China's FDI is neighbour's envy

Inflow this year will be nearly ten times that of India, says an Economist Intelligence Unit report.

HONG KONG: Going solely by the numbers, the high-stakes contest among developing economies to attract foreign direct investment (FDI) seems virtually a no-contest: China appears to be far and away the winner.

According to ‘World Investment Prospects to 2010: Boom or Backlash’, a report released on Monday by the Economist Intelligence Unit and the Columbia Program on International Investment (CPII), China was “by far the main FDI recipient among emerging markets in 2005”. FDI inflows into China were almost $80 billion in 2005, and are projected to go up to $87 billion in 2006.

Compare those figures with India’s — $6.7 billion in 2005 and $9.5 billion in 2006 - and it’s hard not to give in to despair. As the report notes, “India has yet to build a critical mass in FDI, having only initiated investment-attracting reforms in 1991.

Despite the country’s successful positioning as a business processing and IT outsourcing hub, these activities often translate into Indian services sector exports via third-party transactions, not FDI.”

India isn’t, of course, alone in experiencing that sinking feeling over China’s overwhelming superiority in attracting larger and larger FDI inflows. Across South East Asia, there have in recent years been fears of “a great sucking sound” as FDI appears to be moving away from countries in this region to the undisputed engine of world economic growth: China.

These FDI inflow figures are, of course, great advertisements for China. They reinforce the impression that smart money is heading for the Middle Kingdom because that’s where the action is, and will forever be.

But China’s impressive performance is actually a little less rosy than the absolute numbers will suggest. Researchers in leading international financial institutions, including the IMF and the World Bank, have since the 1990s held the view that China’s official FDI inflow figures are exaggerated. And that in fact, anything between a fourth to a third of official FDI inflows into China aren’t FDI at all, but the proceeds of “round-tripping”.

That’s the term used to describe a situation where capital that originates from China goes through another country before re-entering the country as “foreign” investment in order to access the fiscal incentives and improved investor protection offered in China to foreign investors.

Indicatively, in recent years, much of the FDI flows have been routed through Hong Kong, followed by the British Virgin Islands, Cayman Islands and Bermuda, which are well-established tax havens.

In July 2004, Geng Xiao, Deputy Director of the Institute for China and Global Development at the University of Hong Kong, noted in a research paper titled ‘People Republic of China’s Round-Tripping FDI: Scale, Causes and Implications’ that “there is no doubt” that a part of China’s FDI inflows “belongs to the return of Chinese capital that has gone abroad escaping foreign exchange controls”.

What are the advantages from such round-tripping of capital? Perhaps the biggest is in terms of tax breaks. Foreign firms pay a much lower rate of tax than domestic Chinese firms, although that is one of the provisions under review during proposed tax reforms. Yasheng Huang, Associate Professor at MIT Sloan School of Management, has argued that round-tripping is also a way for domestic entrepreneurs to increase their property rights and political status.

It seems inevitable, however, that such round-tripping FDI will decline with the expansion of economic reforms, particularly financial sector reforms, in China. A more accurate picture of FDI inflows into China vis-à-vis other emerging economies may then emerge. Until then, it may be premature to conclude that the contest for attracting FDI inflows is a walkover for China, even given that country’s undisputed attractiveness as an investment destination.

In any case, as Monday’s Boom or Backlash report noted, the concerns of the members of the Association of South East Asian Nations that China is diverting FDI from their countries are misplaced. “FDI is not a zero sum game and many ASEAN countries are attractive places from which to service Chinese demand,” the report added. “In addition, as Chinese wages rise, low-cost manufacturing will become increasingly competitive in some ASEAN markets.” In conclusion, the report forecast that the gap between FDI inflows into China and the ASEAN countries would narrow from now until 2010.