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FDI will continue to play a vital role as China enters the next stage of economic development to become a leader in technology

A review of policy and an outlook on how the New China has monitored and shifted FDI policy since 1978

· investment

{{{Pierre-Adrien Deffis}}}

After 40 years of rapid GDP growth, the Chinese economy emerged as the second-largest in the world, and is about to take the top spot from the US within a few years. Foreign investors played a vital role in supporting China´s growth in every stage along the way as China gradually emerged its agricultural, manufacturing and service sectors to eventually become a technology powerhouse. Indeed, foreign investors have been pouring more resources every year via FDI into the Middle Kingdom to reach an all-time high of around USD 140+ bn or ~1+% of GDP (nominal) in 2019.

When it comes to the development strategy of emerging countries, FDI (Foreign Direct Investment) has often been considered as a double-edged sword. On the one hand, it allows resources to flow into a country and be allocated to projects that are in need and where local financing cannot provide support. On the other hand, it might bring foreign ownership to key industries and assets that strategically should remain under national ownership or hampers the development of local capabilities. In the case of China, FDI has been welcomed and carefully monitored as it helped the gradual development of the economy. For a long time, foreign investors claimed an unfair playing field when it comes to Chinese business environment. This perceived dissatisfaction has further increased after the US-Trade-War started, following the Trump election win in 2016. Despite those claims, FDI reached an all-time high in 2019.

First, we want to provide more background on how China has become such a popular destination for FDI, while at the same time keeping control of ownership over its key assets. Second, we want to investigate the FDI approach of China, shifting from an agricultural economy to an industrialized economy. Lastly, we want to offer a glimpse into the future, as the country is emerging to be one of the leading technology nations.

A timeline of opening up

1978 – 1990s: Reform & Opening -Up

Since the New China emerged in 1949, China’s economy remained fairly closed to the world and to the international trade until the launch of the Economic Reform (改革开放 – gaigekaifang) in 1978, implemented under the leadership of Deng Xiaoping. The implementation of his new liberal policies represented a tremendous change in the history of the New China as they were in direct opposition with the socialist ideal in previous years.

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Figure 1

Those new economic policies had two major aspects: First, the welcoming of FDI (the “open-door” policy or Kaifang) and the reforming of State-Owned Enterprises (SOE) where implemented to adapt China to the requirements of the global economy (the “reform” policy or 改革 Gaige). Because the overall Chinese economic and legal environment were still fragile and not prepared to deal with foreign companies back then, Chinese government established four Special Economic Zones in 1979 to grow and protect those investments: Shenzhen, Zhuhai and Shantou in Guangdong province, and Xiamen in the Fujian province.

In 1984, the government expanded this status to other 14 coastal cities including Tianjin, Qingdao, Shanghai, Ningbo, Wenzhou and Guangzhou. Besides, foreign companies and interests were exposed to looser regulations compared to its Chinese counterparts. For instance, they enjoyed lower corporate tax. In 1979, the government promulgated the Law of the People’s Republic of China on Chinese-Foreign Equity Joint Ventures (EJV) to inform foreign companies on the required steps to set up an activity in China and work with a local partner. Then, the government allowed foreign companies to set up local entities on their own without a Chinese partner thanks to the new corporate structure of the Wholly-Foreign-Owned Enterprise (WFOE) in 1988. Eventually, a third status was created to adapt to the needs of foreign investors with the promulgation of Contractual Joint Venture (CJV). Back then, the choice between a JV and a WFOE was mostly decided depending on the industry regulations and the possibility to find a suitable partner. The three regions which attracted the most FDI in 1985 were Guangdong (49%), Fujian (9%) and Shanghai (8%). From 1992 to 2000, the level of FDI grew rapidly with the opening up of six new cities along the Yangtze River. The amount of foreign capital invested in China went from USD 11 billion in 1992 to more than USD 45 billion in 1997.

As a consequence, China became the second-largest recipient of FDI in the world in 1997 and confirmed its position as a new global power on the world stage. Alongside the welcoming of FDI, the Chinese economy developed rapidly, stimulated by the implementation of new liberal policies and the modernization of infrastructures. According to the National Bureau of Statistics of China, Chinese GDP increased fourfold within twenty years, from USD 218 million in 1978 to over USD 1 billion in 1998, allowing significant returns for those who invested early in the Middle Kingdom.

1990s – 2001: Entering the WTO

After a decade of domestic development, the Chinese government became determined to enter the WTO, in order to become more integrated with the international trade. To fulfil the WTOs entry criteria, China had conducted numerous reforms, the most significant was the Reform of the State-Owned Enterprises (SOE). Until that time, SOEs were fundamentally managed and operated by the government but a majority of SOE were unprofitable and therefore have been unable to survive in an open market economy. To reach a more viable system, the government had no choice but to reform SOEs and allow them to go bankrupt, affecting especially the region of Dongbei (东北), the northeast of China, previously reliant on SOEs in the heavy mining industry, representing the main source of employment.

The country also amended the three existing laws on EJV, CJV and WFOE to match with international requirements by reducing the existing constraints on FDI. Therefore, new sectors opened to FDI and the requirements of setting up a JV with a local partner were progressively lifted, leading to an increase in the number of establishments of Wholly-Foreign-Owned Enterprises (WFOE) across the country. If WFOE became a popular option for foreign companies willing to launch their activity in China, JV kept a major role in the local economy as they provided foreign investors with a faster access to the market and a valuable knowledge of the market environment, unavailable otherwise. JVs are still popular in capital-intensive industries and strategic sectors of national importance.

Figure 2

Given the major reforms of the years 1990s and early 2000s, China was prepared to enter the WTO with a permanent status in 2001. After China joined the WTO, the amount of FDI kept growing steadily from USD 46 billion in 2001 to USD 74 billion in 2007, reaching USD 129 billion in 2014 and eventually reached an all-time high in 2019 at around 1%+ of GDP (compared to around 1.4% for the US).

Figure 3

Shifting focus in sectors in 40 years of FDI

The birth of China’s automotive and other high-tech industries

China welcomed FDI since 1978, but in the early days the majority was directed into the manufacturing sector. Indeed, China wanted to attract foreign investment to develop the secondary sector to lay-out the groundwork for future economic growth.

Accordingly, in 1994, the government launched the Automotive Industrial Policy aiming at consolidating the automotive sector through the development of Sino-Foreign joint ventures. By attracting FDI through JV, Chinese companies enjoyed the potential technology transfer from their foreign partner that eventually permeated the whole ecosystem afterwards. Within twenty years, China rapidly became the factory of the world, by progressively developing a wide array of competitive industries ranging from automotive to machinery and home appliances. As for the automotive sector, the majority of the biggest international actors entered the market in the 1980’s and 1990’s. The JV Shanghai-Volkswagen was created in 1984 and became a major success achieving a local market share of 50% by 1996. If only 3% of the car components was manufactured in China in 1987 due to the lack of local manufacturers, the development of the whole automobile industry lead to the creation of local car components manufacturers. Eventually, in 1997, 93% of the car produced by the JV Shanghai-Volkswagen was manufactured in China, proving the fast development of local automobile supply chains. If Volkswagen is still the unquestioned leader with more than 3 million passenger car sales in 2017 through its JV with local manufacturers FAW and SAIC, the overall domination of foreign companies on the local market is contested nowadays with the growing influence of local brands.

Indeed, the technology expertise that JV partners brought elevated the whole industry and led to the emergence of local actors that combined advanced technology and affordable prices. Therefore, the share of local brands has been increasing from 28% in 2005 to 42% in 2018. The best example is Geely, the company that acquired Volvo in 2010, reaching 1.3 million passenger car sales in 2017, thus becoming the top Chinese brand in the country and proving the success of the development strategy of the manufacturing sector in China. Thanks to the reception of FDI and the spread of Western technologies in the local economy, China managed to create its own national champions relying on modern manufacturing resources, cutting-edge innovations and attractive products able to compete with international standards. The development of the manufacturing sector in China could inspire many other developing countries looking to modernize their economy while preserving the control over key national assets.

See our interview with Prof. Carl Hahn, CEO of Volkswagen AG (1982, 1993) reflecting on the establishment of Volkswagen China in 1984 : https://www.chinatechblog.org/blog/from-humble-beginnings-to-the-largest-automotive-market-in-the-world

Shift to the service sector

From mostly manufacturing-oriented Foreign Direct Investments (FDI), the situation smoothly changed to tertiary-oriented FDI with the progressive liberalization in the 2000’s. Indeed, in 2005 the flow of FDI into the secondary industry represented 74% of the total amount of FDI in China and this figure decreased significantly to represent only 37% in 2014, with the tertiary industry accounting for 62% of total FDI.

Since 1995, every 3-4 years, China published the Catalogue for the Guidance of Foreign Investment Industries which categorized each sector in three categories, “encouraged”, “restricted” and “prohibited”. The number of prohibited and restricted sectors reduced drastically and most of the tertiary industry was liberalized in the 2000’s, enabling the development of foreign companies in several industries such as retail or real estate. Multinational retailers such as Carrefour and Metro set up their local business and grew exponentially throughout China’s expanding urban areas, enjoying the growth of the middle class as well as the subsequently increased purchasing power. Multinational restaurant chains such as KFC and McDonald’s successfully entered the Chinese market and filled the gap in the catering industry by importing Western fast-food culture while adapting to the tastes of local customers. At the same time, e-commerce in China was emerging with the improvement of internet infrastructures and the investment in modern communication technologies.

The number of internet users went from 34 million in 2001 to 210 million in 2007. However, one of the potential hurdles for the development of e-commerce in China was the gap in the banking system and the low usage of credit cards to conduct online payments. It was only in late 2002 that banks in China were united in a single card processing system called China UnionPay. The streamlining of the banking system helped the sector to develop, between 2000 and 2003, the number of bank cards went from 277 million to 650 million.

Even as China joined the WTO in 2001, the banking system was reformed only in late 2006, thus allowing foreign banks to acquire a minority stake in Chinese banks, up to 25%. Along with the development of the retail and the finance sector the government aimed at promoting the service industry to reach stronger domestic consumption and reduce the dependency on exports as detailed in the 12th Five Year Plan in 2011.

Indeed, the Chinese economy was strongly hit by the 2008 financial crisis as global trade reduced drastically during the turmoil. Thus, the liberalization of the service sector met the needs of a growing and affluent middle class that is looking for rich entertainment experiences and efficient financial services. The development of the tertiary sector enabled the country to shift from an emerging economy relying on investment in infrastructures and low-cost manufacturing to a developed economy focusing on cutting-edge innovations and tertiary services. Recent investments of foreign actors into emerging technology companies point towards that direction. Besides, the development of the domestic consumption triggers opportunities for foreign companies in the consumer goods sector to tap into the market of the growing Chinese middle class.

Issues and challenges of welcoming FDI while preserving values of a socialism

Following the liberalization trend, the existing constraints that forced foreign companies to form a JV with a local partner were progressively lifted. Though, the increasing influence of foreign companies was a growing concern for the country and sparked nationalist reactions which led to the return of protectionist behaviors. The fast development of foreign multinationals in the Chinese territory were made responsible for the growing disparity in terms of development between the modern Eastern part of China, hosting most of the FDI, and the underdeveloped Western part.

In 2005, the Eastern region of China was hosting 86% of total FDI, with the three provinces attracting the most FDI being Guangdong (20%), Jiangsu (18%) and Shanghai (14%). However, the government fostered the welcoming of FDI in the Middle and Western region cities to develop diversified and competitive industry such as the car industry in Wuhan and the video games industry in Chengdu, triggering the emergence of modern urban centers in those regions.

Figure 4

When it comes to Foreign Direct Investments (FDI), the government also insisted on the need to protect strategic national assets from foreign interests. Therefore, the Chinese government implemented new protectionist measures to control more efficiently the arrival of FDI in the country.

For instance, in 2006, a new law tightened the acquisition of Chinese companies by foreign investors and now requires companies going through an approval procedure if the company is part of a national-appointed key industry, has influence on the security of the national economy, or display a famous Chinese brand.

Eventually, in March 2007, a new fiscal reform ended with the preferential rates applied to corporate taxes for foreign multinationals. As a consequence, economic policies in terms of FDI were the reflection of the general attitude of the Chinese government hesitating between further liberalization of the market and the protection of national interests. In January 2020, the new Foreign Investment Law has been put into force and eliminated the distinction between EJV, CJV and WFOE to the profit of a unique corporate structure called “Foreign-invested enterprises” (FIE). This new regulation will give more flexibility and agility to foreign companies. In the coming years, China will remain the world’s second biggest recipient of FDI after the USA, and will use the set of existing regulations to better monitor the distribution of FDI throughout the country.

Despite the concerns and negative media coverage in recent years, China´s example of using FDI as a tool for economic development has become an inspiration for many developing countries. Through wise policy making, China maintained control over the ownership of foreign investors’ assets. It took a gradual approach, constantly opening up more and more industries at a slow pace. The fact that actual investment inflows kept rising over the years and are at a solid level in relative terms to GDP, points out the overall satisfaction of foreign investors regarding the investment climate and returns. China itself has been slowing down outward FDI significantly since the peak year of 2016. As China enters its next stage of economic development focused on technology, it will be interesting to see which role foreign investments will play. The significant participation of foreign venture capital funds in the tech industry shows that China continues to welcome foreign investment. Concrete cases like Volkswagen´s recent USD 1 bn investment in battery manufacturer Gotion High-Tech demonstrates that even key technologies in strategic industries are open to foreign investment. However, with nationalistic tendencies due to Covid-19 and an ongoing trade war, it remains to be seen if China can resist to the temptation of nationalist protectionism. 40 years of opening up and economic reforms along with steady progress make us hopeful.

All opinions expressed in this essay represent our personal views only.

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