percent over 1991. At the same time, the number of FFEs rose from 37,000 at the end of 1991 to 84,000 a year later.

Guangdong

The impact of the policy on open economic zones is clearly illustrated by developments in Guangdong province, where the first three SEZs were established. Apart from these SEZs, Guangdong has 2 of the 14 open coastal cities and the Pearl River Delta Zone of Economic Development, which includes 10 cities and 29 counties. Guangdong’s export volume increased by over 19 percent annually during 1979–91, and the province as a whole utilized $15 billion of foreign capital and imported sizable amounts of advanced technology. By the end of 1992, there were 16,000 foreign-funded enterprises—including joint ventures—operating in Guangdong. Although Guangdong is the province that has the largest concentration of foreign investment, similar developments have been recorded in most other open zones—an indication of the extent to which the policy of opening to the rest of the world has contributed to the rapid development of China’s economy.

Nonstate Industries

The share of town and village enterprises in total exports reportedly increased fivefold between 1985 and 1990 and is estimated to be in excess of 25 percent in 1992. About 90 percent of TVE exports are estimated to be manufactures, of which almost half are spread evenly among textiles, clothing, and arts and crafts. The bulk of all TVE export earnings are generated in the eastern coastal provinces/municipalities. Available data for foreign-funded enterprises (including joint ventures) indicate that their contribution to exports rose from 1 percent in 1984 to 5 percent in 1988 and to 10 percent in 1990. All their exports are of manufactured goods, and 94 percent are generated in the coastal provinces.

At the regional level, despite the increasing number and macroeconomic significance of the open zones, two questions on their future may be highlighted. Present domestic policies have created competition among the various provinces to offer the most generous incentives to investors without due regard to the possible adverse impact on government revenue. In addition, concerns have arisen that the proliferation of development zones could divert land from agricultural use, a critical issue given the relative scarcity of arable land. Partly because of these concerns, the Government has slowed the opening of development zones.80 In the longer term, it may become necessary for the authorities to review the policy of offering preferential terms to new investors in these zones.

Whatever the future of China’s open economic zones, there can be little doubt that they have played an important role in transforming China into a market economy (Box 6). They have gone far beyond their initial goals of attracting foreign investment and technology and of earning foreign exchange to procure imports to modernize the economy. Their use as laboratories for experimenting with market-oriented policies and the gradual spread of the various forms of zones have established them as nodes of development that are influencing changes in other parts of the country.

As the Chinese economy becomes more market oriented and open, the time will come for a careful review of the role of such zones. A key question in that context would be whether China’s long-term development is best served by phasing out those special arrangements that should be regarded as transitional (such as certain tax concessions) while extending others to all parts of the country.

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