THE US-CHINA BUSINESS COUNCIL: CHINA OPERATIONS '99

Foreign Direct Investment

March 4, 1999

China's foreign-investment inflows in 1998 remained stable as increased investment from the United States and Europe compensated for falling investment from Asia. In 1998 China utilized $45.6 billion in investment and signed contracts worth $52.1 billion. Faced with an economic slowdown and preoccupied with domestic reforms, it is unlikely that China will act to improve investment conditions in 1999 significantly, but rather will tinker at the margins of existing policies.

The Year in Review

Flat investment growth The economic slowdown and mounting challenges of domestic reform caused Beijing to further tighten China's investment environment in 1998. As a result, though foreign direct investment (FDI) did not substantially decline, neither did it increase in a substantial way at a time when foreign investors were looking for alternatives to collapsing markets in Asia. Contracted FDI in 1998 increased 2 percent while utilized investment increased by less than 1 percent.

Changing investment patterns Foreign companies continue to show a preference for maximizing management control. For a second year, wholly foreign-owned enterprises (WFOEs) were the favored foreign-investment vehicle and are expected to make up almost half of all projects in 1998 (see Table 1). WFOEs also attracted the most contracted FDI, 42 percent of the total, compared to 37 percent for equity joint ventures (EJVs).

Regional composition Investment from Asia continued to account for the majority of FDI, but its share slipped markedly in 1998 (see Figure 2). Contracted investment from Asia through the third quarter of 1998 dropped 12 percent. Hong Kong investment, which still accounts for almost a third of contracted investment in China, was off 4 percent, while Singaporean and Japanese investment dropped precipitously (see Tables 2 and 3). As capital flows from other parts of Asia have slowed, North American and European firms have been increasing their share of investment. Contracted investment from the United States and Europe is up 46 percent and 64 percent, respectively, in part because of a few multibillion-dollar deals. The tax-haven Virgin Islands was the source of $4.9 billion, in contracted investment, up 43 percent. The original source of this money is unclear, although it is likely that some of it originated from PRC firms. Utilized investment followed similar patterns.

Investment Trends

Nineteen ninety-eight saw a significant slowdown in the pace of reforms. New restrictions on the ability to operate in China, including the required re-licensing of direct sellers and the proposed ban on certain telecom investments, further aggravated bilateral commercial relations and discouraged investment despite the central government's expressed desire for it.

• An administrative approach Beijing continued to rely on administrative tools to control the scope and pace of investment, and made it clear that liberalization will occur on China's own terms. On January 1, China promulgated the Guiding Catalogue for Foreign Investment in Industry, replacing a similar list issued in 1995, in an effort to attract investment in such areas as high technology and agriculture; to deter projects in less desirable or sensitive areas; and to limit redundant projects approved at the local level. China also issued a new series of price controls in October to check rising pharmaceutical costs. The controls threaten to deter investment by forcing firms to sell at below cost, and fail to address the root cause of high consumer prices, namely the hospital-based distribution system.
• Re-centralization Beijing moved to recapture investment control from the local level in certain sectors such as retailing. The State Council called for the re-evaluation of ventures approved at the provincial level and for the relicensing of direct sellers. This appears to have been an effort to consolidate central control, discourage alternative approaches to retailing, and protect domestic industry by strengthening the barrier against further market gains by foreign retailers.
• Spreading the wealth Beijing gave new priority in 1998 to investment projects in central and western provinces in agriculture, raw materials, energy, communications, and environmental sectors. New investment incentives included more liberal approvals of business scope and foreign equity stake, as well as preferential tax policies. To date, the statistics show mixed results. While contracted investment in Sichuan, Xinjiang, Ningxia, Shanxi, and Guizhou was up dramatically in 1998 (although from a decidedly low base), investment in other interior provinces fell (see Table 3).
• A focus on taxes The central government increased its focus on taxes as a way to boost revenue and pressured tax departments to raise an additional Yen100 billion ($12 billion) by increasing collection quotas. The December announcement to extend by two years the grandfather period for value-added tax exemptions for foreign enterprises founded before 1994 provided some short-term relief for firms already established in China, but will not help new investments. In another reprieve for FIEs, China's tax authorities failed to enact proposed consumption taxes on an array of consumer products in 1998. The debate on increased taxes is far from over, however, and taxation will likely become an important issue for foreign investors in 1999 and the years ahead. The announcement by the Minister of Finance of a plan to phase out the preferential tax policies (i.e. refunds for value-added and consumption taxes) in Economic Development and Trade Zones (EDTZs) will erode investment incentives for FIEs. This measure highlights likely future uses of tax policy to refocus investment (in this case, away from over-developed zones) and remove some of the tax distinctions between foreign and domestic companies.
• Restructuring and reform Government restructuring left many bureaucratic organs understaffed and unclear about their new responsibilities. As a result, many companies witnessed a slowdown in government decisionmaking. Beijing's call to sell off small and medium state-owned enterprises (SOEs) further prompted foreign investors to explore new opportunities for mergers and acquisitions. Other reform measures included the passage of the securities law, which could begin to fill in the gaps in China's regulations on capital markets. The creation of supra-provincial branches of the People's Bank of China (PBOC) may weaken the influence of local governments on the financial sector. China also announced the separation of the insurance and securities regulatory functions from the PBOC. At the same time, central political pressure on banks to continue policy lending to the state sector raised concerns about the credibility of reforms and the commercial viability of the banking system over the longer term. Restructuring also left many underlying systemic issues untouched. For example, CIETAC, China's arbitration body, was given more authority to hear disputes involving FIEs. But the number of arbitration cases brought to the highest levels of the US and PRC governments continued to escalate in response to poor enforcement at the local level.
• Closing foreign-exchange loopholes China's attempts to stanch illegal outflows of foreign exchange and reinforce renminbi (RMB) stability culminated in a series of notices and circulars issued by PBOC and the State Administration of Foreign Exchange in the fall. With little advance notification, China increased documentation and procedural requirements for the handling and release of foreign-exchange payments, creating delays and increasing expenses for FIEs.

  The underlying purpose of these recent circulars, the systematic elimination of widespread corruption and abuses in the handling of foreign exchange within China, will ultimately benefit American companies. In the short term, however, these circulars affect companies' ability to conduct normal business operations. According to the Council's survey of its members, over 60 percent of the respondents report that their investments have already been adversely affected by these circulars and the atmosphere in which they are being carried out. Nearly 50 percent of the companies have decided as a result of the new regulations to reconsider, delay, or even cancel intended investments and/or financing involving foreign currency (see China's Foreign Trade).

• Domestic protectionism Beijing moved to protect domestic industries threatened by growing international competition. In October, for example, the Ministry of Information Industry issued "buy local" regulations that set market-share quotas for locally produced telecommunications equipment, including mobile switches, base stations, and handsets, and set targets for local content in telecom joint ventures.
• Incremental liberalization Despite an apparent growing awareness of the need to liberalize services to attract much-needed investment, China's leadership showed again in 1998 that it would liberalize services and other restricted sectors incrementally through pilot projects. Restrictions on distribution rights remain the top constraint on further investment. With the exception of some proposed pilot projects, a significant easing of distribution restrictions is unlikely in the coming year. China continued to inch along in opening its legal and financial services markets, granting business licenses to 17 new law firms (including 4 from the United States) and opening Shenzhen to RMB banking, although geographic, numeric, and business-scope restrictions remain in place.

Looking Ahead to 1999

It will be difficult for China to increase foreign-investment inflows without opening new sectors to foreign investment, especially services. China is counting on such increases in 1999, but investment will most likely remain stable or decline slightly. Asian investment is not expected to rebound significantly, and broad, systemic liberalization seems unlikely given the pressures against opening exerted by domestic firms and certain government agencies. Specific project opportunities are likely to continue in areas defined by the current Catalogue, such as high technology, construction, and water resources. In largely closed sectors that are experimenting with foreign participation, such as insurance, banking, and telecommunications, foreign firms are likely to see limited opportunities.

Other significant developments to look for in 1999 include

• the passage of the pending copyright law, which will bring China's copyright regime in line with international standards and protect copyright in new areas such as Internet content;
• the unified contract law, also pending, which is expected to help prepare the regulatory environment for movement in such areas as E-commerce and intellectual property rights;
• the implementation of a proposed comment period before the launch of new policies which, if enacted, will increase the transparency of the Ministry of Foreign Trade and Economic Cooperation's regulatory process;
• the current draft regulations by the State Development Planning Commission and State Economic and Trade Commission detailing the inspections and services for which Chinese government organs can charge FIEs, which if implemented would help establish billing standards and lessen the burden of illicit fees on FIEs;
• intensification of FIEs' concern over China's lack of preparedness for the year 2000 computer problem, which is expected to cause market disruptions into 2000.