The Rise of FDI in China

Foreign Direct Investment (FDI) is instrumental in bringing goods and services to the global marketplace, and the rise of foreign investment not only displays investor confidence in the business and the geopolitical climate of the host country, such capital also links national economies.

Investing in China

The benefits of FDI flow to both the supplier of capital as well as to the host region. China is one country that has stepped up to capitalize on these benefits. China’s trade and investment reforms and incentives led to a surge in FDI beginning in the early 1990s. Such flows have been a major source of China’s productivity gains and rapid economic and trade growth. There was reportedly 445,244 foreign-invested enterprises (FIEs) registered in China in 2010, employing 55.2 million workers and 15.9% of the urban workforce. According to China's commerce ministry, FDI in 2010 surpassed $100 billion for the first time. Over the entire year ending December 2010, inbound FDI increased from 17.4% to $105.74 billion.

So, what are the factors that are driving this increase of FDI in China?  

1. Capital Availability

FDI is comprised of capital that an outside investor is willing to place (and risk) within a local region. Conditions in the global capital markets and general economic environment play a role in determining the flow of FDI into China. A thriving global economy, capital markets and business environment create a large availability of investable capital, a portion of which is converted to FDI. Large amounts of investable capital that proportionately outnumber the amount of sound local investment ideas can cause institutional, company and individual investors to invest their wealth in emerging and developing markets.

2. Competitiveness

China's attractiveness as a destination for investment capital rests on its development of infrastructure, resource availability (physical and labour), productivity and workforce skills, and the development of the business value chain. The level of maturation of these elements can make China more attractive for FDI relative to other nations, such as India, that compete and vie for the same investment capital. A growing and developing economy requires infrastructure and resources to facilitate the sale of goods and services. Lower transaction costs, due to the development of these elements, enables investors to earn returns on their investments as their enterprises can generate profits. Roads, highways, bridges and other forms of physical infrastructure should be present, maintained and provide enough safety for the transportation of goods as well as for the commute of employees. As originally reported by the World Economic Forum, China is currently in the process of building 19 city clusters which are all connected by a high-powered bullet train, with the aim of super-charging economic growth.

Another component for attracting FDI involves the availability of low-costs, skilled employees who possess the necessary aptitudes, experience and proficiencies to create, manufacture, and provide goods and services that can compete in global markets.

3. Regulatory Environment

When a national government enacts and enforces rules and policies aimed at favouring state entities at the expense of privately held firms, such an environment can be detrimental to initiatives that aim to attract FDI. As such, the regulatory environment can either encourage or impede foreign direct investment in China. Excessive regulations tend to hinder entrepreneurial and commercial activities, as managers and employees must spend more time and money to comply with rules and regulations. If an investor wants to set up a manufacturing facility in China, high start-up costs, legal exposure and other cumbersome compliance items may encourage that investor to set up the facility elsewhere, where the business climate is more conducive to industry.

Other types of regulations include mandatory joint venture partnerships in which, together with the foreign investor, the business is required to have a Chinese government agency or local company as a partner. A judicial system that is biased toward protecting Chinese locals - who conduct what are sometimes perceived as unfair, illegal, or unethical business practices - can also contribute to making China a less favourable investment destination.

Another regulatory factor involves the government's promotion of investment activities by providing, attractive financial incentives in the form of tax breaks, grants, low-cost government loans and subsidies. Government-sponsored financial inducements provide the possibility of making a business more profitable within a shorter time period.

4. Stability

Political and economic stability can facilitate an influx of FDI. Stability represents predictability and the opportunity for enterprises to gain better foresight into the future. Alternatively, constant social unrest, rioting, rebellions and social turmoil are settings not conducive to business. Economic instability can also contribute to hyperinflation, which can render the currency virtually obsolete, look at Venezuela for example. To encourage FDI, citizens/workers as well as businesses should have a reasonable basis for respecting Chinese law and order. The justice system should also have effective mechanisms for reducing, or altogether eliminating, rogue and corrupt elements of law enforcement agencies.

5. Local Chinese Market and Business Climate

The most glaring aspect of China is the sheer size of its population and market, and the prospects for growth that result from this size. The ability of enterprises - backed by foreign capital - to sell to a sizeable local market makes China an attractive destination for FDI. As the Chinese economy continues to prosper, evolve and mature, higher-end industries such as healthcare, information technology, engineering, robotics and luxury goods, among others, can gain a bigger footprint in China as its local conditions, resources and other FDI determinants are enhanced. Additionally, economic growth and FDI can start a "success domino effect”. The more the region attracts FDI, the more it grows. The more it grows and matures, the more investors are willing to provide FDI. This point underscores the advantage of China's sizeable market, which presents growth opportunities in current and prospective commercial activity. The more FDI flows into the country, the greater the economic chain reaction, providing a positive effect to sustain such growth. This can be seen by the explosive growth rate of the middle class in China and it is suggested that urban-household income will at least double by 2022. The evolution of the middle class means that sophisticated and seasoned shoppers—those able and willing to pay a premium for quality and to consider discretionary goods and not just basic necessities—will soon emerge as the dominant force.

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6. Openness to Regional and International Trade

Market openness serves several important roles in attracting FDI. Of critical importance is a business' ability to sell its products and services to both local and foreign markets. If Chinese-based enterprises have limited or no access to foreign customers - particularly the United States, Western Europe, Japan and others - then the local market may not be enough to warrant a significant investment in money and energy.

Export-friendly policies then, can play a major role in deciding whether to invest in China, especially for enterprises that have a large portion of anticipated market shares located outside of the local market. In efforts to create a more business-friendly environment, regional and international free trade agreements are typically initiated by market-progressive governments as reasonable mechanisms for inducing economic activity and growth.

The Bottom Line

There are many different factors that determine foreign direct investment (FDI) and it is hard to isolate individual factors, given there are many different variables. It depends on the type of industry. For example, with manufacturing FDI, low wage costs tend to be the most important, as it is a labour-intensive industry. For service sector FDI, macro-economic stability and political openness tend to be more important. For a developing economy like China's, foreign investment is a key way to spur development and pull the country's economy toward a competitive spot in the global marketplace.

If you want to find out more information about investment opportunities in China, please get in touch with the HMC team in Shanghai

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