Why FDI is not the solution

Yasheng Huang's book, Selling China: Foreign Direct Investment during the Reform Era, is an important work whose message has not yet percolated into the collective consciousness.

Huang, a professor at Harvard Business School, has a different take on foreign direct investment, which China has been remarkably successful at attracting: the country is the world's second FDI destination in the world, to the tune of $61 billion in 2004. FDI, Huang says, is not all good. The implications are profound.

The reasons for China's high levels of FDI are popularly described as abundant opportunities, not least low-cost labour. Huang asks whether FDI is the most natural way to take advantage of these opportunities.

Wouldn't sourcing from China enable outsiders to take advantage of China's opportunities just as well as, or better than, an equity investment?

Indeed, why is FDI so high even in traditional Chinese industries, where foreigners have little expertise? And why are even China's backward inland provinces receiving high levels of FDI?

Even assuming that some FDI is domestic Chinese money looking for tax benefits and greater security as FDI, we are still left with a puzzle. (Huang estimates that such "round-trip" FDI stood at a maximum of 25 per cent in the early 1990s, and the proportion is probably much lower now.)

Most sources of China's FDI are small and medium-sized foreign companies, not the Motorolas of the world. This is true even of investors from the non-Chinese world. We may assume that investors of this size bring little technology, organisational know-how, or other advantages to China, yet here they are.

If foreigners see opportunities in China, it should be natural that locals see them, too. In other words, the ratio of FDI to domestic capital formation should stay somewhat constant. China's puzzle is that the ratio has shifted over time in favour of FDI, as if the opportunities are there more for one group of investors than for the other.

Tax benefits are usually said to provide a bias in favour of foreign investors, and may account for domestic investors engaging in FDI round-tripping schemes. But Huang shows that any favouritism shown towards foreign investors at the expense of domestic investors pales in the face of favouritism shown towards state companies.

The real issue is not domestic vs foreign investment, he argues, but a reluctance to support the growth of the domestic private sector. Better to welcome FDI than allow the growth of an indigenous entrepreneurial class that might challenge the political status quo.

FDI has continued to pour into China even as the country is not short of capital. This, Huang argues, is a most strange phenomenon. China's FDI/capital formation ratio increased in the 1990s even as its savings rate increased, as well. China has liquidity but it is not channelled to the right places.

The failing is therefore an institutional one. In effect, FDI has acted as a reason for the delay in reform. India, with about half of China's savings rate and a fraction of its FDI levels, has achieved comparable levels of economic growth. This, Huang argues, points to serious internal distortions in the use of capital in China.

Equity is a very expensive thing to sell, and China, given its economic fundamentals and the attention of the world, should be a seller's market. Allowing foreign investors to dominate a large portion of the Chinese economy can only be explained as the result of domestic economic weakness on a corporate level.

The lack of interest on the part of China's financial system towards supporting private enterprise is one important reason for this weakness. This has changed somewhat since Huang's book was written -- private companies are now more likely to receive bank loans than before, for example.

But a pecking order of firms with respect to access to capital -- what Huang dubs "ideological discrimination" -- still exists. The fragmentation of China's industrial landscape is another reason of weakness.

China is not one large market, with economies of scale, but a collection of small regional markets, kept small by local protectionism or favouritism, as the case may be. Huang makes the important point that foreign capital is more mobile within China than domestic capital.

Even China's largest firms are small by world standards (not to mention the fact that many are incorporated offshore). Hope, China's largest private group, is about 10 times smaller than Tata Sons. Kelon, China's largest refrigerator maker, is about the same size of Turkey's Koc, despite a market that is nine times larger.

Companies that manage to sell across a heterogeneous domestic market are well prepared to compete globally. In contrast, companies that do not manage to break across intra-national barriers are less likely to succeed internationally. This is an important lesson as China aims to build multinationals.

In a case study, Huang looks at the recent history of Shanghai Automotive Industrial Corporation (SAIC) and finds that the foreign equity ratios in its many joint ventures increased in the 1990s versus the 1980s although the supply of FDI grew several-fold while SAIC itself was very profitable. Why did SAIC increasingly accommodate foreign investors?

SAIC, while one of China's more successful industrial groups, is state-owned. Implicit in its willingness to accept increasingly high foreign equity ratios is a growing weakness in SAIC's bargaining position.

In contrast, Huang finds that where private enterprise has flourished, FDI levels have also been comparatively low. Huang's thesis, therefore, is not only about foreign capital and China's private sector, but also about the state sector: how it has failed despite being endowed with superior resources, technology, and human capital.

The title of Huang's book, Selling China, suggests China's embrace of FDI is the outcome of a policy choice, driven by the feat that an embrace of the private sector would unleash changes that would ultimately challenge the existing power structure.

FDI is a more acceptable alternative: foreigners do not harbour political ambitions. Other reasons may relate to cultural factors. That foreign capital in China is better able to transcend domestic barriers and more accepted relative to local private capital may be due to its very outsider status, for example.

"Foreign-ness" may carry intrinsic as well as institutional advantages. "The single greatest advantage of a foreign firm is that it is foreign," Huang writes.

What has happened in China, then, is a de facto, whether explicit or implicit, active or passive, privatisation to foreigners, which has been more politically palatable than a privatisation to domestic economic players. It is also a short-term, expensive solution.

The danger is that this "foreign privatisation" will lead to a nationalistic backlash. While the "commanding heights" of China's economy still include high-profile assets such as banks, telecom companies, and airlines, the levels of foreign ownership in the Chinese economy as a whole are very high.

In the garment industry, 63 per cent of companies are foreign-owned. In leather and related products, the number stands at 64 per cent. In furniture, 54 per cent.

Huang suggests that, in the final analysis, politics still matters in China today -- more so, for now, than economics. Yes, Deng Xiaoping did say that the cat could be black or white as long as it caught mice.

Yes, private entrepreneurs are now welcome into the Communist Party, and many of them have joined. They are also being allowed into previously restricted sectors.

Private property has received some constitutional protection. Yet these steps should naturally culminate in a wholehearted embrace of, and support for, private property. Such a shift, when it happens, would be more important than continuing to attract FDI at the current rate.