Economy will influence inflows

Weak global indicators cloud foreign direct investment prospects in china

Last year, China was the world's second-largest foreign direct investment recipient after the United States, according to preliminary projections by the United Nations Conference on Trade and Development. So what is the outlook for China's inward foreign direct investment for 2013 and beyond?

China cannot directly control foreign direct investment. It regularly outperforms global foreign direct investment trends, but it can't isolate itself from them. In 2012, foreign direct investment around the world fell due to the negative global economic environment. UNCTAD statistics show foreign direct investment declined by 8 percent in the first half of 2012 to $668 billion (503 billion euros). Partial data available for the second half makes clear 2012 did not avoid overall decline.

Many countries suffered severe drops. Foreign direct investment into the United States in the first half fell by 39 percent and India by 43 percent. China's inward foreign direct investment declined 3 percent in the first half of 2012, considerably outperforming the global average, but not escaping the overall fall. The trend continued in the second half with a 3.6 percent decline from January to November.

This year, foreign direct investment in China will again necessarily be affected by global economic conditions. Overall these are not bright for developed economies that are the main sources of foreign investment, which is frequently cut back by companies in difficult economic situations. Given the eurozone crisis, strong European investment in China is unlikely. Japan's economy has entered a new downturn. In the US, an economic recovery will be slow by historical standards, but it is real. In the first 10 months of 2012, US investment into China increased by 5.3 percent. But a slow US recovery, offset by weakness in the EU and Japan, means at best no serious increase in investment levels into China this year.

Turning to China's inward foreign direct investment pattern, its structure is changing due to China's continuing economic development. When China launched its economic reform in 1978, it was investment starved: China's total fixed investment was only 9 percent of US levels. By 2011, total fixed investment in China was 141 percent of US levels. Whereas earlier inward foreign investment was important for China as a source of investment funding, this role is now marginal. Foreign direct investment is equivalent to less than 5 percent of China's domestic investment. Furthermore, in approximately five years China's outward investments are likely to equal inward investments.

But foreign direct investment remains important for speeding China's technological development. This - combined with foreign companies no longer undertaking foreign direct investment to create an export base but to benefit from China's domestic market - interacts with global trends to determine China's foreign direct investment prospects.

The character of China's new emphasis on foreign direct investment, and therefore its willingness to use taxes and other incentives to stimulate it, is clear. China's GDP is the world's second largest and it's likely to overtake the US in five to seven years. But China's GDP per capita, reflecting productivity, is only 11 percent of the US. Even when China's total GDP equals the US, China's GDP per person will only be slightly above 20 percent of US levels. It will take 30-40 years for China's productivity to catch up with the most advanced economies.

In terms of consequences for foreign direct investment, the most advanced economies will therefore enjoy a technological and managerial advantage over China for decades. Equally, China will seek to benefit from investment from these economies for decades. Foreign direct investment is not a short-term fix, but part of a long-term strategy for China.

China's changing guidelines reflect the shift from foreign investment as a financing source to one for technological upgrading. In 2007, restrictions were placed on foreign investment in low value-added sectors such as clothing. In 2011, a further shift in the same direction came when new guidelines went into effect, stating that the "focus is to push forward technology innovation and industrial upgrading".

From 2011, foreign direct investment into industries such as automobiles, coal and chemical plants was no longer encouraged. In contrast, industries such as electrical machinery, Internet equipment and several service sectors were moved into the encouraged category, making them eligible for incentives. The foreign direct investment China above all wants is illustrated in nearly 1,000 research and development centers established by foreign companies.

Another objective is changing the geographical pattern of foreign investment so that more goes to poorer inland provinces. To facilitate this, tax advantages for foreign enterprises in coastal regions, such as Shanghai's Pudong district, were eliminated in 2008 and are maintained only for parts of China's inland regions. Inland regions are attractive because they have lower wage rates, their growth rates are now above many coastal regions and there have been improvements in infrastructure.

But while China's priorities in foreign direct investment are clear, it cannot compel foreign companies to invest. Inward foreign investment only occurs if it fits in with a company's priorities. Investment has to be "win-win" or it won't happen. So how successful will China be in achieving its new foreign direct investment goals?

The first year after 2011's new guidelines showed the desired re-composition of foreign direct investment. The 12.4-percent fall in manufacturing investment in the first half of 2012 was even sharper than the overall decline. But foreign investment in technology-focused industries increased by 6.6 percent. Foreign investment into China's service sector played an increasing role with investment in the service sector reaching $39.5 billion in the first nine months of 2012, 47 percent of the total. There was also a desired geographical shift in investment into China's western region. There are strong objective trends favoring this desired trend continuing into 2013, but also clear policy dangers that could undermine it.

The strongly favorable tendencies are clear. For decades, multinational companies knew China was the world's most rapidly growing major economy. The new factor is that the absolute increase in the size of China's market in dollars each year is now larger than the US. In 2011, the US economy expanded by $647 billion and China's by $1,367 billion. The dollar increase in China's market has been greater than the US each year since 2007. Given the relative growth rates of the two economies, this will continue.

China is therefore no longer only a base for exports but the world's most rapidly growing market. As the incomes of China's population increase, the nation will demand increasingly sophisticated products and require increasingly sophisticated production methods, which will stimulate the desired investment shifts. As the Economist Intelligence Unit noted: "China will continue to attract inward investment owing to the growing strength of its domestic market." Desire to enter China's domestic market, as well as establish an export base, ensured that by the end of 2011 more than 480 of world's top 500 companies had established subsidiaries in China.

But these trends show China's overall economic dynamic, not primarily specific measures on foreign investment. Prospects for foreign investment into China in 2013 primarily depend on its overall macroeconomic dynamic.

In December, Ministry of Commerce spokesman Shen Danyang noted at a news conference: "Global economic growth is still weak, and the divergence of some investment flows to other emerging markets has become clear since the global financial crisis".

In 2011, the overall $219 billion investment into East Asia, dominated by China, was significantly greater than Southeast Asia's $117 billion. But the rate of increase into East Asia was 9 percent, while Southeast Asia's rate was 26 percent. UNCTAD noted: "Overall, as China continues to experience rising wages and production costs, the relative competitiveness of ASEAN countries in manufacturing is increasing".

There is a mistaken view that increasing China's domestic consumption is the key to both its domestic economy and to boosting foreign investment. Investment, by both domestic and foreign companies, does not take place because of demand. Foreign investment, as with the domestic one, can only be maintained by high profitability levels, which require a high profits share in GDP. But China is under significant upward wage cost pressure as its working age population growth slows and, in the future, contracts.

Theoretically, this slowdown in the growth of China's working age population, and its upward pressure on wages, need not pose a problem. If productivity increases more rapidly than wages, rising real wages can be accompanied by high or even rising profitability.

But a combination of high wage growth with high productivity growth is only statistically possible if China's economy grows fast. If China's economy is allowed to slow, or wage increases become too high, profitability will decline, making foreign investment less attractive.

The author is a visiting professor at Shanghai Jiao Tong University. From 2000 to 2008, he was the economic adviser to the mayor of London. The views do not necessarily reflect those of China Daily.