On January 16, 2003, Yasheng Huang, Associate Professor at Harvard Business School, delivered a presentation "Foreign Direct Investment (FDI) in China: Why Surging Levels of FDI May Indicate Serious Economic Problems" at a special lunch forum hosted by Carnegie's China program. Minxin Pei, Senior Associate and co-Director of the China program, moderated.

According to Huang, China's lagging internal reforms contributed to the fantastic growth of foreign direct investment (FDI) in China during the 1990s. The decade should be divided into two periods-pre-1997 and post-1997. While the former period illustrates Huang's argument that FDI rose because internal reform was lacking, the latter period has witnessed a fundamental shift in the pace and scale of China's internal reforms. And when analyzing FDI as a proportion to China's overall economy (persons looking at absolute numbers alone will miss this), the results of these reforms are clear: since 1997, FDI has played a less important role in China's economy.

Overview of FDI Developments

Huang defined FDI as a financial stake a foreign company acquires in a domestic company. By China's high standards, the financial stake must be at least 25 percent to qualify as FDI. Even by these standards, China attracts enormous amounts of FDI. In 2001, FDI in China was $45 billion. Estimates for 2002 hold that FDI inflow could have exceeded $50 billion. In 2002, one survey also found that China outranked the US as the most attractive destination for FDI. The importance of FDI to China is readily apparent. During the 1990s, FDI represented between 11-17 percent of China's fixed asset investments. Compare this to the US where FDI accounted for only 6 percent of fixed asset investments.

Numbers alone do not tell the whole story. Pre-1997 FDI evidenced very unusual qualitative characteristics. To begin, large companies were not the primary source of FDI in China, but rather small companies based in Hong Kong, Taiwan and Macau. This contradicts normal FDI patterns as small companies do not usually invest abroad. Also unusual was the location of FDI inflows-FDI in China was spread across all industries, including those industries in which Chinese entrepreneurs traditionally do very well. Again, this goes against the norm as FDI is generally concentrated in a few industries where domestic entrepreneurs are weak.

Huang then dispelled a popular misconception: FDI in China is not confined only to the coastal areas. Although 80 percent goes to coastal regions, the remaining 20 percent invested in the interior regions is a very significant amount when put into perspective by the interior's much smaller economy. Measured by this proportion, FDI throughout the 1990s exceeded 10 percent of the interior's economy, a percent comparable to North America. What makes FDI unusual in these areas is the remoteness of the interior regions. Huang explained FDI's large role in the interior economy by noting the fragmentation of China's domestic asset market. Domestic companies were restricted to investing only in their own provinces while foreign companies were free to invest anywhere.

Huang pointed to a further unusual fact about FDI in China in the pre-1997 period. As China's exports rose in this period, so too, did FDI in labor intensive industries. This goes against the experiences of Hong Kong, Taiwan and South Korea in becoming leading producers. In those countries, domestic companies controlled the large share of export production while foreign companies acted primarily as purchasing agents. In China pre-1997, however, export production was driven by FDI-an ownership arrangement whereby the foreign entity acquires an equity stake in the domestic company- and not contractual arrangements. Huang attributed this phenomenon to the inability of Chinese entrepreneurs to raise working capital. Turned away by Chinese banks, domestic companies were forced to rely on FDI.

Challenging Conventional Wisdom

Conventional wisdom fails to explain China's unusual FDI patterns. Huang first rejected the conventional wisdom that attributes China's high FDI to the enormous size of its market. This explanation holds true only for absolute numbers of FDI and does not account for the dramatic rise of China's relative measure of FDI (FDI divided by domestic investment). As happened in the United States during its 1990s boom, domestic companies should be equally induced to invest in a booming economy, thereby causing the relative measure of FDI to remain unchanged. Yet in China during the pre-1997 period, FDI increased while domestic investing was constrained.

Another rationale points to China's low labor costs to explain high amounts of FDI. Huang discarded this explanation because low labor costs determine only the location of economic activity. Low labor costs do not determine the type of ownership over that labor production-that is, whether it is domestic or foreign owned. This is particularly important to note in China's case, because export production facilities are owned by foreign companies from Hong Kong, Taiwan and Macau and not by local entrepreneurs.

The need to ensure quality control is also raised as justification for FDI. However, Huang pointed out that quality control is a contractual issue. As Taiwan and Hong Kong demonstrate, carrying out quality inspections is a right always granted to foreign contractors. Indeed, foreign ownership could actually prove detrimental to quality control because the objectivity and incentive to ensure quality control is reduced.

The last conventional explanation Huang considered was the rule of law argument. Some assert that China's poor rule of law necessitates FDI as only equity arrangements would protect foreign investments. Huang noted that this is valid only for intellectual property investments, and not for labor intensive investments. The successful labor-intensive contractual agreements arranged in other underdeveloped countries demonstrate that a poor rule of law is no barrier to the protection of foreign contracts. In fact, FDI is itself a contract, so the increasing amounts of FDI in China also belie this argument.

An Institutional Perspective

Huang utilized an institutional perspective to interpret China's FDI patterns. When assessing relative foreign competitiveness in China (competitiveness of foreign firms divided by the competitiveness of domestic firms), a very clear explanation for the unusual characteristics of FDI in China during the pre-1997 emerges: domestic companies were simply not competitive.

During the pre-1997 period, China had very poor institutional efficiency in allocating financial and economic resources. The banking system allocated massive financial resources to inefficient state-owned enterprises (SOEs) while denying resources to efficient private domestic companies.

In addition to institutional inefficiencies, private domestic companies were hindered by constitutional constraints. China's constitution did not begin to recognize the property rights of Chinese private entrepreneurs until 1999. However, foreign companies had enjoyed those rights since 1982.

Market fragmentation, too, depressed the competitiveness of domestic firms while increasing FDI. Domestic companies were not allowed to invest outside their respective provinces, while foreign companies faced no such restrictions. For example, until 1998, every subsidiary of Shanghai Automotive Industrial Corporation, China's biggest auto company measured by sales, was located in Shanghai. During this same period, China Strategic Investment, a very small Hong Kong company, was able to buy 200 companies over 9 provinces in China.

In the pre-1997 period, these inefficiencies and market fragmentation led to an across the board uncompetitiveness of domestic firms. This explains the high levels of FDI across all of China's industries. Moreover, these factors also explain the failure of contractual agreements in China in favor of FDI. Despite being poorly operated, China's SOEs retained important assets, such as networks and high levels of government investment, which made them attractive acquisition targets. But because privatization was not allowed in China until 1997, SOEs were acquired through joint ventures by FDI. De facto privatization was controlled by foreign entities.

Broad Implications

Since 1997, China has sped up internal reforms, particularly vis-à-vis domestic private companies. In 1997, the four largest state-owned banks were allowed to lend money to private companies. In 1999, the Constitution was revised to extend the property rights enjoyed by foreign companies to private domestic entrepreneurs. For the first time, private domestic companies were also allowed to export directly. And at the 16th Party Congress, Jiang's three represents theory, which welcomes capitalists in the CCP, was enshrined in the party Constitution.

These reforms have led to dramatic changes in FDI inflows. Labor intensive FDI has been reduced greatly, while high tech FDI is increasing. FDI is also becoming more concentrated in specific industries and there has been a striking rise in contractual exports. Taken together, these changes in the post 1997 period point to a more healthy Chinese economy and a higher quality of FDI.

Huang noted two contrasting growth models that have emerged in China. Zhejiang and Jiangsu are two provinces with identical social, economic and geographic conditions, but over twenty years, they have shown very different growths. Zhejiang's economy grew more, is less reliant on FDI and exports are driven mainly by domestic entrepreneurs. On the other hand, Jiangsu followed a Chinese reform model. Over the same period, Jiangsu's economy and exports grew more slowly, and today faces many serious internal problems.

Huang closed by drawing a comparison between China and India. Although China enjoys more favorable conditions than India (higher saving rates and higher FDI inflows), India's economy is beginning to catch up with China. India has pursued internal reforms more aggressively than has China, and today boasts many indigenous companies thriving on a global scale. However, India has been much less aggressive than China in opening up to foreign investment. Huang observed that China and India can learn much from each other. China has not done as well as many say, and India has done as poorly as often thought.

Question and Answer

Huang was first asked to comment on China's situation once FDI profits stop being reinvested back into China. Huang predicted that any domestic instability could have a dramatic impact on China's current account. Presently, profit remittances going out from the service account are being reinvested in the capital account, but any domestic instability will interrupt that pattern. China's current account could go into deficit in three to four years.

Another participant sought an explanation for roundtripping in China. This occurs when a Chinese company exports to set up a subsidiary and then imports the money back into China as FDI. Huang responded that roundtripping occurs primarily because it is a way for marginalized domestic entrepreneurs to increase their property rights and political status. However, as domestic entrepreneurs are afforded more property rights and guarantees, the amount of roundtrip FDI is decreasing.

The last question raised the possibility that China's FDI phenomenon is explained by a mixed model. While institutional inefficiencies account in part for FDI, active policies of the Chinese government designed to receive "know-how transfer" from foreign companies might also be responsible. Huang agreed that "know-how transfer" is intentional in the high tech sector, but that the explanation falls short in explaining labor intensive FDI, which accounted for the bulk of FDI in China during the 1990s. The institutional model is more instructive for pre-1997 FDI. However, post-1997, "know-how" FDI is increasing. Therefore, the overall decrease in FDI relative to the Chinese economy should not be viewed as a sign of unhealthiness but precisely the opposite. As internal reforms progress, domestic companies have become more competitive, the quality of FDI is higher and the Chinese economy more healthy.