In 1997 China received its largest influx of utilised foreign direct investment (PHI in its economic history: US$45.177bn. While an impressive figure, second only to foreign direct investment into the US, the total may indicate more about the past than about either the, present or the future. Utilised FDI, the amount of investment capital flowing into China, rose this year. However, contracted FDI, future foreign-investor commitments made in 1997, decreased by 29 percent year-on-year. Most of the major (mostly Asian-based) investors significantly decreased contracted FDI commitments in China. Taiwan led the pack, decreasing investment by 45 percent, while Hone Kong cut hack by 35 percent and the US decreased its commitments in 1997 by 29 percent.
This declining trend is continuing. In the first quarter of 1998, Taiwan, South Korea, Hong Kong and Japan dropped of 23 percent, 38 percent, 4 percent, and 1 percent respectively. Interestingly, there were big gains elsewhere. During the first quarter of 1998 German commitments rose 136 percent, while commitments from the Virgin Islands rose 137 percent.
Nevertheless, utilised FDI for the past two years has continued to increase, albeit marginally. For the first quarter of 1998, utilised FDI climbed by 9.7 percent. This utilised investment figure continues to grow because of the enormous contracted investment commitments that were made in the past – US$93.8bn in 1994, and US$103.2bn in 1995.
However, with decreasing contracted FDI in the pipeline, China will need to look for ways to encourage foreign investment, particularly from the increasingly important non-Asian countries. To help accomplish this, China will need to adjust its systems to cater to the US and EU, from where utilised FDI rose sharply in the first quarter of 1998, by 28 percent and 75 percent respectively.
The importance of FDI
The overall declining FDI trend is dangerous to China's growth and ultimately to the stability of the nation. China is taking measures to attract FDI. New or reinstated investment incentives, greater flexibility on acceptable investment structure, plus the lack of competition from China's historical investors, may create the best investment climate that China has offered in almost a decade. Sharp investors will be following the lead of Kodak, which has created groundbreaking investment structures.
Foreign investors play an increasingly important role in the domestic economy of China. Pundits often talk of the tremendous growth of China, and rightly so. Industrial output has grown from Yn2,663bn in 1991 to Yn9,960bn in 1996. One particularly significant characteristic of this growth has been the diminishing role of state-owned enterprises. All other categories such as collective, private and FDI have increased their share of industrial output.
By the end of 1996, there were more than 140,000 foreign-funded projects employing more than 16 million people. In 1991, foreign direct investors contributed only five percent to GDP. As of 1997, foreign direct investors were responsible for more than 17 percent of GDP and since 1995 they have employed more than 10 percent of the workforce. As some of the highest paying employers in China, this 10 percent figure somewhat understates the role of non-Chinese owned companies.
As a percentage of GDP, foreign investors continue to expand their role in the domestic economy. Within the next decade, foreign-invested enterprises will probably contribute more to the Chinese economy that the moribund state-run enterprises.
International trade statistics reveal that foreign investors contribute the lion's share to international trade in China. FIEs have been the engine behind much of the trade growth over the past decade. In 1996, FIE trade grew by 25 percent to US$37.1bn, or 47 percent of China's international trade. The FIE's share of exports has grown from 17 percent to 41 percent between 1991 and 1996. In 1996 international trade accounted for approximately 36 percent of China's GDP. From 1991 to 1995, foreign trade grew at an annualised 17 percent. Export-led growth has been a major driver for the Chinese economy, stimulating industrialisation and FDI. In short, FDI is a critical component of the Chinese economy.
Another development that further illuminates recent international trading trends has been the marked increase in smuggled goods. Jiang Zemin's recent attack on the People's Liberation Army (PLA) – China's army turned-corporation – by clamping down on its business operations was interesting in that it highlights the PLA's notorious grey channel importing. Some analysts claim that this year, China's grey channel imports will exceed the formal import channels and that the country will probably run a trade deficit and not a surplus. This puts further pressure on China to accumulate foreign exchange and hence entice foreign investment.
This year China has changed from being a net exporter to a net importer of steel. Indeed a Baoshan spokesperson was quoted in July as saying: "All Chinese steel makers are suffering from escalating regional competition. On the one hand, we have lost a good deal of the overseas markets. And on the other, as the domestic market is being flooded with cheap Korean steel, we are having difficulties keeping our domestic users." Instead of making steel, many producers now import and distribute Japanese and Korean steel, because it is both cheaper and of better quality.
Decrease in Asian investment
The general composition of the utilised FDI pool has not changed significantly over the past two years. Hong Kong is still the major investor, followed by Japan, Taiwan and the US. However, for contracted investment an indicator of future trends ?the Virgin Islands has now moved up to second position and the US to third, while Hong Kong's percentage dropped by four percent over the first quarter of 1997. European contracted investment has dropped by eight percent, but utilised investment has risen by 75 percent in the first quarter of 1998. This may signify a shift over the next few years with Europe and the US playing increasingly important roles in general business developments in China.
To help break through some of China's notorious regulatory red tape, international investors have begun voicing complaints. These voices will undoubtedly become more organised and more vocal. Chambers of commerce and professional organisations have already begun to lobby for changes. Some of these bodies have become influential ?such as the American Chamber of Commerce (Amcham) in Shanghai which boasts more than 1,000 members.
It is increasingly common for companies to use interest groups such as Amcham to make policy statements or to voice their dissatisfaction with unauthorised or arbitrary fees as well as internal, or neibu, regulations. This dissatisfaction is not limited to foreign companies; when given a safe chance to voice their opposition, Chinese companies will also complain about the bureaucratic and regulatory minefield encountered while doing business in China.
Overall, investment trends are down, in both domestic fixed asset investment and FDI. This is precisely why it may be the best time to find great deals. The Financial Times recently reported that Lujiazui Finance and Trade's first half 1998 profits were down 25.58 percent. This company is seen by many as a measure of foreign investment in the economy of Shanghai. Regardless of these figures, there appears to be significant activity particularly from companies looking for bargains and existing investors consolidating their positions.
Kodak creates a new mould
Kodak is an example of a company that has pushed hard for an expanded and liberal business scope, and has succeeded in this quest. It has purchased the shares of three Chinese state-owned enterprises (SOEs) and became the first true foreign share-holding company in the country's history. Kodak's investment-structure precedents are changing the economic investment environment. Similar to the General Motors' investment in Shanghai, Kodak's US$lbn-plus deals give it more control over the final structures. These major projects also carry significant spillover investments as the major sup-pliers follow their main customers.
The photographic film industry has until now been closed to foreign investors, but Kodak has exploited the growing realisation that FDI must play a role in the reorganisation of China's state-owned industries. It agreed to purchase three failing SOEs, pump them up with capital, equip them with the latest technology and employ more than 2,000 people. Beijing may fret that it has sold out to foreigners, but this fear is overridden by the fact that 2,000 people now have work.
The Kodak deal illustrates not only the need to restructure the SOEs but also the growing sophistication of FDI. Kodak needed to integrate several companies, combining accounting and operations across large areas and different tax jurisdictions. Existing wholly-owned or holding company structures could not meet Kodak's needs. Kodak has expanded operational control around the existing holding company structure but it has also created a new mould.
As China becomes less reliant on labour-intensive industries and attracts more sophisticated technologies, it is creating new investment vehicles to support its need to move beyond simple processing technologies. The Kodak deal is a model of how pragmatic Beijing is becoming. Kodak presented a practical solution to its investment issues and worked with Beijing to create a sophisticated investment structure that a few years ago would have been impossible. Other companies, if they follow Kodak's lead, can also create investment structures previously not available in China.
US investment trends
By all measures, US direct investment in China fell in 1997. Contracted investment was down 42 percent to US$4bn, its lowest level in five years; utilised investment, at US$3bn, was down 12 percent. Indeed, for many US investors China has lost much of its appeal. However, for the bigger American corporations, China continues to receive much attention. One significant change has been the greater size of the projects: GM, Kodak, Motorola and Intel have all made large commitments to China. The following examples depict the consolidation and re-engineering of US investment in China.
After planning to pour US$250m into four joint ventures, Whirlpool has pulled back, reconsidering all of its projections and plans for China. Whirlpool is an example of the change in the operating and investing mood in China which is now characterised by consolidation. It has increased its ownership of its microwave oven joint venture from 55 to 90 percent, and is in the process of increasing its interest in its washing machine venture from 55 percent to 80 percent. It recently pulled the plug on its refrigerator joint venture because of hyper-competition, from both domestic and international companies.
Whirlpool's recent changes are typical of many international investors that are tired of poor joint venture partner relations, cost overruns, too many competitors and governmental policy reversals. Investors are still committed to long-term business prospects, but less committed to joint ventures and more focused on profitability.
Many American companies are still feeling the effects of pulling out of China after the Tiananmen incident in 1989. Cooper Industries' Champion Spark Plug Division withdrew from joint venture negotiations with a Chinese spark plug manufacturer in Nanjing in 1989, allowing Robert Bosch, the German industrial giant, to quickly move into the discussions and later close the deal. US investors tend to be taking a longer view on investing in China. They are not as quick either to move in or move out of deals.
The CP Group of Thailand is an example of an Asian company which is actually divesting. CP has sold its 50 percent stake in Shanghai-Ek Chor China Motorcycle to the Shanghai Automotive Company. Tesco, a large British supermarket chain, has purchased 13 Lotus Superstores from the troubled CP Group. These stores are located throughout Southeast Asia. For Tesco, profits may not come in for a few years but retail rents, labour and other costs are falling rapidly.
Wealthy Western firms with capital to finance their growth see the turmoil as a chance to expand their presence in Asia. In China, CP's core agribusiness in poultry and animal feed is declining rapidly as key export markets in Japan disappear. Japan now sources chicken from cheaper South-east Asian producers.
Moreover, the investment cycle for transferring labour-intensive industries from Southeast Asia is almost complete. Tax-incentives and cheap labour and land no longer hold the appeal they once had for Southeast Asian investors. Many investors are still interested in the local market but right now are too consumed with core survival issues at home. Lack of competition from China's traditional investment sources in Southeast Asia presents a window of opportunity to invest in China. Carrefour, a French hypermarket, seems to be taking advantage of this opportunity. Like Tesco of the UK, France's largest retailer is continuing to expand throughout Asia, especially in the area of hypermarkets.
Since the meltdown in Asia in October 1997, China has moved 1996 to ward off any potentially deleterious effects. The most significant change came on January 1, 1998, with the reinstatement of VAT and tariff reductions on capital imports. Other incentives designed to assist exporters have been put into effect, including export rebates and tax exemptions.
China must be taking note as it sees that neighbouring countries South Korea and Japan are throwing open their doors to foreign investment areas that were previously considered sacrosanct or strategic, such as finance and telecommunications. We are seeing more export rebates, tax breaks and, perhaps equally important, an ideological shift from the earlier philosophy of using foreign investors as scapegoats for causing inflation to using for eign investors to bring in much needed capital and managerial techniques.
Another example of the changes that Beijing is willing to countenance is the growth of the wholly foreign-owned enter-prise (WFOE). Last year was the first time the WFOE was the preferred investment vehicle. For new FIEs in 1997, the Ministry of Foreign Trade and Economic Co-operation revealed the following break-down of business vehicles: 45.2 percent WFOE, 43.5 percent equity joint venture and 11.3 percent co-operative joint venture. In 1995, more than 55 percent of the FIEs in China were equity joint ventures while 32 percent were WFOEs.
Problems with partners, the growing complexity of doing business in China, and more acceptance by local officials of foreign control has led to many more companies either increasing their equity share or establishing WFOEs. This trend looks set to continue as recent polls conducted by Fiducia suggest that 67.5 percent of investors.plan to establish WFOEs as they expand operations.
Regional differences in FDI
Foreign investment continues to focus on the coastal provinces. In 1995 coastal provinces accounted for more than 85 percent of FDI. The centre of activity is moving from Guangzhou towards the Shanghai region, including Jiangsu and Zhejiang provinces. With the development of highways and infra-structure that follows the Yangtze up to Wuhan and beyond to Chengdu, more and more investors are looking at the inland provinces where labour and additional input costs are lower. This trend is gradual and is characterised by lower technology investments.
For many companies, the best investment opportunities still lie in the coastal provinces where international business is more developed. However, the central government is worried about the regional disparities in wealth and is searching for ways to build the interior. Many more companies are now seriously considering investments in previously unthinkable regions such as Ningxia.
Inland expansion is inevitable. Just as in the coastal provinces, companies will first be drawn by low labour and land costs. Some cities such as Chengdu are attracting investors with an eye on the local markets.
The city of Nanjing has recently begun to institute policies to encourage investors. Jiangsu province and Nanjing in particular is consolidating joint venture inspection procedures into a single annual inspection limited to 15 days and handled by one central office.
Officials in Nanjing are now issuing an annual report card for all legal fees, authorising companies to refuse fees not listed. These officials are banning the practice of requiring FIEs to use services providers such as government-appointed lawyers and accountants. They are institutionalising regular meetings between governments and FIE executives. These are all significant changes designed to cater to foreign investors.
Structural changes needed
China faces a host of seemingly untenable problems. These include a possible currency devaluation, deflation, unemployment, stagnant growth, declining productivity, excess capacity and reduced foreign investment. Enticing more foreign investors is crucial to its growth but this will necessitate some changes in policies.
China has experienced a marked slow-down in exports of iron, steel, minerals and cotton. During the first half of 1998, exports to South Korea were down 25 percent, Japan down 3.1 percent, Thailand 23 percent and Malaysia 17 percent. Thanks to strong growth in exports to Europe and the US, up more than 21 percent, overall exports are still realising growth. But this may not long remain politically feasible. Moreover, as Southeast Asia stabilises and gains access to operating capital, these countries will increase their competitive edge in the markets where they compete with China.
Additionally, China is beginning to exhaust options for enticing FDI and supporting exporters. In January, the reinstated duty-free capital imports policy created a small boost in FDI. VAT export refunds have increased by 3 percent and interest rates have been lowered. But these changes have not solved long-term productivity and quality challenges. Nor can they defend against the significant price cuts of competitors.
There is a growing realisation that structural changes will need to be made to the investment system. In the absence of fierce competition with Southeast Asian investors for key projects in China, today's Western investors in China will be able to negotiate better terms both in dollars and in structure. Although there will be difficult short- and medium-term macroeconomic challenges, this is a great time to expand operations in China.
The Asian financial crisis and investment trends in China are encouraging Beijing to develop new ways to entice foreign investment. There is increasing competition for foreign capital as many investors negotiate formerly unheard-of access to markets, particularly in Japan and South Korea. Beijing is moving to improve the legal and regulatory framework and embrace the overall ideological argument that foreign investors are good for the economy.
We have not seen radical or revolutionary investment incentives but we have witnessed slow changes in the right direction, such as increased operating control in retail, distribution and general services. China's local and central governments are becoming more responsive to the needs of foreign businesses. While investors should carefully consider investment options in China, this is a great time to negotiate.
This article was written by Francis Bassolino, a senior consultant in the China Business Services Group of Deloitte & Touche in New York. Francis specialises in cross-border investing. He can be reached on tel: (1) 212 436 6584 or email: email@example.com