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China's Foreign Direct Investment Strategy

Though a developing country, China has become the world's largest recipient of foreign direct investment (FDI). But questions are being raised about how those funds are being sought and used.

Over the past 25 years, China has achieved outstanding progress in economic development and FDI has played an important role in this success. China is expected to continue to be a fast-growing economy in the future, and it is also respected as the best destination for FDI.

However, China is struggling with an overheating economy, high materials consumption, and disparities between urban and rural areas, regional imbalances, environmental pollution, unemployment and surplus labour forces.

FDI and China's Economic growth

FDI has become an important component of China's national economy, and an engine of growth. Figure 1 shows the trend of FDI and GDP (gross domestic product), which are positively correlated.

Evidently, FDI drove exports in 2002; exports of foreign-invested enterprises (FIEs) increased.

41.4 percent to US$240.3 billion, accounting for 54.8 percent of the national total. Over the same period, FIE imports grew by 44.7 percent to US$231.9 billion, representing 56.2 percent of China's total. Figure 1 shows the historic development of the role of FDI in the national trade volume.

There is an imbalance in sector distribution. Reference data from Table 1 shows that FDI in China is concentrated in the manufacturing sector, generating some excess supply capacity in certain product markets. At the same time, the level of FDI in infrastructure, energy and agriculture has been very low. The share of FDI in high-tech industries has also been modest. The services industry needs more FDI so as to improve service levels in China. These are sectors directly related to people's lives and welfare, but health care, sports and social welfare, culture, and education receive a meagre share of total FDI in China.

A number of studies have found that export-oriented FDI, because of its heavy reliance on imports, has generated few technology transfers or linkages with domestic Chinese enterprises. It generates less local added value per unit of output than domestically owned enterprises engaged in the same activities, experts said.

Of particular concern is that many governments in order to attract FDI have relied upon offering very generous tax concessions or direct financial incentives. This reduces the potential for positive effects of FDI through an increase of government revenue. Such competition, particularly where discrimination between foreign and national investors is concerned, creates incentives for rent-seeking and corruption. This results in the diversion of resources into non-productive activities and can have longer-term effects on China, because it can undermine systems of corporate and political governance, sources said.

The Interface between FDI and the Environment

It is possible that some countries could be attracted to China by a perception that environmental standards are lax. Some may refrain from upgrading environmentally low-standard operations to attract certain types of investments, and individual firms may be sensitive to the costs of complying with more stringent environmental standards. This section presents preliminary analyses and findings of some existing studies, as well as a number of highly publicized positive and negative cases.

FDI may have a positive effect on the environment through transfers of new technologies because they are likely to be cleaner in terms of environmental emissions and more efficient in terms of resource use and recycling than technologies available locally. Reductions in resource use and pollution may also be driven by better management and pressures for efficiency associated with privatization and acquisition by foreign investors. These effects may extend to local companies who employ staff previously employed and trained by the FDI company or where multinationals work with their local suppliers to raise environmental standards by providing technical assistance. Access to capital supplied through the use of FDI may relieve one of the key constraints on investment in cleaner, more-efficient technologies. Some multinationals have polices that commit them to operating on a basis of uniform international standards usually based on those of developed countries. These may well be stricter than the environmental and social standards required by host-country legislation. The reasons for this include efficiencies involved in operating with a single set of standards and concerns about visibility and potential environmental liabilities.

Studies indicate that some foreign investors have set up enterprises to decompose, renovate and process waste metals, electronic appliances, tires, and harmful chemical pollutants. Most of them have a serious impact on the environment. Some of these investors even import foreign garbage into China, ostensibly for the purpose of recycling. Taiwan used to be an important location for recycling hazardous materials from the United States. In 1993, its environmental authorities banned trading in discarded-metal materials. A number of Taiwanese investors relocated their production facilities to the eastern mainland coastal areas, such as Shenzhen, Zhuhai and Changzhou. They continue importing tons of waste materials such as used cells, vehicle plates, computers, adapters and other electrical and electronic components for recycling in China. The effect on the surrounding environment is enormous. Some foreign firms do not pay enough attention to pollution prevention, nor do they adopt adequate and effective measures to treat pollution. Some of them even try to elude the environmental monitoring mechanism. Most of these incidents occur in projects financed by medium- and small-scale foreign firms, according to an UNCTAD/CBS project report.

In 1996, Fumao Phosphor-Chemical Industrial Limited Company, a joint venture set up by a Chinese fertilizer manufacturer and a Taiwan chemical company in Guizhou Province, allegedly discharged sewage into the Yanchang River. It caused very heavy environmental pollution, and over 400 persons suffered from phosphorus poisoning. The company had ignored environmental laws for a long time. It even refused inspection by the local Environment Protection Bureau (EPB). When its vitriol factory started to operate in September 1995, its associated environmental protection facilities had not even been installed. Furthermore, it switched to the use of an inexpensive raw material of high dense phosphorus content. The facilities could only reduce acidity, but not eliminate phosphorus. The water of high density phosphorus was directly discharged and resulted in severe pollution. An investigation revealed that the phosphorus content of the sewage discharged from the factory was up to 703.45 milligrams per litre, 250 times higher than the national standard. The Yanchang River polluted by the sewage had phosphorus 20 times higher than the national standard. The EPB of the province fined the factory and directed it to take effective measures to eliminate the pollution, sources said.

In Northeast China, a well-known joint venture was set up by a Thai transnational corporation (TNC) and a local partner. The investment was about US$24 million in the first phase. It was supposed to be screened and monitored by National Environment Protection Bureau (NEPB). However, the company went into operation in 1992 without completing environmental administrative procedures. The company did build facilities to dispose of their waste water, but they were far less effective in function. Environmental protection engineers and the company's senior management were not aware of the national standard for discharging waste. In the second phase of investment, a sewage disposal facility costing US$1.8 million was not completed until May 1997. It was estimated that 30 million tons of highly polluted sewage was discharged through the Yinma River into the Songhua River in 1997.

A foreign affiliate manufacturing plastic products in Longhai city imported "industrial raw materials" from Europe. There were 100 containers weighing more than 1,000 tons. When the firm opened the containers and made a spot check, it found they were all filled with industrial garbage. However, the company neither asked for compensation nor replacement. They just left it out in the open. The stench was extremely foul outside the workshop.

The Interface between FDI and Social development

FDI, where it generates and expands businesses, can help stimulate employment, raise wages and replace declining market sectors. However, the benefits may only be felt by a small portion of the population, where employment and training is given to more educated, typically wealthy elites or where there is an urban emphasis. But wage differentials (or dual economies) between income groups can be exacerbated. Cultural and social effects may occur with investment directed at non-traditional goods.

Infrastructural development and technology transfers via FDI are beneficial to China. Parent companies can support their foreign subsidiaries by ensuring that adequate human resources and infrastructures are in place. In particular "Greenfield" investments into new business sectors can stimulate new infrastructural development and technologies to host economies. These developments can also result in social and environmental benefits, but only where they "spill over" into host communities and businesses. Investment in research and development (R&D) from parent companies can stimulate innovation in production and processing techniques in the host country. However, this assumes that in-house investment (in R&D, production, management, personnel training) will result in improvements. Foreign technologies and organisational techniques may actually be inappropriate for local needs. They may be capital intensive and generate a negative effect on local competitors, especially smaller business that are less able to make equivalent adaptations. Similarly, external changes in suppliers, customers and other competing firms are not necessarily an improvement on original domestic-based approaches, according to a 1999 UNCTAD (United Nations Conference on Trade and Development) report.

FDI can have important social benefits and can lead to poverty alleviation if employment is generated for unskilled labour or if capacity-building and training is built into the activity, upgrading human capital. A 2000 International Labour Organization (ILO) study found that large-scale foreign-owned enterprises in China paid considerable attention to training and skill development.

Indirectly, poverty reduction may result from spillover effects on local enterprises or from FDI generated increases in governmental revenues that allow more spending on social safety nets. FDI is often associated with investments by the companies concerned with community development in the areas where they operate. Foreign-owned companies may have indirect effects. Poverty reduction may result from spillover effects stemming from local enterprises or from FDI-generated increases in governmental revenue, which may allow more spending on social safety nets. FDI is often associated with investments by companies concerned with community development in the areas where they operate. Foreign-owned companies may have better labour standards than local companies, because they are under more pressure from consumers or from the general public in their home countries. Finally, foreign investment in basic services such as water and energy may lead to a more effective delivery of services to the poor.

In China, criticisms have been made of the harsh discipline in some foreign-owned companies, violations of the Labour Law concerning working hours and overtime, inadequate participation in the social insurance system, as there is no national regulation that compels foreign-owned companies to participate in a pension scheme, and a rapid increase in industrial disputes amongst such companies and because of poor industrial safety practices. The different styles associated with different ownerships of foreign-owned companies whether European, North American, or Japanese or overseas Chinese has a considerable bearing on the extent to which such problems occur. According to an ILO study, the enterprises with the worst employment conditions in South China are the locally owned ones. While some foreign firms have been associated with abuses, others offer higher than average wages and employment conditions, according to the ILO study.

Regional imbalances are another negative effect from FDI in China. More generally, FDI may accentuate inequality between regions of a country, particularly where certain areas are targeted for inward investment, such as in export processing zones, or between individuals such as those working in foreign-owned companies that have better working conditions and remuneration. Thus, in China the regional distribution of FDI is extremely unbalanced and mainly concentrated in the coastal areas. This is because of the geographic advantages associated with coastal areas and because of the preferential investment policies extended in these areas. Policies have changed, but the imbalance is expected to persist for some time, experts said. To some extent, FDI exacerbates regional imbalances in China.

Overview of Global FDI Prospects and China's Position

Experts are optimistic about the prospects for global FDI flows during the next four years (2004-07). Their optimism extends to almost all geographical regions, but in varying degrees. 

China and India are the hot spots for FDI, followed by the United States, Thailand, Poland, the Czech Republic, Mexico, Malaysia, the United Kingdom, Singapore and Republic of Korea. All countries are expected to intensify their efforts to attract FDI, reflecting a more intense competition worldwide for FDI projects. (Table 2) 

In Asia and the Pacific, optimism about FDI prospects is broad-based in terms of industries. In the manufacturing sector, improved prospects are expected for motor vehicles and other transport equipment, machinery and equipment, chemicals, and to a lesser extent electrical and electronic products, publishing and media, and printing and recording industries. In the services sector, banking and insurance, business services, tourism, transportation, computer-related services, retail and wholesale will take the lead in attracting FDI in the years to come (Figure 2)

Experts predict that the most likely options for business expansion overseas are evenly divided between mergers and acquisitions (41 percent) or Greenfield investments (37 percent). Other modes of international business expansion such as, licensing and strategic alliances were mentioned by only 22 percent of the respondents.

The message emerging from this survey is that countries are expected to intensify their efforts to attract FDI, reflecting increased competition worldwide for FDI projects. The number of experts that expected countries to adopt no new measures to promote FDI in 2004-05 was significantly lower than those that indicated having observed no such measures being put in place during 2003. The general expectation is that countries will become more active in promoting FDI, in particular, through further liberalisation measures, additional incentives and increased targeting. (Figure 3)

In the coming years, we expect that China will continue to attract more FDI, The timetable set for further openings after WTO entry will ensure that foreign capital will continue to flow into China mostly in the form of FDIs. There is little doubt that inflows will continue to grow. But when evaluating the FDI contribution to China's future economy, attention should also be paid to its quality in addition to quantity. The strategy and the policies concerning FDI should be adjusted to maximize benefits and minimize negative effects.

About the author

Guo Huaigang, the Director of Department for the Foreign Investment Development in Beijing Municipal Bureau of Commerce. He took part in the programme for the Study of International Organizations (PSIO), HEI Joint with WTO and Beijing Municipal Government, China.