Foreign Direct Investment In China And Worldwide

3902 words - 16 pages

Topic: Outline some of the recent and most salient trends and developments with regards to foreign direct investment worldwide and critically examine the determinants of inward foreign direct investment in China.Part 1: Outline some of the recent and most salient trends and developments with regards to FDI worldwide.Since the mid 1970s the amount of foreign direct investment (FDI) has been increasing at a fast pace. The world inward stock of FDI in 2003 was 22.9 percent in comparison to a mere 4.4% in 1960 (UNCTAD-DTCI 1994; cited in Ietto-Gillies 2005). The developing countries have the highest percentage of FDI, a testimony that FDI is a relevant element for developing economies. Over the last few decades, the composition and geography of FDI has undergone some major shifts as outlined below.Trends in the Composition of FDIThe value of cross border mergers and acquisitions (M&As) rose to $716 billion in 2005, representing an 88 percent increase from the prior year. Such levels border the first year cross border M&A boom in 1999. While the high level of M&As reflect strategic choices of transnational corporations (TNCs), it was also propelled by the recovery of stock markets, which in creating a steady investment climate, led to a large number of sizeable deals. The average transaction value of these deals is worth more than $1 billion (UNCTAD, 2006: 13).Figure : Cross-border M&A sales for the world of purchaser, 1987-2005Source: UNCTAD, based on its on-line statistical database (www.unctad.org/fdistatistics).A recent variation in the composition of FDI relates to that of collective investment institutions, namely private equity firms and hedge funds, which have emerged as prominent sources of FDI through cross border acquisitions.Private equity funds focus primarily on "companies in distress, as well as in firms divested by large enterprises that prefer to concentrate on core competencies" (UNCTAD, 2006: 16). Consistent with prior years, in 2005, private equity firms in the United Kingdom and United States accounted for 85% of raised funds (Private Equity Intelligence, 2006 cited in UNCTAD, 2006: 18). The concentration of private equity firms in these regions has been on ongoing trend however recently, there has been growing levels of expansion into other regions of the world. In 2005, 10 percent of all private equity funds raised were spent outside Europe and North America (Private Equity Intelligence, 2006: 9; cited in UNCTAD 2006). The nature of firms that private equity funds are attracted to is illustrated by their prominence in the European financial markets and the companies in Asia that were financially distressed following the 1997 Asian financial crisis.Hedge funds are another form of FDI that like private equity firms, participates in buyout transactions. In 2005, hedge funds raised a record $1,200 billion in 2005 (UNCTAD, 2006: 18).New institutional investors from developing countries are also emerging in prominence, such as Capital Asia and Dubai International Capital based in Hong Kong and United Arab Emirates, respectively (UNCTAD, 2006: 19). These funds often utilise bank loans to finance private equity buyouts, essentially exposing the private equity funds to substantial vulnerability to the global macroeconomic environment, such as a sharp increase in interest rates.Sector AnalysisBy sector, in 2005 the primary sector has increased in importance in contrast to the declining trend in the manufacturing and services industry. The growth of the primary sector has been fuelled chiefly by the strength of the mining industry. The magnitude of its cross border M&As sales and purchases is estimated to have "rose more than six fold" (UNCTAD, 2006: 7) from 2004. The sector's share in both sales and purchases in 2005 of 20% closely mirrors the peak attained in 1987 - 1988 (Loc. cit).Figure :Sectoral breakdown of cross-boarder M&A sales, 1987-2005Source: UNCTAD, 2006:7In 2005, inward FDI has been highest in the "oil and gas, utilities, banking and real estate" (UNCTAD, 2006: 7). More significant is the emergence of the petroleum industry in receiving FDI, recording a 14% share of all cross border M&A sales (UNCTAD, 2006: 8). The petroleum, finance and telecommunications industry collectively accounted for more than one third of the total value of M&A deals in 2005 (Loc. cit).In terms of outward FDI, the petroleum and telecommunications industry although remained high ranking acquiring industries, were second best to the collective investment institutions, who in 2005, "accounted for more than 30% of total cross border M&A purchases in terms of value" (UNCTAD, 2006: 9). What is notable with the current FDI growth trends discussed above is the concentration in a few specific industries rather than broad-based industrial sectors.Region analysis: TriadRecently, the Triad (European Union, United States and Japan) share in global inward FDI flows and stocks has fluctuated between 60 to 70 percent (UNCTAD, 2006: 6). The European Union (EU) is the most significant recipient of FDI within the Triad, with the share of the EU in FDI inflows to the Triad increasing to 75 percent in 2003-2005 from 62 percent in 1978-1980 (UNCTAD, 2006: 6). Today the EU accounts for almost half of global inward and outward FDI flows and stocks. Conversely, both the United States and Japan's share in both inward and outward FDI flows and stocks has declined. Recently, Japan has however, gained somewhat as a recipient of FDI.Developed CountriesThe largest share of FDI originates from and is also directed to developed economies. In 2005, TNCs from developed countries were responsible for almost 87 percent of the world outward FDI stock and the developing countries contributed 12 percent to world outward FDI, directed mostly towards other developed countries (UNCTAD, based on its on-line database).Since 1990, the percentage of world stock directed towards developed countries has declined, partly due to the emergence of China as an attractive location for investment as well as acquisitions by TNCs (Sader 1995; cited in Ietto-Gillies, 2005: 31). Overall, developing countries have become relatively significant recipients of FDI in terms of both inward flows and stock. Their share in global FDI inflows rose from an average of 20 percent in 1978-1980 to an average of 35 percent in 2003-2005 (UNCTAD 2006, 6).Moreover, the share of inward stock into the developed countries has moved from 37.2 percent in 1914 to 71.8 percent in 1990 to 69.2 percent in 2003 (Ietto-Gillies, 2005: 29). The share of developing countries in global outward FDI stock has fluctuated between 8 percent and 15 percent over the past twenty-five years, indicating the emergence of this group of countries as a major source of FDI (UNCTAD, 2006: 6). More notably, West Asian FDI outflows have more than doubled to $16 billion in 2005, with China recording a "six fold increase in outward investments, amounting to $11 billion" (UNCTAD, 2006: 5).The increasing importance of FDI from these countries reflects stronger ownership advantages of developing-country firms. For instance, "developing countries accounted for over half of global output at purchasing-power parity value in 2005, more than 40 percent of world exports and for two thirds of global foreign exchange reserves" (UNCTAD, 2006: 6). Moreover, in 1986 Turkey was the only developing economy among the 20 most competitive economies and by 2005 there were five additions: Taiwan, Singapore, the Republic of Korea, the United Arab Emirates and Qatar (World Economic Forum 2005; cited in UNCTAD 2006).The emergence of developing countries and the transition economies of South East Europe and the Commonwealth of Independent States in the FDI scene (UNCTAD, 2006: 6), albeit currently holds a small share, is increasing and is expected to an emerging source of FDI in the future.Figure :China's Inward FDI Flows From 1979-2005Source: UNCTAD, based on its on-line statistical database (www.unctad.org/fdistatistics).Part 2: Critically examine the determinants of inward FDI in ChinaSince the opening of its borders in 1979, China has attracted a spectacular amount of FDI, becoming one of the world's largest hosts of foreign investment, seconded only by America. Its accession into the WTO in 2001 has increased not only enthusiasm but flows of investment constantly fuelling its economic growth. Henley, Kirkpatrick and Wilde (1999) note three main vehicles for inward FDI into China: equity joint ventures, co-operative joint ventures and fully foreign-owned ventures. Location advantages, policy instruments and the changing nature of FDI are crucial to understanding what attracts TNCs to China. Sun, Tong and Yu (2002) provide the term location theory to identify important overarching determinants of FDI distribution across provinces within China from market scale and wage level, to the extent of industrialisation and transportation. However, as Sun et al. (2002) highlight, the location of FDI within China is characterised by enormous temporal as well as spatial diversity. This suggests complex fluctuations in the nature of FDI and its requirements as well as the weighting of the determinants' importance.Nature of FDI in ChinaFDI in China demonstrates a number of time, source, sector and regional distribution patterns (Zhang, 2001: 337). World growth of FDI outflows during the first half of the 1990s coupled with the increasing liberalisation of China's FDI regime and explosive growth of the domestic economy have been the notable features causing the sharp FDI boom in 1990s in contrast with steady but small amount of inflows in the 1980s. A similar change over time has been the initial sourcing of smaller-scale FDI from Hong Kong and Taiwan in particular (Zhang 2001; Henley et al. 1999) to large TNCs in the 1990s. This has been accompanied by a sectoral shift from the former, being more concerned with export-oriented light industries and textile projects, to Western firms looking to China's domestic market for capital-intensive goods such as machinery, chemicals and services (Zhang, 2001: 337). However, despite increased liberalisation, old geographical trends of FDI distribution have remained directing the principal towards the coastal regions such as Guangdong and Fujian.The empirical research on FDI determinants indicates that TNCs allocate their investment among countries so as to maximise their risk-adjusted profit (Caves 1996; cited in Zhang 2001). It has been suggested that the profit of FDI made by TNCs in a country depends on three sets of determining factors. Dunning (2001: 174) in his eclectic paradigm, suggests that, ownership, location and internalisation, are key in explaining the activity of firms outside their national boundaries. Ownership is the competitive advantage that a firm possesses over another country in the provision of an income-generating asset (ibid: 176). Location is the extent to which a firm chooses to locate beyond their national boundaries. While internalisation is the extent to which a firm realises that it is more advantageous to produce internally than using the open market. The exploitation of these advantages results in profit for the firm as well as several positive impacts on the Chinese economy (Dees 1998) such as improving Chinese factor productivity (Liang and Zhu 1996; cited in Dees 1998) and positively impacting state revenue, employment and the balance of payments. While the two forces of ownership and internalisation have been argued to be firm specific (UNCTAD, 1998: 90) and concerned with the supply side of FDI, (Zhang, 2001: 340) the government policy of any given country can indirectly affect the value of these advantages to the firm. However, regardless of ownership and internalisation advantages, governments must concentrate primarily on providing certain location prerequisites in order to provide an attractive investment climate.Location Advantages and Policy InstrumentsPerhaps the primary impetus for to the escalation of FDI in China has been its rapid economic growth recorded at 10.5 percent of Gross Domestic Product (GDP) for 2006 (CIA World Factbook 2007). There is a positive correlation with a strong GDP growth rate and an increase in FDI, as the search for new markets is one of the primary motivations for TNCs' internationalisation. Additionally, Zhang (2001: 340) identifies a correlation between a province's market size, and its level of potential FDI. According to Young (1997; cited in Sun et al. 2002), Chinese provinces have limited trade with each other, allowing TNCs to serve only the market where they locate which may be a reason for the ongoing geographical concentrations. This is supported by Sun et al. (2002: 85): "the fact that the coastal regions have high population density but poor natural resources and the inland provinces have low population densities but are rich in natural resources seems to suggest that the purpose of FDI in China is mainly for the potential market and labour abundance but not natural resources."The nature of labour in China has also been a fundamental determinant of the flow of FDI. The level of labour quality, such as the literacy of a population, or the number of engineers, scientists and technicians per 1000 employees (Braunerhjelm and Svensson 1996 cited in Sun et al, 2002: 89) affects the suitability of the host location to modern technology (Zhang 2001). However, labour cost can negatively impact the attraction of FDI. Conventionally, foreign investors generally aim to take advantage of cheaper factor inputs in China, particularly since export-oriented FDI is labour-intensive. Recently, as reflected in the model of Branstetter and Feenstra (1999), multinational firms in China tend to pay a wage premium to their workers in order to attract quality. This suggests, as pointed out by Lipsey (1999), that low wages, associated with low per capita real income, were not the main attraction for FDI (Sun et al. 2001). Instead the major determinant seems to be the cost of labour for a given level of quality.Another factor contributing to the geographical concentration of FDI are the economies of scale and positive externalities (Sun et al. 2002) that arise from co-location, known as agglomeration effects. Cheng and Kwan (2000) note the self-reinforcing nature of FDI investment, which can be a powerful determinant for certain industries such as manufacturing (Zhang, 2001: 341) which can benefit from improved efficiencies. According to Wheeler and Moody (1992; cited in Sun et al. 2002), infrastructure quality, the degree of industrialisation and cumulative foreign investment can be used to capture the agglomeration benefits. Sun et al.'s (2002: 98) findings show that a "one percent increase in infrastructure build-up almost doubles the inflow of FDI." However, as the nature of FDI in China has changed from export-oriented to market-driven, the proximity to other TNCs, particularly those that are trying to serve the same market, may have a negative impact on attracting FDI. As Sun et al. (2002: 98) divulge "it may be that agglomeration has a limit".Historico-cultural links as an FDI determinant, although common in a post-colonial world, play a specific and significant role in China between Hong Kong and Guangdong as well as Taiwan and Fujian. According to Zhang (2001) loyal overseas Chinese investors have substantially contributed to China's success in attracting so much FDI in the last two decades. This bond between source and destination is powerful, as it removes many problems such as language and cultural barriers, notably the practice of guanxi. However, the investment from these provinces has been primarily in assembly and processing (Henley et al., 1999: 232) and therefore has had little impact on narrowing the technology gap. It is arguably the case that the existence of these bonds has excluded foreign firms, costing China the import of better technology and productive techniques. However, the significance of these cultural barriers has declined in the face of increasing political reform.Minxin Pei (2001) highlights the power of economic development in affecting political reform and liberalisation, as evidenced by the growth of international trade and FDI exercising a profound influence on Chinese reforms of internal price structure and changes in ownership laws of enterprises (Hussain 1996; cited in Dees 1998). The increasing number of China-centric bilateral agreements have also been argued as potential FDI determinants that foster a productive investment climate through the strengthening of policies to protect the "treatment of foreign investors and establishing the mechanisms for dispute settlement" (UNCTAD, 1998: 117). With the continued trend for TNC's attraction to China's growing domestic market, the amount of access will be an important factor in a firm's location decision. Since 2001, areas of the domestic market have been substantially opened resulting in a trend shift from export to market oriented FDI (Zhang 2001); however, the level of openness can have an ambiguous effect on FDI-a more open economy attracts investment because it welcomes foreign capital (Sun et al. 2002) but too great a level of openness can result in the market becoming crowded from the perspective of a firm.Another ramification of the political climate on the firm can be indirectly upon the ownership and internalisation advantages. Henley et al. (1999: 238) note that China's notorious "lack of an effective legal system for property rights…deters the transfer of state of the art technology", which is often the key ownership advantage of a firm and therefore its loss substantially affects the decisions of many firms. Similarly, China's opaque bureaucracy, particularly local government involvement, has an effect on the internalisation decision, as the more complex the legality of doing business, the less attractive the conditions for FDI.As compensation, the Chinese government has undertaken many policies aimed at encouraging FDI directly, in the form of tax exemptions, land use and other financial rebates. Cheung and Kwan (2000: 384) note that "export-oriented FDI is more responsive to preferential tax treatment, but FDI that is aimed at the local market is more responsive to policies that affect domestic demand". It can be said that as the nature of FDI has changed over time, as has the effectiveness of these policies.The 2006 World Investment Report highlights that many Chinese investors have actually begun to take advantage of these rebates by 'round tripping' through Hong Kong. This has a highly distorting effect on FDI figures, making it hard to pinpoint what the effect of the incentive has had as a determinant on genuine FDI, however in 1994, Hong Kong accounted for 61 percent of FDI stock in China (Dees, 1998: 177) of which some analysts attribute 25-50 percent (WIR, 2006: 12) to round tripping.One of the final aspects of China's liberalisation has on determinants, is the increase in FDI substitutes. Investment brings a multitude of benefits, one of those being the inflow of foreign capital. A province may not need much FDI if it can tap the foreign capital market and use the money to invest in the local industry. In this sense, other means of foreign investment such as equity capital, can partly substitute the need for FDI. It is expected that the variable is negatively correlated to the amount of FDI within the province (Sun et al. 2002).ConclusionThis report's focus has highlighted the temporal, sectoral and locational changes of FDI within China that coincide with movements in the main sources of investment. These factors have all had ramifications on the investment determinants' prevalence over time, as well as their adherence to the global trends identified in Part 1 of the report. What is possibly the most notable worldwide trend is the movement away from the conventional concentration of FDI from developed to developing countries. It is arguable that this trend could be largely attributed to the emergence of China on the forefront of the FDI scene.The achievements of the Chinese government in affecting the attractiveness of China's investment climate both directly, through incentives such as tax exemptions, and indirectly, through policy concerned with ownership and internalisation, has been notable. Following the wake of increasing market liberalisation, characteristics specific to China have made it a highly desirable location for TNC investment. Advantages such as market potential and labour abundance provide growing incentives for market-oriented TNCs, shifting the importance away from export-driven investment. The major determinant of inward FDI to China is now a more complicated trade-off between cost and quality, as opposed to the earlier focus on cheap labour.The cultural barriers, which conventionally created technology gaps and further precluded China from receiving FDI, have been lessening in the face of political pressures and the forces of globalisation. However, determinants such as poor intellectual property rights and an opaque and inconsistent bureaucratic system have a negative correlation with the level of FDI inflows. In addition, some of the ostensible incentives have resulted in practices such as round-tripping that may well have counterproductive effects to both the level of FDI inflows and the economy.The world has yet to see the full impact of China's WTO accession as a locus for change in FDI determinants, but this event could revolutionise their investment regime, significantly affecting the country's future economic development.Word: 3226BibliographyCheng, Leonard K, and Yum K. Kwan. (2000) "What are the determinants of the location of foreign direct investment? The Chinese experience." Journal of International Economics 51, pp. 379-400.CIA. (2007) The World Factbook- China. Downloaded from https://www.cia.gov/cia/publications/factbook/geos/ch.html as at May 2, 2007.Dees, Stéphane. (1998) "Foreign Direct Investment in China: Determinants and Effects." Economics of Planning 31, pp. 175-194.Dunning, J.H. (1993) Multinational Enterprises and the Global Economy Wokingham: Addison-Wesley.Dunning, J.H. (2001) "The Eclectic (OLI) Paradigm of International Production: Past, Present and Future." Int. Journal of the Economics of Business, Vol. 8, No. 2.Henley, John, Colin Kirkpatrick and Georgina Wilde. (1999) "Foreign Direct Investment in China: Recent Trends and Current Policy Issues." World Economy 22(2), pp. 223-243.Ietto-Gillies, Grazia. (2005) Transnational Corporations and International Production: Concepts, Theories and Effects. Edward Elgar.Pei, Minxin (2001) "Political institutions, democracy and Development" Democracy, Market Economics And Development: An Asian Perspective, p.25. Washington DC: Iqbal Faruqh ed., World Bank Publications.Sun, Qian, Wilson Tong and Qiao Yu. (2002) "Determinants of Foreign Direct Investment across China." Journal of International Money and Finance 21, pp. 79-113.UNCTAD. (1998) World Investment Report: Trends and Determinants. New York: United Nations.UNCTAD. (2006) World Investment Report: FDI from Developing and Transition Economies: Implications for Development. Chapter 1 Global Trends: Rising FDI Inflows. New York: United Nations.UNCTAD. (2007) "Foreign Direct Investment." Downloaded from as at May 1 2007.Zhang, Kevin Honglin. (2001) "What attracts foreign multinational corporations to China?" Contemporary Economic Policy 19, No. 3, pp. 336-346.

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