Latest Global FDI Structure and China's Rise

In late October 2002, United Nations Conference on Trade and Development (UNCTAD) released its annual forecast, providing an overview of global FDI flows. Major findings are as follows:

• World FDI inflows would decline in 2002 by 27% to USD534bn after the first decline in 10 years in 2001, which was also the largest annual decline in 30 years.
  
• The decline of inflows into developed countries would be greater than developing countries, at 31% and 23% respectively.
  
• In developed countries, the United States would record the largest decline of 65% from USD124.4bn to USD44bn.
  
• Asian developing countries would also record decline of 12% to USD90bn.
  
• China's utilized FDI would probably top USD50bn for the first time, overtaking the US as the largest recipient of FDI inflows for the first time. (Note: the Ministry of Foreign Trade and Economic Corporation just reported that utilized FDI in 2002 reached USD52.7bn, up 12.51% YoY. The following calculations would use this figure.)

The fall in world FDI inflows for the 2nd consecutive year was attributable to global economic slowdown, lack of recovery momentum, corporate scandals and geopolitical risks. Cyclical factors played the major role. As for the US, three years of decline in the stock market severely reduced cross border M&A activities. And as loan repayments by foreign affiliates in the US to their parent companies surged, inflows plunged. But for China, as it accelerated its openings during the first year as a WTO member, capital began to flow into sectors that were relatively closed before such as the service sector. Besides, global manufacturers also underwent cross border restructuring. On top of it, China's investment environment proved much more attractive in a volatile global backdrop. All these helped push FDI inflows to reach USD52.7bn in 2002, or more than 9% of the global total. These unique structural characteristics would help maintain China's attractiveness to FDI far beyond 2002.

Prospects of China's FDI Inflows

When evaluating FDI's contribution to China's economy, attention should also be paid to its quality in addition to quantity. In the coming years, we expect that China will continue to attract more FDI, but its global share as well as the status as the largest recipient may shift. The timetable set for further openings after WTO entry will ensure that foreign capital will continue to flow into China mostly in the form of FDI. There is little doubt that inflows will continue to grow. However, as the global economic cycle turns, world FDI flows would probably rebound. As a result, China's global share may decrease accordingly even though inflows continue to increase. Moreover, the US economy accounts for 1/4 of the global output and it used to attract 20% of world FDI inflows. The dramatic drop to 8% in 2002 will likely prove to be the bottom once its economy and global cross border M&A recover. In that case, it may recapture the title of the world's largest recipient.

In terms of the quality of China's inflows, funds mostly went into the manufacturing sector. The service and agricultural sectors lagged behind. The high tech sector has just begun to catch up and cross border M&A barely took form. In these areas, there is still a large gap between China and developed countries. China's FDI accounts for 4% of GDP and 10% of its fixed capital formation, lower than the global average of about 15%. It exerted a disproportionate influence on the economy because investment helped drive exports. From labor-intensive in the 80s to capital-intensive in the early 90s, and to technology-intensive industries nowadays, FDI in China has shifted its focus. Currently, foreign affiliates account for 1/4 of China's total exports and 80% of high tech exports. Technology transfer brought by foreign investment is helping China move towards higher value added. But with manufacturing still occupying the largest share, and the service sector commanding just 25% of the inflows, structure of FDI in China will probably transform in the future.

China lags far behind in cross border M&A. The following table shows the ground China has to make up for to reach the global average. But this also illustrates the tremendous potential. As China deepens its open door policy, major sectors including financial, insurance, telecom, etc. will make marked progress in attracting foreign capital. In addition to low manufacturing cost and huge domestic market potential, service sector liberation and cross border M&A will help sustain rapid growth of FDI inflows for a long time, securing a stable source of economic growth.

Impacts on Asian Countries

There is no denying that Asian countries would feel rivaled by China, especially when China's FDI intake and global share have been rising in a period when global FDI inflows have been contracting. Some even claim that China "intercepted" some of the funds destined to them. The growing apprehension adds a new challenge to China when it pushes for economic cooperation and free trade within the region. We believe most of such doubts should prove to be farfetched once thorough understandings about China's FDI inflows are reached.

Firstly, it is the structural elements related to China's WTO entry that led to its rising inflows. China did not adopt the beggar-thy-neighbor strategy. According to UNCTAD, it was the slowing flows from the US and Europe that largely contributed to the slide in Asia's FDI. Japan has been most vocal of China threat. But in 2001, China's FDI originated from Japan amounted to USD4.3bn, versus USD2.9bn in 2000. Japan accounted for about 10% of China's total inflows. This is hardly a significant blow considering that Japan is the largest capital exporter in the world.

Secondly, China's FDI inflows were not incompatible with its economic scale. FDI accounts for approximately 10% of China's fixed capital formation. This is lower than the 15% average of the world, as well as developing countries and Southeast Asian countries. In order to correct the misconception given rise by inflow amounts, UNCTAD constructed a Performance Index and a Potential Index. The former is the ratio of a country's share in global FDI inflows to its share in global GDP, and the latter is an unweighted average of eight normalized economic and social variables. China's average ranking in recent years is 47th in the Performance Index and 84th in the Potential Index, lagging behind most developing Asian countries.

Thirdly, China's rise should be interpreted as twin opportunities. While FDI further promotes China's exports, it also expands its domestic market. Asian countries and regions directly benefit by recording surging exports to China. Korea, Taiwan, Singapore and the Philippines led the charge in 2002. Indirectly, China's cost competitiveness forces Asian countries to move up in the value chain by shifting from low tech manufacturing to higher value added, pushing for economic as well as industrial transformation. In the medium to long term, China will begin to export large amounts of FDI. This is a largely neglected area and will post profound and lasting impacts on Asian countries. Up till now, China's outward FDI is small with cumulative stocks by the end of 2001 being only USD27.6bn according to UNCTA, while the flow was only USD1.8bn in 2001 alone. It would take several years' time before China exports FDI in significant amounts. In some sectors such as apparel, footwear and household electronics where competition in China's domestic market has reached the "white hot" stage, overseas expansion seems to be the logical development. And in shipping, energy and construction, state owned enterprises are encouraged to expand overseas. By the end of 2000, Hong Kong, the US, Canada and Australia collectively accounted for 45% of China's outward FDI and Southeast Asia only 6.1%, demonstrating tremendous potential. Therefore as a sound strategic positioning, Southeast Asian countries should actively pursue, instead of impede, economic cooperation and free trade with China.

How to Assess the Exaggeration Issue of China's FDI Statistics

There have always been doubts about China's economic and financial statistics ranging from GDP growth to FDI inflows. With respect to its FDI inflows of USD52.7bn in 2002, some argue that it overstated China's ability to attract foreign investment. There are two major issues. The first is about reinvested earnings by foreign affiliates in China. Some believe they should not be included in FDI calculation. The second is about the phenomenon of round tripping-----funds originated from the Mainland disguised as foreign capital and repatriated to the Mainland. Some argue they should not be counted as foreign investment. If China's FDI inflows are somewhat inflated, we believe it is because of round tripping. There should not be any doubt about recording reinvested earnings. According to the international standards stipulated by the IMF and the Benchmark Definition of FDI published by the OECD, they should be counted as FDI inflows. For China, they are an important source of FDI. UNCTAD statistics show that in 2000-2001, foreign affiliates' reinvested earnings accounted for 1/3 of all China's FDI inflows. Foreign affiliates contribute to 23% of China's industrial production, 18% of tax incomes and 48% of total exports, commanding an important presence in China's economy. Although reinvested earnings originate from China, as long as they are invested instead of flowing out of the country, they should be counted as new FDI inflows based on international practice.

Is there such a phenomenon of round tripping? The answer should be "Yes". First of all, the favorable tax treatment foreign investors enjoy will remain an incentive for round tripping. Foreign investors in the Mainland enjoy a tax-free holiday for two years after their first profitable year, then a 50% discount on taxes for a further three years. Profit consideration will therefore make round tripping a tempting practice. Besides, although China has been imposing foreign exchange control, capital flight could not be completed curbed. Thus it is quite possible that some of the funds flowing back to China would be disguised as foreign capital. China's capital flight is a rather complex issue. No accurate estimate could possibly be made. Economists usually use the Net Error and Omission under China's Balance of Payments account as a reference to the size of the flight. From 1997 to 2000, the amounts were USD17bn, USD16.5bn, USD14.8bn and USD11.9bn respectively (in a downtrend). Although not all of it is capital flight, the consensus remains that a large proportion is and part of it should find its way back into China. Round tripping can take many forms such as under-invoicing exports, over-invoicing imports, and overseas affiliates of Chinese companies borrowing funds or raising capital in the stock market and reinvesting them in China. Assessment is made even more difficult when there is more buying into existing Chinese joint ventures. As these joint ventures are typically set up with an offshore holding company structure, they will not show up in the FDI statistics. Lastly, a large proportion of China's FDI inflows comes from Hong Kong or overseas tax havens and this reinforces the notion of round tripping. The following table shows that Hong Kong's share (not dollar amount) of China's FDI inflows has been declining since 1992. The decline continued after 1997 when it was handed over to China. Meanwhile, inflows from overseas tax havens such as the British Virgin Islands, Bermuda and Cayman Islands have been on the rise and make up for Hong Kong's decline. A rational explanation is that after the hand-over, some money was concerned enough to abandon Hong Kong for these overseas tax havens. From 1998 to 2002, FDI from the British Virgin Islands accounted for 9% of China's inflows, but a whopping 177% of its own outflows, reflecting the size of tax haven routing. For the first eight months of 2002, it was reported that Hong Kong, the Virgin Islands and Cayman Islands ranked 1st, 2nd and 8th in China's ten largest sources of FDI inflows, totaling USD16.2bn or 50% of the aggregate, adding further evidence of round tripping.

The most important question remained is what percentage round tripping accounts for China's FDI inflows. In other words, how serious is the problem of exaggeration? Unfortunately, there is neither official statistics nor consensus. Hong Kong and overseas tax havens encourage free flows of capital and it is impossible to trace the real origins of money. A 2002 report by International Finance Corporation (IFC) of the World Bank put the estimates at 30-50% of the total in the year 2000. And the market's general assessment is that the ratio has declined from 30% to around 10-20% in recent years. We are inclined to the latter estimate considering Hong Kong's share has been on a steady decline, China's capital flight has also been on a steady decline on improved supervision, and the progressive development of national treatment of foreign capital under the WTO guideline to avoid the accusation of export subsidies.

Round tripping not only affects the calculation of FDI, it also has a far-reaching impact on parties involved regardless of its proportion. For Hong Kong, the flows confirm its status as an international financial center and benefit its financial sector. Many Asian countries and regions like Japan, Taiwan and Southeast Asian countries opt to route money via Hong Kong to avoid domestic hostility towards investing directly in China. As a result, investment from Hong Kong also comprises of funds from other countries and regions as well as from China. For China, should the money remain in the country, it may merely stay idle within the banking system instead of being invested due to the lack of tax incentives. The contribution to growth would be minimal. With respect to out-flowed capital, it is obviously preferred that it flows back as investment instead of staying overseas, because this will contribute to growth. But in such a case, the government will collect less tax revenue and its fiscal strength will be weakened, tantamount to a double-edged sward. Nevertheless, as China accelerates its openings, foreign investors will receive national treatment and tax reform will also reduce the incentives of round tripping. Yet, we still believe the problem will not be completely eliminated because for a developing country, providing preferential measures to attract foreign investment will remain a long-term growth strategy.