Foreign Investment in China

Summary

Foreign direct investment (FDI) poured into China at record levels in 2004, totaling more than $153 billion in new agreements, up by one-third over 2003. Utilized FDI (the amount actually invested during the year) also surged to a record high of almost $61 billion, rising 13.3 percent over 2003. Though not a record high, the number of contracts in 2004 reached 43,664, up about 6.3 percent (see Table 1).

While the PRC government is still actively encouraging foreign investment (see section on the revised investment catalogue below), the continued inflow of foreign money and competition has led some PRC companies and government agencies to debate whether too much investment is coming in. Nonetheless, FDI will continue to flow strongly into China in 2005, not only into traditional manufacturing ventures but also increasingly into the equipment manufacturing, electronic machinery, high-tech, entertainment, retail, and financial service sectors.

Table 1: Foreign Investment in China, Jan.-Nov. 2004
Note: Percentages may not add up because some categories were omitted from this table.
Sources: Ministry of Commerce and the USCBC
Investment Vehicle Number of Contracts Amount Contracted Amount Utilized
  Total % Change % of Total $ Billion % Change % of Total $ Billion % Change % of Total
Foreign Direct Investment (FDI) 43,664 6.29 100.0 153.47 33.38 100.00 60.63 13.32 100.00
Equity Joint Ventures 11,570 -7.60 26.50 27.64 8.37 18.01 16.39 6.46 27.03
Contractual Joint Ventures 1,343 -13.19 3.08 7.79 4.13 5.08 3.11 -18.88 5.12
Wholly Foreign-Owned
Enterprises		 30,708 13.97 70.33 117.28 43.70 76.42 40.22 20.49 66.34
Share-based Enterprises with
Foreign Investment		 43 16.22 0.10 0.77 99.09 0.50 0.77 136.68 1.27
Cooperative Development 0 -100.00 0 0 -100.00 0 0.11 226.45 0.18

Trends 2004: The Year in Review

Despite government efforts to cool the economy, FDI flows into China continued to rise during 2004. The United States, however, regained its place as the top global recipient of FDI at $121 billion (utilized), according to United Nations Conference on Trade and Development (UNCTAD) figures.

Asian investors lead

As in previous years, Asian investors led China's FDI inflows for the first 11 months of 2004. Hong Kong (where investors from other countries as well as the mainland are also based) held a clear lead, followed by the British Virgin Islands, South Korea, and Japan (see Table 2). US investment in China ranked fifth, at nearly $4 billion. After falling sharply in 2003, most likely the result of caution prompted by severe acute respiratory syndrome (SARS), US investment recovered in 2004 with a 23.1 percent and 7.2 percent increase in contracted and utilized investment, respectively. US investment as a share of the total contracted FDI in China rose steadily from 1990 to peak at 14.6 percent in 1999 before gradually declining to the current 7.9 percent (see Figures 1 and 2).

Distribution of investment by province (or "Go West—and Northeast—young man")

In 2004, FDI ventured north and inland from traditional investment centers such as the Pearl and Yangzi River deltas and Beijing. While FDI in Guangdong fell 10 percent year-on-year during the first seven months of 2004, FDI flows to Yunnan and Shaanxi provinces exploded by nearly 578 percent and 203 percent, respectively. China's northeastern provinces were also major recipients of FDI inflows, with growth rates of 78 percent and 40 percent in actual and contracted investment, respectively, for the region (see below). It should be noted, however, that these high growth rates result largely from low FDI numbers in previous years and that the traditional eastern FDI destinations still lure the bulk of FDI. Shanghai, for example, received more than 10 percent of all FDI in 2004, or nearly $7 billion.

This shift in FDI flows can be attributed to government incentives intended to spur investment in northeastern and western China; rising land, labor, and living costs in popular coastal investment destinations; and the desire of companies to secure a competitive footing in the domestic consumer market as these areas become more developed and as China opens its retail and distribution sectors. Automaker Ford Motor Co., and foreign auto parts makers like Tenneco Automotive Inc. and Lear Corp., have set up production facilities in western China. High-tech companies are also establishing operations in western China: Intel Corp. announced a $375 million chip testing and packaging facility in Chengdu, Sichuan, earlier in 2004; and Infineon Technologies AG announced in January 2004 that it was establishing an integrated circuit design center in Xi'an, Shaanxi.

Figure 1: Total FDI in China, 1990-2004 ($ billions)



Table 2: Origins of FDI, 2004
Source: Ministry of Commerce
Origin Amount Invested (US$)
Hong Kong $19.00 billion
British Virgin Islands $6.73 billion
South Korea $6.25 billion
Japan $5.45 billion
United States $3.94 billion
Taiwan $3.18 billion
Cayman Islands $2.04 billion
Singapore $2.01 billion
Western Samoa $1.13 billion
Germany $1.06 billion


Figure 2: US Direct Investment in China, 1990-2004 ($ billions)

Government controls have limited impact

Since late 2003, the Chinese government has been taking steps to rein in sectors of the economy that were growing too quickly, chiefly the steel, cement, aluminum, and real estate sectors. Though FDI flows into these industries have fallen, the impact on overall FDI flows into China was not substantial in 2004.

According to Ministry of Commerce (MOFCOM) figures, the number of newly approved foreign-invested enterprises (FIEs) in the steel industry dropped by 53 percent and contracted investment fell 9 percent. The drop in foreign investment in the cement industry was even greater: actual and contracted investment fell by 67 percent and 74 percent, respectively, and no foreign investment was made in China's aluminum industry in 2004.

Despite the overall decrease in FDI in this sector, domestic enterprises were affected to a greater degree than foreign investors, since central-government controls focused largely on limiting redundant or energy-inefficient projects, such as the low-end, small-scale steel furnaces that have proliferated during the recent building boom. Moreover, government steps to limit domestic bank lending to low-end industries and operators in the real estate and construction sectors have disproportionately restricted the growth of domestic enterprises.

M&A activity intensifies

The China Securities Regulatory Commission issued several regulations last year that have facilitated mergers and acquisition activity (M&A). Instead of establishing new joint ventures or wholly foreign-owned entities, foreign investors may now establish operations and market position more quickly by acquiring a Chinese firm. According to the People's Daily, M&A deals in China—including both cross-border and domestic deals—for the first half of 2004 were worth $23 billion, equal to 65 percent of last year's total. Of this amount, $7.3 billion was in inbound foreign acquisitions of Chinese companies—equal to 137 percent of last year's total, according to M&A Asia.

More M&A activity is expected in the next 12 to 18 months as multinationals seek to expand their presence in China, especially in the consumer goods, beverage, financial, and electronics sectors. One such deal was Amazon.com's complete acquisition of Joyo.com, China's second-largest online business-to-consumer retailer, in a bid to gain access to the growing business-to-consumer market. Domestic companies are also likely to increase M&A activity to boost competitiveness as foreign rivals enter the market.

Chinese investment abroad also rose in 2004. Perhaps the most publicized case involves Lenovo Group's purchase of a majority stake in IBM Corp.'s personal computer business for $1.75 billion. The deal also gave IBM a stake of nearly 19 percent in Lenovo, and Stephen Ward, who is currently senior vice president and general manager of IBM's Personal Systems Group, will become chief executive of Lenovo.

Banking

With the opening of China's financial sector as part of its World Trade Organization (WTO) commitments, foreign banks and financial institutions have been ramping up efforts to gain market share in domestic commercial and investment banking services. Through the first half of 2004, major foreign players such as HSBC Holdings plc moved to expand their domestic presence through acquisitions of shares in Chinese banks. Goldman Sachs, Inc. received approval to enter into the young domestic investment banking market and established Goldman Sachs China in partnership with Beijing Gaohua Securities, itself a joint venture established by Hainan Securities head Fang Fenglei and Lenovo. Newbridge Capital Group became the first foreign investor to become the largest shareholder of a Chinese bank after buying a controlling stake in Shenzhen Development Bank (SDB) for roughly $150 million. And HSBC obtained a 20 percent stake in the Bank of Communications, China's fifth-largest lender, for $1.75 billion in August 2004 (see China's Economy).

R&D investment keeps rising

Foreign investors had established more than 700 research and development (R&D) centers in China by mid- 2004, with a total investment of $4 billion as of June 2004. Intel Corp.'s recent decision to establish a $39 million R&D center in Shanghai's Waigaoqiao Free-Trade Zone is representative of the trend of foreign high-tech companies setting up advanced R&D centers alongside their China manufacturing centers. Lucent Technologies also announced in September 2004 that it would invest an additional $70 million in its 3G Mobility Research and Development Center in Nanjing, Jiangsu.

Debate over the role of FDI

During 2004 and early 2005, doubts over the benefits of FDI for China reemerged as economists and academics questioned whether China's foreign exchange reserves are too high, and Chinese companies pressed for unification of the tax regime and limits to incentives designed to attract foreign investment. Contributing to the discourse, MOFCOM has made public comments about not capturing value from foreign investment, particularly export-processing ventures. While the debate will likely continue through 2005, the Council does not expect any concrete actions to limit FDI during the year.

Opportunities

Trading and distribution rights

The new rules opening up trading and distribution rights to foreign enterprises, which took effect in mid-2004, should help reduce the local protectionism and inefficiencies related to the dominance of SOEs in the distribution sector. MOFCOM also released plans for the logistics and retail sectors. The Outline for Reform and Development of the Distribution Sector calls for improvements in efficiency and professional service, as well as the development of large, internationally competitive logistics companies.

The Outline for Development of the Consumer Product Market describes measures to improve production and logistics to obtain better product quality, open more stores in central and western China, increase agricultural efficiency, and raise the number of stores in both rural and urban areas. Although MOFCOM sets no specific targets in the plan, the government evidently intends to use it as a roadmap for future regulatory measures. For foreign companies in the retail sector, the plan's emphasis on regional markets and better logistics is a positive sign; foreign enterprises that have already opened retail outlets in inland locations should benefit. It remains to be seen how future regulations will improve areas of longstanding concern to foreign logistics companies, such as burdensome tolls and inconsistent road quality.

As of the end of 2004, a number of companies sought to apply for trading rights and distribution rights, in addition to those Hong Kong-incorporated companies already granted such rights early through the mainland's Closer Economic Partnership Arrangement (CEPA) with Hong Kong. Clarifications from MOFCOM on how existing FIEs can revise their scope of business to allow domestic sale of imported products remain outstanding, however.

Some companies had also begun to consolidate their operations in China to better position themselves to take advantage of the liberalized market. United Parcel Service (UPS) signed an agreement on December 1 to take direct control of operations in 23 cities across China for a payment of $100 million to Sinotrans, its joint-venture partner in China. Competitors such as DHL and FedEx Corp. also moved to expand their market share after liberalization.

Revised investment catalogue

The Catalogue Guiding Foreign Investment in Industry, compiled by MOFCOM and the National Development and Reform Commission, provides a clear roadmap to the areas where the government is currently encouraging foreign investment and provides insight into further areas of FDI growth.

The government bodies issued a revised version of the catalogue in November 2004 that took effect on January 1, 2005. The new catalogue maintains the previous catalogue's division of investment projects into three categories: encouraged, restricted, and prohibited. Foreign investment in encouraged sectors frequently enjoys preferential treatment, often including the right to establish wholly foreign-owned subsidiaries, while investment in restricted categories is often limited to JVs. All project areas not expressly listed in the catalogue or restricted by other PRC regulations are permitted.

The 2004 version of the catalogue contains fewer restrictions than existed in the last revision, in 2002. Most changes are in the encouraged category and clarify designated sectors or items already present in the 2002 catalogue. A full translation of the catalogue is available on the USCBC website (www.uschina.org).

Sectors that have been modified or that contain more items in the encouraged category include

More interesting is the relaxation of restrictions on investment in the previously tightly controlled areas of TV and radio program production and distribution, and film production. Television program production and distribution, and film production, have been moved from the prohibited to the restricted category, though the Chinese side must still retain a controlling share. US-based consulting firm PriceWaterhouseCoopers (PwC) predicts that China's media and entertainment industry will grow 25 percent a year, reaching $86 billion by 2008. The film and television sectors are considered especially promising, with PwC estimating television advertising revenue to jump from $514 million in 2003 to $693 million in 2008. Major players such as the Walt Disney Co. and Viacom International Inc. have already begun exploring television production joint-venture possibilities.

Additionally, as part of China's WTO accession agreements, foreign companies can now invest in the construction, renovation, and operation of cinemas and increase their stake to more than 50 percent after an initial grace period.

Favorable policies for investing in China's Northeast

After being largely left behind as other parts of the country moved toward a market economy, China's northeastern provinces—Heilongjiang, Jilin, and Liaoning—which were once home to China's heavy manufacturing base, have recently benefited from an increase in FDI due to favorable government policies. In an effort to bolster the local economy, and also address mounting unemployment as state-owned enterprises (SOEs) shed workers in an effort to compete, the central government launched the "Revitalize the Northeast" plan in fall 2003.

The plan offers preferential tax and value-added tax reform policies, among other incentives, to FDI to the Northeast. For example, manufacturing enterprises in the Northeast may shorten depreciation periods for their fixed assets (excluding houses and buildings) when calculating corporate income tax and cut the amortization period for transferred or invested intangible assets by up to 40 percent. In light of rising land costs, labor shortages, and the heavy impact of power shortages in traditional coastal investment destinations, investors may also be drawn by the Northeast's well-established infrastructure (a positive legacy of the centrally planned economy that facilitates the shipment of materials and finished products in the region), ample natural resources, and underutilized labor pool.

As the recent uptick in FDI flows indicates, foreign strategic investors have already begun to show interest in the region. In June, Anheuser-Busch Companies, Inc. purchased Harbin Brewery Group Ltd. for $717 million. As of December 7, FAW-Volkswagen, a joint venture between FAW Group and Volkswagen AG, officially put a second automobile plant into production in Changchun, Jilin. The plant is Volkswagen's largest overseas investment project, with a total investment of roughly €792 million ($1.03 billion), and it will have created 8,500 new jobs in the region by the time it is fully operational.

Despite the region's advantages, the success of the "Revitalize the Northeast" campaign depends on successful SOE reform. This will not be easy; SOEs must improve their management, become more efficient, and shed the enormous "cradle to grave" social welfare burdens that have undermined their ability to compete with lean, modern firms, both foreign and domestic.

Retail and wholesale sector

China's opening of its retail and wholesale sector has spurred the entrance of new foreign firms and boosted investment from chain stores already active in China such as Wal-Mart Stores, Inc. and Carrefour SA. Foreign chain distributors that have seized upon the more favorable conditions to enter China's expanding retail market include 7-Eleven, Inc., which opened its first Beijing store in April 2004. In an effort to reduce costs and delivery times, multinational retailers have begun integrating China directly into their supply chains and purchasing networks through the establishment of local purchasing departments. Some companies have set up procurement centers in cities such as Shenzhen, Shanghai, and Tianjin for easy access to production facilities, transportation, and services.

Challenges

Intellectual property rights

The protection of intellectual property rights (IPR) continues to be a top concern for companies investing and operating in China. In an annual survey of the USCBC membership, IPR was the second most important issue for member companies in 2004 (after trading and distribution rights), up from fifth place in 2003. Piracy of consumer products and industrial goods is widespread, and exports of counterfeit products appear to be on the rise. The PRC government has, however, made progress in drafting new legislation designed to protect the rights of intellectual property owners. A recent development was the issue on December 21 of a long-awaited legal interpretation by the PRC Supreme People's Court and Supreme People's Procuratorate that is part of a package of actions pledged by Vice Premier Wu Yi last April to toughen criminal sanctions against IPR violators. The Legal Interpretation on the Criminalization of IPR Violations roughly halves the criminal thresholds for IPR violation, suggests guidelines for punishment, expands copyright laws to cover Internet-based piracy, and establishes criteria for culpability. While this interpretation is a step forward, and indicates that the importance of combating IP abuse is understood at the central level, significant problems remain in the area of enforcement. Thus, IPR protection will remain a key challenge and business consideration for the near future.

Power shortages to persist

The power shortages that have plagued China during peak load times since last year are likely to continue for the near future. (In Shanghai, for example, the power shortages are expected to continue through the next two summers). Despite government price increases and efforts to boost production, demand during peak times remains heavy and continues to exceed modest increases in supply. Although current power shortages do not appear to have dampened FDI flows significantly in 2004, the shortages may influence future investment choices. As mentioned above, locations such as China's northeastern provinces, or the inland areas of Sichuan, Hubei, or Chongqing, all of which are better able to cope with rising energy demands because they have relatively high capacity and less industrialization, may benefit as investors consider moving manufacturing facilities from the hard-hit east coast.

Looking Ahead

WTO commitments

At the end of 2004, year three of China's membership in the WTO, China had opened up a wide range of sectors to increasing levels of foreign investment (see WTO Scorecard) in line with its accession agreements. The year-four service commitments, which China must implement by December 11, 2005, are both fewer and smaller in scale than in previous years. China's year-four commitments will primarily affect investment in the advertising and financial service sectors, in addition to the noteworthy openings to wholly foreign-owned enterprises (WFOEs) in a large number of other sectors. Developments in these sectors, as opened under CEPA, provide a preview of the investment environment.

Specific commitments include:

Direct selling law

China was to allow foreign-invested direct sales entities by December 11, 2004, according to its WTO commitments. This deadline has passed and the measures have yet to be released, though MOFCOM circulated draft rules in late 2004. The history of direct sales in China has been rocky, as the Chinese government banned direct sales in 1998 in an effort to contain the spread of fraudulent pyramid schemes. As a result, direct sales companies were forced to establish a store-based sales model in China. Many foreign-invested direct sales enterprises managed to survive by adapting their business practices. The new measures are likely to create a surge in direct selling activity as companies already established in China before the 1998 ban, such as Amway Corp., Avon Products, Inc., Herbalife, and Mary Kay Inc., seek to expand market share and fend off new market entrants. The final measures are anticipated early this year.

Future direction of FDI

Facilitated by WTO-related market openings and increasingly comprehensive infrastructure and distribution systems, FDI in China will continue to move beyond the traditional investment locales and sectors. Similarly, while China will remain an important low-end export manufacturing base in the near future, multinationals and Chinese companies are producing increasingly sophisticated goods in the information technology, high-tech, pharmaceutical, and chemical sectors. China is also becoming a credible center for low-cost R&D in certain industries, marking a shift away from pure production. FDI flows into the professional and financial service industries will also rise as China removes barriers to foreign competition to meet WTO obligations. Moreover, investment in entertainment and consumer goods will rise to meet rising income levels.

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Last Updated: 14-Mar-05