Foreign Investment in China

Published February 2007

Summary

Overall foreign direct investment (FDI) inflows to China dropped by 4 percent in 2006, though non-financial FDI increased 4.5 percent.
In 2006, more than 40 percent of FDI flowed into China from Hong Kong and companies registered in the British Virgin Islands. The United States continues to be China's fifth-largest source of FDI.
China's FDI outflows grew 32 percent to $16.1 billion in 2006.
China is expected to pass legislation unifying foreign and domestic corporate tax rates in the coming year, with implementation expected in 2008.
Strengthening protectionist policy trends and emerging labor issues are poised to be key FDI issues in 2007.

2006: The Year in Review

In 2006, China maintained its position as one of the world's top destinations for foreign direct investment (FDI). Foreign-invested enterprises (FIEs) play a large role in China's economy, accounting for 27 percent of value-added production, 4.1 percent of national tax revenue, and more than 58 percent of foreign trade. According to the PRC press, companies from 190 countries and regions have invested in China, including 450 of the world's Fortune 500 companies. By the end of 2005, FIEs in China employed more than 24 million PRC citizens.

As China has now implemented the majority of its World Trade Organization (WTO) commitments, a wide range of industries are now open to foreign investment. According to findings in the USCBC's 2006 Member Priorities Survey, a majority of US companies report that they primarily invest in China to serve the Chinese domestic market, not export back to the United States. UBS AG estimates that the total share of US, European, and Japanese multinational corporations (MNCs) in Chinese exports is only 11 percent--most exports are from Hong Kong, South Korean, and Taiwan firms. Further, UBS estimates that 75 percent of Western and Japanese MNCs are in China to sell to the domestic market.

By the numbers

In 2006, China's overall FDI inflows totaled $69.5 billion, a 4 percent drop from 2005 (see Table 1). After a decline of 0.5 percent in 2005, this year's drop may come as no surprise to some and should not be interpreted to suggest that foreign investors are losing interest in China. Rather, China's financial sector was the recipient of massive amounts of foreign investment in 2005, when a seemingly constant stream of foreign banks took equity stakes in domestic lenders. As a result, 2005 FDI levels were significantly higher than they had been before or have been since. Separating financial sector transactions from the non-financial flows shows that China's non-financial FDI inflows actually increased 4.5 percent, from $60.3 billion in 2005 to $63 billion in 2006 (see Table 2).

In 2006, China approved just over 40,000 new FIEs, down nearly 6 percent from 2005. In 2006, as in recent years, wholly foreign-owned enterprises were the predominant legal structure for foreign investment (see Table 3).

In February 2006, the PRC Ministry of Commerce (MOFCOM) announced that it would no longer report the value of contracted foreign investment deals. In the past, contracted FDI figures were used to estimate future commitments. In explaining why it would no longer report these figures, MOFCOM said that the figures were unreliable. Apparently, local officials had been inflating these figures because their performance was traditionally partially evaluated on the ability to attract foreign investment. By no longer publishing the numbers, MOFCOM evidently hopes that local officials will focus on bringing in actual foreign investment rather than just signing contracts.

Top foreign investors

The top sources of FDI into China in 2006 remained largely unchanged from previous years (see Table 4). Hong Kong continued to lead the list, followed by the British Virgin Islands, Japan, South Korea, and the United States. Taiwan, Singapore, the Cayman Islands, Germany, and Western Samoa rounded out the top 10.

Investment growth from Japan, South Korea, and the United States slowed in 2006, but overall FDI has been buoyed by inflows routed through Hong Kong and the British Virgin Islands, which jumped 13 and 25 percent, respectively. In fact, Hong Kong and the British Virgin Islands together accounted for more than 42 percent of China's total FDI inflows in 2006. This is an issue that MOFCOM, the State Administration of Foreign Exchange, and the State Administration of Taxation have been watching closely, concerned that as much as two-thirds of China's official FDI is actually the result of "round-tripping"--a phenomenon in which PRC funds are funneled out of China to return masked as FDI in order to become eligible for preferential policies available only to foreign investors. The phasing out of tax incentives for FIEs, combined with tighter regulations on such offshore entities, could lead to a tapering off in flows from such regions.

Profitability

In USCBC's 2006 Member Priorities Survey, 81 percent of respondents reported that their company's China operations are profitable. According to a MOFCOM official, FIEs have recorded more than $200 billion in post-tax profits in China since the 1990s. UBS estimates that the foreign-owned share of FIEs' repatriated or reinvested total profits was $27 billion in 2005.

Renewed focus on FDI quality

In mid-2006, China's National Development and Reform Commission (NDRC) announced that it had formulated plans to better manage foreign investment in China's economy. The plan addressed the relationship between national security and foreign investment, stating that China should gradually relax restrictions on foreign holdings of domestic enterprises, except where national security is a concern. The plan's announcement stated that foreign capital should be directed toward high-tech industries, modern service industries, high-end manufacturing, infrastructure development, and ecological/environmental protection. NDRC calls for foreign companies--large MNCs in particular--to increase their investments and set up their production, assembly, and training bases in China so that a "spillover effect" can enhance the independent innovation of Chinese enterprises. The plan does not detail incentives that could be used to attract foreign companies, but NDRC's priorities could affect future PRC government policymaking regarding FDI.

Outbound FDI

As China's economy continues to grow and policies encourage the development of brands that can be considered "national champions," FDI originating from China has been growing at a considerable rate. Xinhua News Agency recently reported that China's outbound direct investment, excluding the financial sector, reached $16.1 billion in 2006, up 32 percent over 2005. By the end of 2006, China's cumulative FDI abroad had reached $73.3 billion. About 30 percent--or $4.74 billion--of China's outbound direct investment in 2006 came from overseas acquisitions. According to MOFCOM and PRC National Bureau of Statistics data, China's total outbound FDI reached $12.3 billion in 2005, a leap of 123 percent over 2004 and the first time that the annual figure passed the $10 billion mark. By the end of 2005, China's cumulative FDI abroad had reached $57.2 billion, 81 percent of which was from state-owned enterprises that are directly managed by the State Assets Supervision and Administration Commission.

Hong Kong and tax havens, such as the Cayman Islands and the British Virgin Islands, received 81 percent ($9.93 billion) of total Chinese outbound investment (and perhaps explaining why these destinations in turn are some of the largest sources of "foreign" investment coming back into China). It is also worth noting that Latin America passed Asia as the top regional recipient of Chinese investment.

The top sources of outbound FDI from China were coastal and border provinces--specifically Fujian, Guangdong, Heilongjiang, Jiangsu, Shandong, Shanghai, and Zhejiang--which together accounted for 62.5 percent of China's outbound FDI. In terms of sector preferences, nearly 50 percent of Chinese FDI poured into the service sector, 23 percent targeted manufacturing, 22 percent was covered by wholesale and retail, and 17 percent was injected into the mining industry.

What to Watch in 2007

Rising protectionist signs

Six PRC government agencies in August released measures on foreign acquisitions of domestic Chinese enterprises that give MOFCOM the right to block deals that "may have an impact on state economic security." A June State Council opinion defines machinery and capital equipment as a "pillar industry" and states that sales of stakes of key enterprises to foreign investors will require its approval. Draft regulations on Urban Commercial Networks submitted by MOFCOM to the State Council for review would apply only to foreign-owned retailers looking to open new stores in China.

These are just a few of the recent policy moves that several media outlets and analysts have pointed to as signs of rising protectionism in China. Others include efforts to block foreign input in domestic standards development and to favor domestic standards-based equipment in government procurement as well as different treatment for foreign, as opposed to domestic, competitors in the auto, chemical, insurance, securities, freight forwarding, and express delivery industries.

It has become apparent that the new rules are emerging in an environment of intensified debate in China, with many Chinese voices advocating the need to restrict further foreign penetration into the economy. This sentiment is evident in an array of sources, and PRC policymakers seem to be taking note of these opinions and feeling pressure to respond. With the August mergers and acquisitions rules on the books and the Antimonopoly Law on the way, this sense of rising protectionism may play a significant role in 2007.

Unified corporate income tax

Currently, the PRC government's nominal corporate income tax rate is 33 percent. This rate is often adjusted for both FIEs and domestic firms, with FIEs in particular enjoying numerous and substantial tax breaks. As a result, FIEs enjoy an effective income tax rate of 11 percent, while domestic firms face an effective rate of 23 percent. Chinese firms have complained about the incentives given to foreign firms, and pressure has mounted on officials to "unify" the tax code.

In response to the pressure, PRC legislators have been working on a new corporate tax law that may pass at the next full National People's Congress (NPC) meeting in March. If passed, the law is likely to take effect January 1, 2008.

The new law would set the unified corporate tax rate at 25 percent and would lower the threshold at which the tax would kick in. Overall, the law would narrow the scope of preferential policies available to foreign investors. While it is unlikely that an increased corporate income tax rate on FIEs will be a significant deterrent on foreign investment, it may cause foreign investors to reevaluate the opportunities in China's special economic zones (SEZs). Under the current system, SEZs offer tax rates of as low as 15 percent to attract investors, but they may lose this incentive under the new law.

Emerging labor issues

Human resources issues--primarily attracting and retaining talent in the highly competitive PRC job market--have long been a challenge for FIE managers in China and topped USCBC's operating issues survey last year. A number of new labor-related issues came to the forefront of foreign investors' attention in 2006 and are likely to be focus of FIE operations in 2007. Two of the most noteworthy are the pending Employment Contract Law (previously referred to as the Labor Contract Law) and the emergence of labor unions within FIEs.

Employment Contract Law The NPC is currently in the final stages of reviewing a new Employment Contract Law, which will affect the framework for labor contracts in China. The draft of the new law contains several provisions of importance to the foreign investment community, including issues surrounding noncompete agreements, termination provisions, and the creation of company rules and regulations. Though most, if not all, US FIEs already sign contracts with employees as required by the 1995 Labor Law, the advent of a new Employment Contract Law, which seems mostly directed at labor practices in domestic companies, will require FIEs to devote more legal and human resources attention to the transition to new contract requirements. A final version of the Employment Contract Law will likely undergo a third reading and be approved in 2007. USCBC submitted comments on the latest draft to the NPC, at its request, in late January.
Labor unions In 2006, the All-China Federation of Trade Unions (ACFTU) employed new, more-aggressive tactics in its campaign to raise unionization rates in FIEs. The legal bases for trade unions in China--the PRC Trade Union Law and Labor Law--remain unchanged, but ACFTU's new methods have publicly and directly targeted some larger foreign companies and employers for unionization. Much of the current drive may be tied to boosting ACFTU's financial resources (2 percent of payroll is distributed within the union network). According to press reports, the Guangdong ACFTU branch announced in January 2007 that it aims to establish union branches in 80 percent of FIEs and 60 percent of private enterprises in Guangdong.

Unionization and its impact on FIEs bears watching in 2007. Current PRC regulations allow unions a role in major decisions by FIEs, including the right to review all employee dismissals, to attend board of directors meetings, and to participate in any meetings involving salaries or work conditions. In practice, unions have played little role in these areas. US investors also tend to bring to their PRC facilities global labor and environmental, health, and safety standards, which usually exceed local requirements and practices. FIEs without unions will likely find this an issue to address this year.

Banking--access granted

China met its year-five WTO commitment when the PRC State Council issued regulations in late 2006 that removed geographic and business restrictions on foreign-invested banks.

Initial reaction to the regulations, which require foreign banks to incorporate their local operations as Chinese entities if they wish to conduct a full range of renminbi (RMB) currency business with PRC residents, appeared to be largely positive. According to press reports, Standard Chartered Bank plc was the first foreign bank to file an application to set up a PRC-incorporated subsidiary, and other banks such as Citigroup Inc., HSBC Holdings plc, ABN AMRO Holding NV, Bank of East Asia Ltd., and Hang Seng Bank Ltd. have followed suit.

Though the new rules mean that foreign banks may now provide RMB banking services to Chinese citizens, other issues remain unresolved. For example, the rules do not affect the 25 percent limit on foreign ownership in existing PRC banks. In addition, authorities have yet to issue the bankcard regulations that have been in draft form for the past three years. Without these regulations, foreign banks will not be able to market their own credit cards to clients.

Direct selling

In September 2005--nearly a year later than its WTO commitments required--the PRC State Council issued direct selling rules, effectively lifting a seven-year ban on the door-to-door business model. Though MOFCOM has been slow to issue company licenses, industry leaders such as Avon Products, Inc., Nu Skin Enterprises, Inc., Amway Corp., and Mary Kay Inc. received their licenses within the last 12 months. The new rules, however, place restrictions on the direct selling model that may inhibit the industry from taking full advantage of China's huge market potential.

Table 1: China's Foreign Direct Investment (FDI) Inflows
Source: PRC Ministry of Commerce (MOFCOM)
	2005	2006	Year-on-Year Growth (%)
Number of projects	44,019	41,485	-5.76
Utilized FDI ($ billion)	$72.41	$69.47	-4.06

Table 2: Non-Financial FDI Inflows
Source: MOFCOM
Year	2002	2003	2004	2005	2006
Utilized FDI ($ billion)	$52.74	$53.51	$60.63	$60.33	$63.02
Growth (%)	13	1	13	-0.5	4

Table 3: Foreign Direct Investment by Vehicle Type
Note: FDI=foreign direct investment; EJVs=equity joint ventures; CJVs=cooperative joint ventures; WFOEs=wholly foreign-owned enterprises Source: PRC National Bureau of Statistics
	Number of Projects			Utilized FDI Value ($ billion)
	2005	2006	% Change	2005	2006	% Change
Total FDI	44,019	41,485	-5.76	$72.41	$69.47	-4.06
EJVs	10,480	10,223	-2.45	$14.61	$14.38	-1.62
CJVs	1,166	1,036	-11.15	$1.83	$1.94	5.92
WFOEs	32,308	30,164	-6.64	$42.96	$46.28	7.73
Foreign-invested shareholding ventures	47	50	6.38	$0.92	$0.42	-54.0
Banking, insurance, and securities	18	12	-33.33	$12.08	$6.45	-46.64

Table 4: Top 10 Origins of FDI*
*Note: Does not include financial sector flows. Source: MOFCOM
Country/Region of Origin	Amount Invested 2005 ($ biliion)	Amount Invested 2006 ($ billion)	Year-on-Year Growth (%)
Hong Kong	$17.95	$20.23	13
British Virgin Islands	$9.02	$11.25	25
Japan	$6.53	$4.60	-30
South Korea	$5.17	$3.89	-25
United States	$3.06	$2.87	-6
Taiwan	$2.15	$2.14	-1
Singapore	$2.20	$2.26	3
Cayman Islands	$1.95	$2.1	8
Germany	$1.53	$1.98	29
Western Samoa	$1.36	$1.54	13