Ken Davies, principal administrator in the directorate for financial, fiscal and enterprise affairs at the Paris-based Organization for Economic Cooperation and Development (OECD), says the best way for China to increase the amount and the quality of foreign direct investment (FDI) is to develop a rules-based environment in which the rule of law, individual rights and property rights are respected.
"This will encourage investment and creativity, not just by foreign companies but by local ones as well," he says. He adds that when Chinese government officials ask the OECD about which of its member countries they should look to for examples, he says this is not necessary: instead of booking a trip to North America or Europe, officials can simply look at what Hong Kong has achieved.
This is in contrast to the practice, pursued worldwide to mixed effect, of trying to use fiscal incentives such as tax breaks to attract FDI. Davies reports that such efforts have not always been positive when tried by OECD members.
Davies, a former resident of Hong Kong when he worked at the Economist Intelligence Unit, was back in town to promote a review about Chinese FDI written and published by the OECD. The analysis was based on a request by Beijing for an impartial look at its FDI situation.
The OECD, because its 30 members constitute the wealthiest developed nations in the world, has a unique perspective on FDI: in 2002, some 90% of global FDI originated from OECD members. Moreover because it is a research body, without any political or economic power, it is considered impartial. It has 'outreach' programmes with many developing countries, and the biggest one is with China, with which it assists on many policy areas.
FDI is of course important to China. Last year China usurped the United States as the world's leading recipient of FDI, with about $53 billion. So far it has received 25% more the first seven months of 2003 than it did in the first seven months of 2002, which could put it on track to hit around $60 billion this year.
Impressive - and yet China remains concerned about the quality and the breadth of its FDI intake. The sheer size of the country means that on a per capita basis, its FDI figures are actually quite small. In 2000, the last year in which data is available for comparisons, China received only $30 per head of FDI, versus an OECD average of about $1,200 per head. Of course, the amount of FDI in places such as Shanghai and Guangzhou is extremely high. This means much of the country, the hinterland in particular, is completely missing out. (It also means that, as huge as China's absolute FDI receipt seems, its potential as a capital destination has only begun to be tapped.)
Therefore the government is concerned about how to attract more FDI. It also wants to adjust the nature of this capital, as most of it has gone to short-term, labour-intensive ventures.
Although the showcase investments by the likes of Motorola and Volkswagon make headlines, the truth is that most FDI into China comes from small- to mid-sized companies in places like Hong Kong and Taiwan that are pretty low-tech, and which are looking for a quick payback. Davies reports that even last year, about one third of China's FDI came from Hong Kong companies, and 47% of its accumulated FDI is from Hong Kong. Meanwhile, its total FDI from the United States is on par with investment from Thailand.
The big economies like the US and Japan are simply not big investors in China; rather they are active in two-way trade. But China's government is keen to get FDI from American companies like Motorola because it is long-term and it brings foreign hi-tech and research to China.
Another area that the OECD looked at was how this FDI is used. The global trend is now that cross-border M&A accounts for the great majority of FDI, with rather less aimed at greenfield projects. This is the reverse for China, although its domestic M&A activity is rising. This lack of cross-border M&A-related investment is a problem for China's development, because it needs foreign capital and expertise as it restructures its companies.
The OECD found that there are many things the Chinese authorities can do to try to attract more of this sort of FDI. One example Davies sites: provincial and municipal authorities often sabotage mergers and acquisitions if it means losing tax revenue to a head office located in another part of the country. The central authorities can establish clearer rules regarding M&A to streamline the process.
There has been a debate that China doesn't actually need foreign investment. Its high savings rate, maintained throughout its reform (unlike in Russia, for example), leads some observers to argue that what China really needs is capital-market and banking reform, to mobilize those savings efficiently.
It is true that such reforms are necessary, but Davies argues that FDI plays an irreplaceable role in improving China's corporate sector. The spillover benefits of FDI go well beyond the simple fact of a foreign-owned factory. The biggest effect is that the presence of foreign enterprises sparks domestic competitors to outperform, raising the bar for an entire industry. Local firms can copy Western practices and then apply those lessons to local conditions. He notes companies like Whirlpool have exited because the local competition became too fierce - something that no one sees in sectors where foreigners have been shut out.
FDI also leads to increased localization of management, as locals learn enough skills to replace expensive expats. Davies says salary inflation for many expat posts that marked Chinese business a few years ago has reversed. Moreover, locals at foreign companies learn those management skills that they never needed in a command economy. Foreign plants also require local suppliers to raise their game. So a foreign-owned manufacturing site brings progress across a range of areas that makes China's companies far more competitive - and leads to better listed companies, which enhances capital-market reform.
The area in which Davies did not comment, of course, was political. China needs to adopt a rules-based system of law and regulation. Although Hong Kong is not a democracy, it comes from an Anglo-Saxon tradition where at least the colonial power was democratic, and in which standards of accountability existed. Whatever the current quibbles over the Hong Kong government, it is clear that 'rule of law' is a tricky objective for a country of one-party rule, in which accountability and rules inevitably turn murky and opaque depending on who you know and how far up the chain you go. The OECD's advice seems very sensible; whether China can implement such a regime is one of this century's greatest challenges, in regards to FDI and broader concerns.
