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Foreign Investment in China

Summary

  • FDI in China rose in 2004 despite government efforts to cool off the economy. And despite a dip in the number of new projects, contracted and actual FDI were both up year-on-year for the first quarter of 2005. Early 2005 data indicates flows will likely continue to rise this year.
  • Asian investors led investment in China in 2004, with the United States coming in fifth at nearly $4 billion, and will likely continue their lead in 2005.
  • The trend of investment venturing beyond traditional manufacturing industries into the information technology, high-tech, and service sectors and into lower-cost, interior locations will continue in 2005.
  • New areas of opportunity for 2005 include entertainment, retailing and wholesaling, trading and distribution, and direct sales.
  • Protecting intellectual property rights remains a top challenge, along with realizing distribution rights.

Foreign direct investment (FDI) continued to flow strongly into China during the first quarter of 2005 and at the current pace is likely at least to meet last year's record highs. Contracted FDI during the first quarter reached more than $35 billion, up nearly 4.5 percent over the same period in 2004. Utilized FDI (the amount actually invested during the year) totaled almost $13.4 billion, increasing 9.5 percent over the first quarter of last year. The number of new contracts was down slightly at 9,305, or about 9.15 percent less than a year ago, possibly indicating an increase in project size.

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 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 "Revised investment catalogue" below), the continued inflow of foreign money and competition has prompted some PRC companies and government agencies to question 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.

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 in 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.

Government controls have limited impact

Since late 2003, the PRC 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 merger 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 Chinese firms. 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 after the merger is completed as expected in the second quarter of this year.

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 decision last year 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 debate, MOFCOM has made public comments about the fact that China does not capture 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.

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, which will likely continue through 2005. 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 2004 uptick in FDI flows indicates, foreign strategic investors have already begun to show interest in the region. In June 2004, Anheuser-Busch Companies, Inc. purchased Harbin Brewery Group Ltd. for $717 million. In another beverage industry investment, Kirin Brewery Co. Ltd. of Japan acquired a 25 percent stake in Dailian Daxue Brewery in Liaoning for $36 million last November. As of December 7, 2004, 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 O792 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.

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/members/documents/2005/01/investment_catalogue.pdf).

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. However, the government has still shown signs that it will be carefully controlling foreign investment and content in this sector. We will continue to monitor this sector closely in 2005.

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.

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 enforcement 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 made some progress in drafting new legislation designed to protect the rights of intellectual property owners but it may not be enough to quell rising frustration. 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. Though 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.

Persistent power shortages

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, peak demand 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.

WTO Commitments

Year-four

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:

Unsolved problems

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 rise further as China removes barriers to foreign competition to meet WTO obligations. And investment in entertainment and consumer goods will rise to meet rising income levels.

Table 1: Foreign Investment in China, 2004
  Number of Contracts Amount Contracted Amount Utilized
Investment Vehicle 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
Sources: Ministry of Commerce and the USCBC
Note: Percentages may not add up because some categories were omitted from this table.

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

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


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

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