China and Foreign Direct Investment

That China’s economy is now deeply integrated into the wider global economy and that inward foreign direct investment (FDI) flows and trade growth have been mechanisms for this integration integration over the last fifteen years is hardly news. But the dimensions and speed of change continue at a torrid pace. Here we discuss the size and geographical concentration of the FDI and raise several key issues linking FDI and wider economic performance. One is whether FDI-led growth can continue as the prime developmental path for China, or do constraints on global aggregate flows, rising wage rates, or limits on the ability of markets abroad to absorb Chinese exports, at some point, serve to restrict growth. If so, when will any one of these factors slow growth and what could become an alternative growth path? Another issue is whether regionally concentrated, location-specific FDI has been a prime contributor to the growing inequality in China that threatens to politically constrain growth. Yet another is whether proposed or likely policy change, such as removing the substantial tax preferences toward FDI under a proposed unified tax, or a significant renmimbi revaluation, or both together, could also serve to limit FDI inflows.

In what follows, we first document the dimensions of inflows of FDI into China in recent years, emphasizing its links to China’s large processing trade. FDI inflows to China now account for nearly half of all Organization for Economic Cooperation and Development (OECD) outflows, are split between horizontal (serving the Chinese market) and vertical (export oriented), and are highly regionally concentrated. We then go on to discuss the contribution of FDI inflows to China’s growth drawing on an earlier growth accounting paper, which argues that a plateauing of FDI inflows to China could reduce growth rates by 3 to 4 percentage points.¹ We then use this as a bridge to discuss potential constraints on China’s future growth linked to FDI and trade. We note that for more than twenty years Western economists have been predicting the demise of Chinese high growth, which has not happened. Sections follow on regional concentration of FDI and inequality in China and the potential impact of tax preference removal and renminbi revaluation on FDI inflows.

Inward and Outward FDI in China

FDI inflows have grown rapidly in recent years, and China now accounts for nearly 50 percent of OECD outflows, while Chinese outward foreign direct investment has been relatively small.

Inward FDI

Foreign direct investment was prohibited in China until restrictions were lifted as part of China’s open door policy of 1979, when a new foreign investment law was adopted. In its early stages, FDI was restricted to China’s “Four Special Economic Zones” and limited to equity joint ventures. Most of the FDI went into hotel construction and energy. In 1984 a new foreign investment law accelerated FDI growth, and a number of preferential policies were also used by both central and local governments to attract investment.

A sharp increase in FDI only occurred after 1992 when China reaffirmed the policies of openness and market-oriented reforms introduced earlier. Significant tax preferences toward FDI introduced in 1991 and 1994 were also instrumental in the post-1992 surge. The resulting growth in China’s inward FDI has been spectacular. In 1985 annual FDI inflows were less than U.S.$2 billion, while in 2006 they were around U.S.$70 billion, thirty-five times those of twenty years earlier.² Between 1985 and 1991, the annual growth rate of FDI inflows into China was 14 percent, with annual amounts during this period being less than U.S.$4.5 billion. The sharpest increase in FDI inflows occurred in the early 1990s—U.S.$11 billion in 1992 and U.S.$28 billion in 1993, with growth rates of over 150 percent in both years.³ By 1997 China had FDI inflows of U.S.$49 billion, and they increased again after China joined the WTO in 2001. During years 2001, 2002, and 2003, world FDI inflows declined sharply by 41 percent, 26 percent, and 10 percent, respectively...