China in Transition

The More FDI, the Better?

Chi Hung KWAN
Consulting Fellow, RIETI

China has seen sustained high economic growth since its market-opening reforms began in the late 1970s. Inflow of foreign direct investment (FDI) has played an important role in achieving this growth. With China's entry into the World Trade Organization, the market environment is expected to continue to improve and foreign investment is likely to make further inroads into the country. However, such active use of foreign investment has spawned some very serious problems.

China gives preferential tax treatment to foreign investors in such areas as tariffs and income tax, but the extent to which such tax breaks are offered differs according to region. This has led to such problems as tax evasion, investments by domestic firms under the guise of foreign companies, corruption connected to the issuance of permits and licenses and an outflow of capital to overseas markets. Furthermore, differences in preferential treatment, geographical conditions and the investment environment have led to an uneven geographic distribution of direct investment and an economic gap has developed between coastal and inland regions. On the trade front especially, the excessive tax breaks given to the processing industry have had a major impact on the domestic raw materials industry because of a huge influx of imports from overseas. As a result, industrial advancement has been blocked, with many firms turning to the manufacture of processed goods.

It is true that foreign investment is a must if China is to expand its economy by continuing to upgrade its industrial structure. In fact, direct foreign investment in areas such as advanced technology and equipment has made up for the lack of technology at Chinese firms. But in reality, foreign companies fully control management, using their overwhelming superiority in management resources such as technology, funding, trademarks and markets. They control the core technology and main manufacturing processes and only entrust labor-intensive areas to the Chinese side. Because of this, there is little very value added by the Chinese, and the profit-sharing structure very much favors the foreign investor. In addition, it is foreign investors who are snapping up most investment opportunities in China thanks to their abundance of funds, and, as a result, domestic capital looking for investment opportunities is flowing overseas, sometimes in the form of capital flight.

Another fact that should not be overlooked is that such distortions have weakened the incentives for China to improve its potential competitiveness. Authorities initially implemented policies to actively attract foreign investment in an effort to strengthen international competitiveness by gaining access to advanced technology through the international division of labor. But in reality, Chinese firms have come to face disadvantageous competitive conditions and are unable to absorb and digest core technology and make it their own. At the same time, they have invested little in research and development.

To solve this problem, Chinese firms must first develop their own core technology and transform the technology of foreign companies into their own. The current situation, in which technology from foreign companies is utilized because of a lack of domestic R&D funding, needs to be changed so that the value added by the Chinese side can be increased. In addition to this, laws that enable foreign and domestic firms to compete on an equal basis must be created, and measures need to be taken so that domestic companies can develop without having to specialize in assembly and processing. To realize these goals, the current tax system, which favors multinational corporations, must be altered so that domestic companies can also receive national assistance.

April 11, 2003

April 11, 2003