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Wanda Tseng, Deputy Director, Asia and Pacific Department, IMF
Yasheng Huang, Associate Professor of Business, Harvard University
Nicholas Lardy, Senior Fellow, Brookings Institution
Markus Rodlauer, Division Chief, Asia and Pacific Department, IMF
Harm Zebregs, Economist, Asia and Pacific Department, IMF
MR. STARRELS: Welcome to the International Monetary Fund. My name is John Starrels, of the External Relations Department, and you're here for another Economic Forum in our ongoing series of engagement with the outside community.
We have an absolutely stellar presentation today. Before commencing, two very brief housekeeping announcements. Literature is available and we hope you will take it with you. We welcome lively dialogue and encourage you to avail yourselves of the microphones located on the arm rest next to you. With that, I take pride and pleasure in turning the floor over to Wanda Tseng of the IMF's Asia and Pacific Department.
TSENG: Good afternoon. Again, welcome to the International Monetary Fund. I think the topic of our Forum this afternoon is particularly timely given the attention that has been focused on China in recent years and the challenges that the economy is facing.
I have had the opportunity to travel to China quite frequently in the last several years, and I have witnessed for myself the tremendous changes and transformation that has been brought to this very dynamic economy.
China's economic performance has been very impressive by most standards. This year the IMF's World Economic Outlook is forecasting growth of 7.5 percent and a bit more next year. China was able to weather the storm of the Asian financial crisis relatively unscathed, and it had worked to reduce its external vulnerabilities by its high level of reserves and its favorable debt indicators. And I think at the same time, and most important of all, it has taken lessons from the Asian financial crisis and accelerated reforms of the state enterprise sector and the corporate sectors.
These achievements in China have added to the visible successes in the economic transformation of China that has been brought about by two decades of economic reforms. These reforms have resulted in spectacular growth, substantial inroads in reducing poverty, and the development of a very vibrant non-state sector.
One of the key driving forces of this transformation has been China's progressive opening to the outside world through trade and foreign direct investment, and most recently, that has culminated in China's accession to the WTO.
Our Economic Forum this afternoon will look at China's experience with foreign direct investment. The questions that we will be asking are: What have been the driving forces behind these flows? How have they contributed to the performance of the Chinese economy? And what is the outlook for the period ahead, both in terms of further liberalization and the implications particularly regarding the convertibility of the renminbi exchange rate?
Our distinguished panel of experts will be addressing these issues, and I would like to start our discussion by having Markus Rodlauer make a very brief presentation on putting FDI in China into a more macro context.
Just let me set down some of the rules. I would like to ask all the presenters to keep your remarks to about ten minutes, and I think that will leave time for us to have a more interactive discussion with the audience.
So let me first introduce Markus Rodlauer. Markus is a division chief in the China Division. He has been heading the work on China for the last year or so. Before that he worked on a number of Asian countries and some transition economies. He has been the Fund's resident representative in both Poland and the Philippines. So he has had tremendous experience with the problems and challenges of transition economies.
Markus is also one of the authors of a book that the IMF is putting together called "China - Competing in the Global Economy" that will be coming out fairly soon.
MR. RODLAUER: Thank you, Wanda. Good afternoon again. I will just start very briefly and give you a short overview of China's balance of payments in recent years and how these external flows relate to the domestic economy in terms of the savings-investment balance.
This provides a background to the subsequent discussion by Yasheng, Nick, and Harm on the role of foreign capital and foreign investment in China.
Table 1 summarizes the balance of payments of China in recent years. It shows, as you can see, a fairly substantial current account surplus in recent years, on average about US$25 billion, which is about 2.5 percent of GDP. And, in addition, it has received foreign direct investment net inflows of about $40 billion on average, which is about 4 percent of GDP. And this is, as I said, on a net basis, so the gross flows, inflows, were even somewhat larger, on the order of 4.5 to 5 percent of GDP. So, together, money coming into the current account and FDI amounts to something like 6.5, 7 percent of GDP, $65 to $70 billion.
Where has all this money gone to in the balance of payments sense? Well, first, a substantial amount you can see has ended up in the central bank where the sort of reserve increase—and this is a negative, if there is an increase. The reserve increase has averaged about US$22 billion over the past years, 2.2 percent of GDP. And for the remaining two-thirds, it's very hard to say, which are basically non-FDI capital flows and errors and omissions. Data weaknesses really prevent a clear analysis of where these moneys have gone.
There are some data from the Bank For International Settlements which have identified flows through the banking system, through the equity markets. Those are roughly balanced. So, you know, the rest is sort of outflows through the balance of payments or errors and omissions, fairly large, of about $40 to $50 billion on average over the past few years.
Now, in this context, a noteworthy development that you may see here in the last year has been that, while there have been substantial outflows in the years up to 2000, $50 billion, China's balance of payments, other than FDI and current account, has actually strengthened a lot in the last year, which has then boosted the reserve increase to almost $50 billion in the last year, in 2001.
So let me then move on and see how these BOP flows relate to China's domestic economy.Here we see that one of the most striking features of the Chinese economy is the huge amount of domestic savings in the economy,averaging about 40 percent of GDP, which compares very favorably, of course, with basically almost all international comparisons. China's domestic savings, nearly 40 percent of GDP,compares favorably not just with other developing countries or other advanced economies, but even within Asia they have a huge margin, and emerging Asia, basically 15 percent of GDP higher savings.
And the next chart shows how China's high domestic savings rate has financed an equally astounding aggregate level of domestic investment, not quite as high but, also 35 to 40 percent of GDP, which in the end means that we have very high domestic savings of about 40 percent of GDP, and slightly less domestic investment which resulted in what we call net foreign savings or a current account surplus of about 2.5 to 3 percent of GDP negative net foreign savings.
So what do these numbers say about the role of foreign capital, of foreign investment in China? Well, I'm just going to throw up a few hypotheses here, several points that could be made, and then those will be discussed further in the subsequent presentations.
On the one hand, clearly, given the very high domestic savings rate, China does not need foreign capital from a financial balance of payments point of view to supplement domestic savings. It has been able to finance a very high, a very decent amount of investment without the financial contributions from foreign savings.
So on the need for foreign direct investment, therefore, one could draw two broad conclusions.On the one hand:foreign investment has plugged a fairly large hole in the BOP because of these capital outflows, other outflows, and FDI has been the counterpart that has made the balance of payments close more or less—although this, of course, has changed last year. This other balance has improved a lot, which then improved the reserve balance. Or one could say that while FDI inflows are clearly not needed in a balance of payments sense, from an external finance perspective, it may have been critical in raising the productivity of all this investment that has occurred, 35 percent of GDP of total investment. As we know, China has had this fabulous growth record of about 10 percent on average GDP growth per year, which means that an incremental capital output ratio of about 3 looked very high, and certainly, given the technological contributions of foreign direct investments and so forth, the role of foreign investment was not so much in financially contributing to the balance of payments, but in improving the productivity of all this investment and, therefore, contributing to growth.
So maybe I should just stop here and then ask our subsequent presenters to speak more on FDI in particular. Thank you.
MS. TSENG: Thank you, Markus.
For our next speaker, we are very fortunate to have Professor Huang from Harvard University. He was gracious enough to fly down through the weather this morning from Boston. Professor Huang is an Associate Professor of Business at Harvard University. His current work focuses on the institutional and policy determinants of foreign direct investment in China. He has published widely, including a book called "Inflation and Investment Control in China." Before joining the Harvard faculty, he taught at the University of Michigan, and he was also a consultant at the World Bank from 1987 to 1989.
PROFESSOR HUANG: I am going to pick up where Markus left off, and I very much agree with him that at the macro level, FDI into China, and I believe actually FDI in general in a number of Asian countries, is not a macroeconomic phenomenon, but is a microeconomic one.
I agree with the observation that FDI has possibly improved productivity of investment, but the overall theme of my research shows that FDI has done that in a very specific institutional context, and let me just spell out what that context is before making my presentation.
That context basically is one in which the government, the Chinese Government, has systematically suppressed efficient private entrepreneurs from making the same contributions, same productivity improvements as foreign entrepreneurs did; and, therefore, the effect of FDI on productivity boosting. The productivity boosting effect of foreign entrepreneurs is made artificially greater in that specific context. That's sort of the overall theme of my presentation.
Before I get to that, I need to illustrate why I view FDI that way, why I view FDI as making this type of contribution in the institutional context that I just laid out.
First, I'm going to give a very brief overview of FDI, and the idea there is that FDI has actually played an incredibly important role in China, in the Chinese economy, and possibly more important than many people previously have realized. And then I'm going to talk about the drivers of FDI, and there I'm going to argue that a lot of conventional ideas about what drove up FDI inflows into China are partially correct, which means they're partially wrong. And so I'm going to address why they are wrong. Those ideas, the conventional ideas have to do with market size, cheap labor, things like that. I believe they don't adequately explain the FDI patterns in China.
Then I'm going to provide an institutional story why institutions are a very important part of the FDI story.
Just to show how important FDI has become, this is a picture that shows the growth of FDI relative to the domestic firms across a number of categories, across three categories: The share of industrial output value has increased from the early 1990s, about 7 percent to about 28 percent. You see also the share of value-added tax, which has increased dramatically in the course of the 1990s.
What's very interesting is this: In the 1990s, FIEs, foreign-invested enterprises, including both joint ventures as well as wholly owned foreign subsidiaries, accounted for 15 percent of exports. In 2000, they accounted for 48 percent.
The conventional wisdom says that, look, FIEs have made huge contributions to the Chinese export performance. I agree with 30 percent of that. I think 70 percent of the story is foreigners come into China and take away the export opportunities previously performed by domestic firms, domestic private firms and—because domestic private firms face very, very stringent credit constraints, so they cannot finance their export production. And foreigners come in, mostly from Hong Kong—and I include them as foreigners for technical reasons—foreigners and Taiwanese and firms from Macao essentially provide equity financing to the credit-constrained private Chinese entrepreneurs. So there's both a boosting effect of exports, but there's also a switching effect from domestic to foreign production.
Another picture that shows how important FDI is, and I think this is a dramatic picture. If you use FDI flows, this is the average, the annual average between 1992 to 1998. If you use the FDI flows divided by non-state gross fixed capital formation, that's—because SOEs in China play such an overwhelming investment role, and it's, I think—analytically it's more appropriate to compare foreign firms to non-state firms. If you take out the SOEs, the share, the annual average share of FDI in China is about 28 percent. Singapore, which is traditionally an FDI-dependent—extremely FDI-dependent country, is 30 percent. Malaysia is 24 percent.
What's very interesting, if you look at these three countries, is, in fact, they share many, many similarities at a micro and institutional level, and I would argue—and I'm doing research on Singapore and Malaysia now, and there is a lot of evidence to show that. If you go back to the 1960s and 1970s, what the Singaporean Government did and what the Malaysian Government did was very similar to what the Chinese Government did in the 1980s and the early part of the 1990s, which was to adopt policies that systematically suppressed local entrepreneurs, and so the basic idea is that if you think about FDI as an import of foreign know-how, if you suppress domestic know-how, to grow the economy at a certain level you need to import more foreign know-how to get to that level.
In Singapore, the same thing happened. It's not a terribly well-publicized story. In Malaysia, it also happened because of the ethnic tensions between the economic elites, who are just Chinese, and the political elites, who are Malays. So there was that.
In China, I think it's more because of an ideological consideration. Government is concerned about the power of the private firms. It's not ethnic.
There's one sort of [inaudible] idea out there which says that it is the coastal regions in China that receive most of the FDI. That's absolutely true if you look at the percentage distribution of FDI across different provinces. But what's really—what's missing in that judgment is the fact that interior regions in China, in fact, have depended very, very heavily on FDI. Think about the growth of FDI flows from 1990 to 1999. In 1990, China got about $3 billion, $4 billion of FDI. But in the second half of the 1990s, China got about $40 billion of FDI per year.
So even a small percentage of $40 billion is actually a huge number, but one estimate, about 13 percent of the cumulative FDI flows between 1990 and 1998 went to interior regions. These are interior regions that don't have easy access to Hong Kong. The transportation system is poor. The economy is very, very small.
If you take the FDI stock-GDP ratio in 1998, in interior Chinese provinces, it's about 11 percent. To put that number in perspective for North America, it's about the same. It's about 11 percent. Central and Eastern Europe is about 13 percent. And for Southeast and Southeast Asia, it's about 11 percent.
So we are talking about poor interior regions in China that have depended on FDI to the same degree as these economies that are very, very open. So the puzzle for me is not why these interior regions don't get much FDI. The puzzle for me is why they get any FDI at all. The linguistic ties between those regions and Taiwan are not there. And one of the reasons—let me show another picture and then I'll get to the reason.
This is from the World Bank report, and it's a pity that no recent study has been done on this topic, which is to compare FDI dependency in a number of provinces with inter-provincial capital mobility, so a firm located in one province investing in another province.
What this 1994 World Bank study shows is that for the six provinces for which they have data, it's the domestic investment data that are lacking. It's not the foreign direct investment data. For six provinces for which there are data, about four of them depended significantly more on FDI than they do from investment from other regions. So there's a great mobility of foreign capital. There's a great dependency on foreign capital and the mobility of foreign capital.
What makes that statement really, really interesting is lack of mobility of domestic capital, and there is some evidence to show that the domestic capital mobility has actually declined over the reform era while China has become more dependent on FDI. And this tells us something about the barriers in the Chinese system that are systematically promoting FDI but restricting domestic investment at the same time.
One of those barriers is local protectionism, and if you believe that one province has a net deficit in terms of its saving relative to its investment requirement, if it has a project that cannot be financed from investment from a different province, then FDI plays a very, very important role because essentially a foreign company is not restricted in terms of its capital mobility.
That's why in China you'll find very small firms establishing multiple plants across a number of provinces, and you'll find very large Chinese firms establishing all its plants in one province. The largest auto company in China is Shanghai Automotive Industrial Corporation. As of 1998, all of its 38 subsidiaries were located in Shanghai; whereas, you'll find a small [inaudible] company known as China's Strategic Investment, which acquired 200 companies across nine provinces. So if you believe that there is an economic need to integrate the assets disbursed across different provinces, if domestic firms cannot do that, somebody has to do it, and that somebody turns out to be foreigners more often than not.
What's also interesting about the distribution of FDI is that not only FDI is found in many, many provinces in China, including poor interior provinces; they are found in many, many industries in China. The industry concentration of FDI in China is extremely low compared to industry concentration in other countries. And this shows—or it tries to show that the top three industries with most of Hong Kong FDI in Taiwan accounted for 86 percent of the FDI. For Indonesia, the top three industries accounted for 79 percent; for Malaysia, 75 percent.
And you'll find the same thing in Latin America. Basically FDI only goes to a few industries. You know, the analytical reason for that is very, very simple. They are industries that locals are good at, and they are industries that foreigners are better at. So what you'll find is concentration of FDI. What you don't find is disbursement of FDI—except in China. In China, these top three industries accounted for 47 percent, only 47 percent of the FDI. So FDI—and there are a number of industries that you wouldn't necessarily expect to see FDI, such as silk manufacturing, ivory sculptures, herbal medicine. These are the things that the Chinese are very good at and they have been doing this for thousands of years, and yet you find these industries populated by foreign firms.
One idea is that China is a huge, growing market, and that's why China gets a lot of FDI. That's kind of true—it's only true in explaining the absolute increase of FDI. So in 1990, China received $4 billion of FDI. In 1999, it received $40 billion of FDI.Market fundamentals can only explain that story.
The reason why—it doesn't explain why China shall over time become more dependent on FDI, which is FDI divided by domestic investment. It's the fact that a growing,good market fundamentals should appeal to both foreign investors and to domestic investors.
That actually is what you see in Taiwan, in Malaysia, in the United States. In the United States, the economy expanded tremendously in the 1990s, but the share of FDI relative to domestic investment hardly changed. If a German company wants to invest in the United States, Microsoft also wants to invest in the United States. So the denominator and the numerator increase at the same time. So the share of the investment changes.
What you see in China is this incredible growth in the first half of the 1990s. And then what's also very interesting is this sharp decline beginning around 1996, 1997. And I believe this decline is a result of the fact that the government began to treat private entrepreneurs much better. So private entrepreneurs are also motivated to increase their investment and become more optimistic about the future.
I know I'm sort of running out of time. Let me just show a few more slides.
The export functions of the foreign firms in China, as I showed before, are extremely important. They are important relative to the similar export functions of foreign firms in other economies. In China, you find—this is 1995. You find foreign firms accounted for about 61 percent of the garment and footwear exports. In Indonesia, it's only 33 percent. In Taiwan, it's only 5.7 percent.
What's also interesting is that foreign companies are playing a much more important role compared to foreign companies in Indonesia and Taiwan, both in labor-intensive industries, which are these three industries—leather and fur products and furniture—as well as in capital-intensive and technologically intensive industries.
What's very interesting about Taiwan's story is that Taiwan is also known as a huge export success. And what's important there is that the export success was achieved by local entrepreneurs, and local entrepreneurs were able to get financing in a way that the Chinese entrepreneurs until recently were not able to get from the formal financial system.
Let me just explain the connection between the importance of local financing vis-à-vis contract export. If I'm a Chinese entrepreneur and Wanda is a Hong Kong entrepreneur, Wanda can give me an export contract which represents a business opportunity. But the business opportunity has to be financed, and if the local bank doesn't give me money, then I cannot finance the production of the export contract.
In that situation, what Wanda is going to say is: Yasheng, why don't I provide some equity financing. I will own 50 percent of your business, and I will give you some capital so you can carry out the export activities.
In Taiwan, you don't have to do that. And what's very interesting is that in this particular case, even though we are talking about simple manufacturing operations in garments and footwear, essentially foreign entrepreneurs are playing the role of a venture capitalist, providing seed capital to businesses that are discriminated against by the banks. There are no technological risks. There are no product risks. These are mature industries, mature products. There are political risks because the private entrepreneur is not favored by the banks.
Another role that foreign companies have played is privatization. Just now I told you a story about the connection between FDI and the private production of export products. A lot of FDI has also gone into SOEs, and there's this idea that a lot of the FDI that has gone to the state sector finances greenfield investment, new investment. That's actually just not true.They are thought of as greenfield investments only because of the legal format which they take, which is joint venture. But that's just a legal fiction. That's a legal requirement. That has nothing to do with the underlying nature, economic nature of these transactions.
In my field study, I have found many, many examples of SOEs contributing their brand name, contributing their customer base, contributing their own operating assets in order to finance an equity claim on a newly created joint venture. After the joint venture is created, the SOE becomes a shareholding company. That doesn't have any operating assets on its balance sheet.
If you look at the balance sheet before the joint venture creation and after the joint venture creation, before the joint venture creation it will have operating assets like machinery and equipment. After the joint venture creation, it would have essentially financial claims on the joint ventures. And this is one of the fundamental reasons why there are a lot of conflicts between Chinese shareholders and foreign shareholders, because the Chinese shareholders—in this case, the SOEs—have lost the sources of alternative income. Their only source of income is the dividend income from the operations of the joint ventures. So the Chinese firms tend to want a dividend distribution, whereas foreign firms want to reinvest the earnings, and this is one of the reasons why there is such a conflict.
In the machinery industry, an industry populated by the SOEs, what's very interesting is—this is sort of a complex story, but the basic message of this picture is that the investment income—this is SOEs. The investment income more than makes up the operating income. I think this is 1997. In 1997, the SOEs in the machinery industry collectively made a loss of 10 billion Yuan in profits, in operating income, but they more than make up that loss by the dividend payment from the joint ventures, which is 16 billion Yuan.
If you look at other firms, no other firms exhibit this kind of behavior. If you look at private firms, for example, the private firms, there are not many private firms, so this is a small number, 0.2 billion in operating income, and there's practically no dividend income at all.
The SOEs are in a class by themselves. This is a factory in Suzhou in Jiangsu Province, and the factory manager told us that they formed a joint venture with Phillips in 1994. After the formation of the joint venture, his predecessor, the general manager at the time, had to sit behind a cardboard box which was used as a desk and had to sit on another cardboard box as his chair, because the office furniture was also contributed as the equity contribution to the joint venture. Nothing was left. Nothing was left. So there's that—it's a privatization story, and it's a privatization story that has taken place in a specific context, and that context is that the Chinese Government has not allowed domestic private companies to acquire the same SOE assets that are available to foreigners.
So essentially the Chinese Government encouraged FDI, and a lot of it is a de facto privatization story. And then the Chinese Government has not allowed until very, very recently domestic private companies to bid for the same assets. That's one of the reasons why the valuation of the Chinese assets is actually very low, and that has nothing to do with the morality of the SOE managers. It has to do with a lack of competition for the same assets. If the Chinese Government allows privatization, then the valuation would be higher.
The third institutional driver, which I already alluded to, is the fragmentation of the capital market and economic market. And that also drove up FDI flows enormously, and we can, you know, debate whether this way of attracting FDI is a good way of attracting FDI. I have some issues about this way of attracting FDI, but we can talk about that in the question and answer period.
Thank you very much.
MS. TSENG: Thank you, Professor Huang, for your very comprehensive introduction on the FDI story in China.
I now invite Harm Zebregs to give a somewhat different perspective on the FDI story. Harm is an economist in the Asia and Pacific Department of the IMF. He's been working on China for the last two or three years, and he's been writing a number of papers on productivity growth in China and trade and investment.
MR. ZEBREGS: Thank you, Wanda. Good afternoon. Today I will discuss the main determinants of FDI in China. I will also briefly touch on the contribution of FDI to GDP growth and Total Factor Productivity growth in China, and I will conclude with some preliminary lessons that can be drawn from China's experience.
We've already discussed the numbers a bit. As this chart clearly shows, China's success in attracting FDI is mostly in the 1990s. After Deng Xiaoping's tour of the southern provinces in 1992 where he reaffirmed China's commitment to market-oriented reforms and policies to open the economy, FDI surged from almost nothing to $40 to $45 billion per year in the 1990s.
When you express FDI flows to China as a percent of GDP, it's about 5 percent during the 1990s, and then it looks somewhat less impressive as other countries—for example, Malaysia have attracted even more, like over 8 percent of GDP in the early 1990s.
What also should be mentioned, of course, is that part of China's success may be exaggerated because of round-tripping and misreporting. Round tripping is capital that originates from Mainland China and that returns to China disguised as FDI to take advantage of tax benefits and tariff benefits.
The sources of FDI. The main sources have been Hong Kong and Taiwan, and their importance declined somewhat in the 1990s as enterprises from the United States and the EU and Japan entered China in larger numbers. But, still, Hong Kong, Taiwan, and Singapore, areas with a large Chinese Diaspora, account for over 50 percent of FDI flows to China.
The geographical distribution, Professor Huang already discussed this in terms of FDI as a percent of GDP.This is in absolute numbers, and here you can see that in absolute numbers, the coastal regions attract close to 88 percent of FDI inflows, whereas the central and western provinces get, respectively, 9 percent and 3 percent.
The determinants of FDI: In the economic literature many determinants of FDI have been identified I'll only discuss those that are relevant for the case of China. I start with those determinants that related to a country's economic structure. Market size, that's an obvious one, I guess, in the case of China. Both at the national level and at the provincial level, market size has been found in empirical studies to be an important determinant of FDI.
There is an issue about two-way causality here because, on the one hand, FDI is attracted by a large market; at the same time, FDI contributes to GDP growth.
Market size has apparently been more important for FDI from Europe and United States than for FDI from Hong Kong and Taiwan, which tends to be more export-oriented.
China has an abundant supply of cheap labor, and some analysts have suggested that the low-wage costs have been a very important factor in attracting export oriented FDI from Hong Kong and Taiwan, especially because of rising wage costs in other economies in the region. And this has contributed to China's rapid emergence as an important competitor in labor-intensive manufacturing.
Infrastructure: China's infrastructure compares favorably to some other economies' in the region, but especially when you compare FDI flows to different provinces, it's been found in several empirical studies that infrastructure has been an important determinant. The coastal regions have better infrastructure, and that has also contributed to their success in attracting large sums of FDI.
Scale effects: Another issue that's found in many studies is that there's a strong persistency in FDI flows, both to China and to individual provinces. This suggests that once a province has attracted a critical amount of FDI, they'll find it easier to attract more FDI. This has been interpreted as a signaling effect.—Once there is a large enough number of foreign investors present in a certain area, it's a signal to other investors that conditions are apparently good or are good enough in that area to do business, and that will subsequently attract more foreign investors.
The cultural and legal environment: We already saw that a large—or more than half of FDI came from Hong Kong, Taiwan, and Singapore where there's a large Chinese Diaspora. I'll skip that.
Bureaucracy and legal environment: Many foreign investors perceive the Chinese legal system as ambiguous. Legal disputes are often settled through personal contacts rather than through formal contracts that are enforced by the court. This ambiguity in the law has in turn led to corruption. China scores actually relatively low on corruption and governance indicators in international comparisons, and this has deterred FDI from Europe and the United States apparently more than investment from Hong Kong and Taiwan.
It seems that familiarity with local culture has proven to be helpful in surpassing bureaucratic hurdles and corruption, and this is also one of the reasons that investors from Europe and the United States have often sought local counterparts so that they can do business in China.
Reduced barriers and preferential policies. The reduction of these barriers to FDI and policies to improve the investment environment have played a key role in attracting FDI in China, and from the beginning of the reform process, the Chinese authorities considered attracting FDI as an important goal as it would introduce new technologies, know-how, and capital, and it would also help develop the export sector. But initially the laws and regulations were too strict to attract significant amounts of FDI, as we saw in the first chart, where you could see that throughout the 1980s FDI inflows were not that dramatic.
These preferential policies have been in the form of tax concessions and special privileges — [tape ends].
— reduced enterprise income tax rates and tax holidays. The special privileges apply mostly to enterprises in open economic zones.
The open economic zones have played a central role in the gradual opening of the economy to foreign investors, and an important difference between these zones and other areas in China is the administrative decentralization that permitted investment decisions in open economic zones to be taken largely outside the state plan.
I'll briefly discuss the impact of foreign direct investment on the economy.
FDI has raised GDP growth in two ways. One is through higher capital accumulation. That effect is relatively small and is estimated at about 0.4 percent per year of GDP growth during the 1990s. The more significant contribution is through higher productivity growth, and this has been estimated at about 2 to 2.5 percent of GDP growth during the 1990s, or about half of total TFP growth.
This chart shows that there has been a strong co-movement between the stock of FDI and total factor productivity. Also at the provincial level, there is a positive relation between FDI and TFP growth. The yellow dots are provinces.
FDI has also generated positive externalities through foreign-funded enterprises on the rest of the economy. These foreign-funded enterprises are the most productive enterprises. Their labor productivity is about twice as high as that of SOEs. And some preliminary empirical results suggest that the presence of foreign-funded enterprises is positively correlated with output growth of other enterprises in the same province.
FDI has created job opportunities. Foreign-funded enterprises currently account for about 3 percent of urban employment. FDI has also contributed to the transformation of the industrial structure. China's trade growth during the reform period has been about 4.5 times as fast as world trade growth, and the foreign-funded enterprises have played a key role in this achievement. Their share in exports has risen from 1 percent in 1985 to between 45 and 50 percent currently.
What are the lessons for other countries? These are tentative lessons. More work needs to be done to draw firm conclusions, but, first of all, in my view, China's success is not unique in the sense that factors that have been important in attracting FDI to China have also been important in attracting FDI to other countries. Large domestic markets, low-wage costs, improved infrastructure, all this complemented with the open FDI policies and especially the establishment of the open economic zones, they all seem to have been very important factors in attracting FDI. But they have also been important elsewhere.
Then there's political commitment. China had to overcome several obstacles to FDI that were rooted in history and in ideology. And it did so by limiting the opening of the economy in a few localities initially and by giving autonomy to those localities where it allowed foreign-funded enterprises to set up a business. Thereby, it allowed a market-based economy to develop alongside a centrally planned economy, and although the decentralization created some problems, it also gave local authorities strong incentives to grow and to develop their economies.
The success of these initial experiments created strong demonstration effects, which then induced broad support for further reforms and opening up.
As we saw, FDI contributes to GDP and productivity growth. I think China is a clear example of that case.
Then, of course, there are some pitfalls. The tax incentive system in China has become increasingly complex and biased, and this problem has become even more prominent now with WTO accession. But the authorities are addressing the problem and are working towards unifying the tax rates for foreign-funded enterprises and domestic enterprises.
There are also regional income disparities. By focusing on special regions, China's FDI policy has contributed to the growing income disparities between coastal and inland provinces, and the authorities are now giving priority to reducing regional income disparities by developing the western and central regions of the country, including by attracting FDI and by investing in infrastructure in these regions.
MS. TSENG: Thank you very much, Harm.
Our next speaker is Dr. Nicholas Lardy. Dr. Lardy is a senior fellow in foreign policy studies at the Brookings Institution here in Washington. He is a well-known China scholar, and he has written on Chinese trade and foreign economic policies. He was a member of the Yale School of Management in 1997 to 1999, and his most recent book is called "Integrating China in the Global Economy."
DR. LARDY: Thank you. Thank you very much and thank you for inviting me to participate in the Forum this afternoon.
The previous speakers have given a very comprehensive overview of trends in foreign direct investment. My charge is really to look a little bit more forward and look at what the effects of WTO might be on the patterns that have been analyzed. Before I do that, though, very briefly I'd like to cover a couple of topics.
First, I tend to agree with Professor Huang that distortions in the financial system have been a very important determinant of the reliance on the external sector. You can see it in foreign direct investment. You can see it in capital markets as well, where the domestic stock markets have developed at such a slow pace that more capital by a very substantial margin is still being raised on external capital markets rather than on domestic markets, even though there's a very high savings rate and a very huge pool of savings, as Markus' slides showed us at the outset. So there are some distortions, but yet I do think the policy issues that Harm has touched on are quite important. I think the two that have not been given sufficient attention in the remarks earlier I would say first is the processing program or the processing arrangement that China has put in place that allow foreign firms to operate at international prices within China by allowing duty-free imports of both capital goods and parts components and assemblies that are used for export processing. Processing has been an enormous driver of China's trade growth. It's certainly one of the most important reasons that by last year China was the sixth largest trading country in the world as compared to about the 37th largest trading country in the world when reforms began in the late 1970s.
Another policy I would just point to very quickly that hasn't been mentioned, which I do think is important, and that is, convertibility on the capital account which has existed since 1996, which allows foreign-invested firms to repatriate declared dividends from joint ventures. I think that's another thing that should be highlighted on the policy side.
I'd like to talk, before turning to WTO, also about two what I would consider to be myths that I think are fairly widespread. The first is that all of this processing activity and the role of foreign firms, which have been so important in driving exports, really in some sense are detached from the domestic economy, that they're really an enclave. Obviously, the previous presenter doesn't agree with that. He thinks there are productivity effects. But I think also one can look at what's happened to value-added in the processing sector. And it is true the rate of value-added in the processing sector in the early 1990s was relatively low, but over the decade of the 1990s, value-added as a percentage of output in the processing sector roughly doubled. And what that means is as more and more foreign firms have been operating, they're creating a demand. There has been the development of backward linkages. You get a lot of domestic firms that are now beginning to produce more parts and components that are going into processing activity that has generated all the exports.
So I think we're seeing an economy where the integration or the linkages between the externally oriented processing sector and the domestic economy has increased over time.
The second myth which is very widespread these days, I think in particular, is whether or not foreign investment has been profitable for those firms that have undertaken it. There have been two recent books—one called "The China Dream" and one called "China's Coming Collapse"—which really look at China's experience of reform over the last 20 years, primarily through the lens, I would say, of foreign-invested companies, foreign joint ventures, and basically they pile anecdote on anecdote about all the foolish investment choices that foreign firms have made and all of the bureaucratic and other obstacles that the Chinese Government has placed in their way. And, of course, one can compile a rather large number of such cases.
But I think given the fact that foreign direct investment in China is now well over US$400 billion and involves tens of thousands of companies, in any universe that large one is bound to find all kinds of disastrous outcomes. And so I prefer to look at the more systematic data on what has happened to profitability of foreign-invested companies in China, and here, contrary to what a lot of people think, that nobody has ever made any money in China, if you look at the data that, for example, were in Alexander Lehmann's recent IMF working paper, which looks at the profitability of American-invested companies in China, you find that profitability in the 1990s or the second half of the 1990s was about 14 percent after tax, which is almost the same as profitability of American investment in countries like Argentina, Brazil, Mexico, and Turkey. In other words, China does not look like an outlier at all; it rather looks fairly usual comparable to some other large emerging markets economies.
Chinese data, which cover all foreign-invested companies in China, tell a very similar story. Between 1994 and end 2000, profitability on a pre-tax basis of foreign-invested companies in China has averaged about 8 percent. Returns were somewhat higher in the early and mid-1990s; then they fell in the Asian financial crisis, and in the year 2000 they reached a new high of 9.9 percent.
Now, this does not take into account returns such as royalty fees and license payments that flow from foreign affiliates to corporate parents. It's just simply looking at the profitability of the joint venture company itself. And on a comparative basis, these returns look even more favorable since almost all joint ventures in China are eligible for 100 percent tax exemption in their first two years of profitability and a 50 percent tax exemption on the next three years of profitability and a 17 percent rate of taxation going forward after the fifth year, although that may be subject to some adjustment, as has already been mentioned.
So I think the idea that the foreign sector in China is an enclave is overstated, and the idea that foreign investors in China aren't making any money I think is also a misstatement.
Now, let me return to my assigned topic of what's the effect on foreign direct investment in China, WTO entry for China, what will it be. I think the main effect of China's WTO commitments is to liberalize foreign investment access, particularly in telecommunications, financial services, and distribution. And most of these sectors have been, by and large, closed to foreign investment.
For example, if you look in the late 1990s, the share of FDI going to financial services was 0.2 percent of the total. In distribution in the form of wholesaling and retailing, it was only about 2 percent. And manufacturing was about 55, 60 percent in most years in the second half of the 1990s.
Now, I think some commitments on rules-based issues such as TRIPs and TRIMs will make certain kinds of manufacturing investment in China more attractive, and eliminating a lot of other conventions in China like offset requirements and a number of other practices that have been common also will make investment in manufacturing more attractive.
But I do think that there will be a shift of investment towards the service sector because, as I said, the greatest liberalization is in financial services, telecommunications, and distribution. These are sectors of the economy that are underdeveloped by a variety of different measures.
So, on balance, I expect a moderation in the rate of increase in the inward flows of foreign direct investment. I know Goldman Sachs has predicted they're going to be $100 billion a year by 2005. I quite frankly would be surprised. I think they will continue to go up at a fairly modest pace over the next three to five years, but I don't think they're going to be at $100 billion in only three years. The second trend, as I've already indicated, is likely to be a change in the composition with some gradual decline in manufacturing and a rise in the importance of services.
This will be moderated somewhat, as I've already indicated, by the fact that some of China's commitments will make manufacturing more profitable. Even some of their distribution commitments will make investments in manufacturing more attractive, and also China is going to get the advantage of the phase-out of quotas that have governed world trade in textiles and apparel for several decades at the end of the year 2004, and I think there will be substantial additional investment in China by foreign firms, particularly in the apparel sector. So that will tend to offset what I see as the decline, the general trend for a decline in the manufacturing share.
But I think the policy environment remains favorable and, indeed, WTO has improved it substantially for foreign firms in China, and so I think that the outlook is moderate growth in the totals and some significant change over time in the sectoral composition.
MS. TSENG: Thank you very much, Nick, for this forward-looking perspective on FDI in China.
Now I ask Markus to give the last presentation, which is also a forward-looking piece, looking at what are the implications of the liberalization on the capital account, including FDI, for the convertibility of the renminbi.
MR. RODLAUER: Thank you, Wanda. Given the advanced time, I'll try to be very brief and race through. I'll talk briefly about the outlook for convertibility of the renminbi and the further liberalization of the capital account.
As you all know, China has started in the late 1970s, early 1980s by opening up its foreign trade regime and foreign direct investment regime, and recently has then also opened a bit the portfolio inflows. Two recent milestones in external liberalization were the unification of the exchange rate system in 1994 and then the achievement of current account convertibility in 1996. That means today exporters or importers basically can do their transactions and get foreign exchange if they can prove they have an underlying current transaction.
However, there still are extensive capital controls. China basically maintains these very tight controls on the capital account for several policy reasons. First, it allows scope for an independent monetary policy and at the same time keeping a stable exchange rate. Second, it limits the vulnerability to capital flow reversals. And, third, it helps to protect certain domestic industries.
So in the current regime, as I said, FDI is fairly open, so it's a very encouraging attitude to foreign investment. But one should still remember it's very tightly regulated on an individual basis. For each deal, for each foreign investment that comes in, there are very precise conditions specified at the outset on employment, on the way of financing and how much money has to be brought in and so forth.
Then there are the portfolio and other capital flows like loans. Those, again, are very tightly, strictly controlled, and the way the control system works is that it's segregated between domestic enterprises, domestic agents, and foreign enterprises, foreign agents.
So, for example, in the equity markets, there are two divided markets. One is for domestic residents and domestic renminbi. You can buy and sell stocks if you're a Chinese citizen and have renminbi. This is one side of the market. The other side of the market is foreigners with foreign exchange who can buy another type of stocks. This has recently been opened up a bit. Some domestic residents now can buy foreign stocks, B market stocks, but still this principle pretty much applies to all the capital account transactions, loans and so forth.
So while these capital controls, as I said, are fairly comprehensive from a regulatory perspective, they have proven to be not watertight. Particularly during the Asian crisis, we have seen a very large amount of disguised outflows, and you'll recall the numbers in the first table where we had about 50 billion of outflows, which really there isn't a very good explanation for. These large outflows during the Asian crisis then prompted some tightening of these controls by the authorities, and they were somewhat effective but, still, we have fairly large unexplained outflows.
Now, where do we go from here? Should and will China further open its capital account? Clearly, there is a strong case for China to eventually open up the capital account with the ultimate goal of full convertibility. I don't think it's necessary to restate the quite well known overall benefits of convertibility. In one way, it's unavoidable. Every advanced economy today has an open capital account, and, specifically what's in there for China, clearly it would provide access to cheaper financing, new technologies, and for individual Chinese agents, access to much more diversified and risk-balanced portfolios; and in the end it would result in higher investment and higher growth. And also given the difficulties of actually keeping capital controls in place effectively, it is in the end, in the long run, inevitable, particularly since, as Nick has explained, WTO now has created concrete commitments of the authorities to integrate the financial sector much more.
Now, one could conceivably think that these financial sectors could become integrated but still keeping capital controls. But the more you integrate in the real side and have businesses coming in and out, the more pressure there will be to actually allow also a freer flow of capital. So, in the end, I think it will become inevitable, and it is, I think, a very appropriate long-term goal. And it is, therefore, not surprising, and appropriate, that China itself has stated explicitly and set itself these goals, this long-term goal.
While the benefits are very well known of capital account liberalization, so are, of course, the risks. Capital account liberalization affects financial stability through two main interrelated channels. On the one hand, there is the risk of overheating from very large capital inflows, and, on the second part, on a more micro level, opening up the capital account to free flows of capital across borders really allows excessive risk taking by individual enterprises, and especially banks. And so that from the micro level, it fosters, because of the well-known problem of asymmetric information, the risks that banks just go overboard and assume excessive risk and excessive liabilities.
These conditions raise the risk of sudden reversals of these capital flows, which could then lead to external payments crises and, therefore, large output losses and welfare losses.
A third risk which we have learned in recent years also is that initial shocks in one country to one economy, to one financial system, can be transmitted and spread much more easily to other countries through the so-called contagion effect if you have an open capital account.
Now, the Chinese authorities, of course, are very well aware of this risk and have, therefore, chosen a very deliberate and a very gradual path of capital account liberalization. And the authorities—when you ask them why is it that you keep your capital account still under control, what they mostly mention very specifically is that until their enterprises and their banks are reformed and have tight budget constraints and behave in a commercial manner, they are afraid that you would just have excessive borrowing, huge excessive borrowing, like we have had in many other transition economies, where increased latitude for enterprises and banks to make economic decisions without having the commercial orientation, the tight budget constraints, leads to huge excessive borrowing and, therefore, instability. And the second reason they mention is that their still fairly narrow capital markets could lead to very large volatility if you have uncontrolled flows across the border.
So how then to go about capital account liberalization? Well, two broad lessons from the country experience in recent years we have drawn is that those countries that have avoided crises are those that have strong macroeconomic policies and those that have a strong financial system. For China, on the macro side, I think they rank very well on one of three items, which is the external position. It's very, very strong as we know. But there are two other issues that are still to be resolved. One is you need to have sustainable public finances, which in China is still something to work on given the problems in the enterprises and in the banks. And then also the choice of the exchange rate regime, the more you open up your capital account, the more it will be necessary to have a flexible exchange rate system. And also given the very large structural changes underway in the economy, our advice has been in recent years increasingly that at some point China will have to move from its currently fixed exchange rate or very stable exchange rate system to greater flexibility gradually.
So on the macro side, there is still some work to do on the public finances and on the exchange rate and monetary policy side. In the banking and SOE side,—certainly it's key to rehabilitate the state-owned enterprises and the state-owned banks before you can think of substantially further opening up the capital account. You need a strong prudential system to contain excessive risk taking, and you need good accounting, auditing, disclosure standards to allow information to be transmitted to the markets, as well supervisors.
So, there is a large work program ahead to be able to reach this ultimate goal of convertibility, but I'd like to emphasize another point here, too. Our experience has been that opening up and liberalization is a very complex and interrelated enterprise. And while full liberalization has to come, of course, at the later stages, one cannot really wait with individual opening up until everything is perfect. Market reforms, as I said, are inter-dependent. For example, markets will not develop at all unless you open up a bit. So one has to do many of these things in tandem and gradually at the same time, which necessarily creates uncertainties and is certainly a volatile enterprise. But one has to start somewhere, and then the key is, of course, to monitor very closely, very carefully, and to be very flexible along the way and implement carefully.
China I think has got it quite right from the beginning in terms of the sequencing of what flows to open first and what last. It started with FDI. It then went over to portfolio equity flows in the stock market, and other debt-creating flows, particularly in the short end, should come last.
So, in conclusion, maybe three points. One is convertibility certainly is a valid long-term goal, and the authorities have adopted it. However, it needs to be very carefully phased in and supported by reforms and appropriate macro policies. It is, however, an inevitable process that will come, and certainly WTO accession has provided further impetus both for the actual integration of China's economy to the rest of the world, for the further opening of the capital account, and for all the necessary supporting reforms.
MS. TSENG: Thank you, Markus.
I think we don't have too much time left. I wasn't a strong enough chairman, I think. But if you are available we can make about 20 minutes for questions and answers, and I'll take questions from the floor.
QUESTION: This is primarily directed at Professor Huang and Mr. Zebregs, but other panelists may have some light to shed on it. It concerns the financial cost of FDI relative to other sources of financing, and I pose that question both at the firm level and at the macro level. Let me start with the macro level.
As Markus Rodlauer pointed out at the beginning, China is an odd animal from a macro perspective. It exports net savings and then imports huge amounts of investment capital in the form of FDI. It gets very little return on the foreign investments—on the investment in foreign reserves, U.S. treasury bills and other things like that, but it pays very heavily on the foreign loans and on FDI.
FDI typically is considered an expensive form of financing because foreign equity return expectations are typically much higher than the cost of bank loans.
What does it mean at the macro level for China as a whole? Is China as a whole on the margin losing huge amounts financially because of this inefficient domestic recycling?
And, secondly, because of the heavy dependence on FDI, do a lot of firms get stuck with high cost levels, high financial cost levels?
MS. TSENG: Professor, do you want to take that question?
PROFESSOR HUANG: Let me sort of get about this issue from a more micro level than macro level. I agree with you that FDI is a very expensive way of financing economic development. In part, it's equity financing. It's not contractual financing.
Nick was very perceptive in raising this issue about export processing. Here I think it's very, very important to emphasize FDI is an ownership arrangement. By the IMF definition, FDI establishes foreign control of a domestic firm. There are other ways foreign firms can do business in China, interact with Chinese domestic firms on a long-term basis. One is export processing. It's a contractual mechanism. In labor-intensive industries, you find prevalence of contractual mechanisms in practically every other country except in China—I mean Africa. In Africa, I think there are two issues: one is the low level of savings, so it is a sort of more macro story; there is also a low level of indigenous capabilities. A government firm in Hong Kong actually sets up operations in Africa, and they import labor from China to manage these operations.
Unless you believe the Chinese are not capable of sewing the sweater, knitting the things together, putting up these shirts and stuff like that, so you need to import foreign know-how through FDI, unless you believe that, then you think FDI makes a lot of sense.
I don't believe Chinese are that incapable compared to Taiwanese, compared to Hong Kong entrepreneurs and workers in the 1960s and 1970s who relied mostly on contractual mechanisms.
And then the issue of financing comes in. Until 1998, Chinese private entrepreneurs could not export. That means they couldn't, even if their production generated foreign exchange earnings, they couldn't keep it.
The one way you can keep the foreign exchange earnings is to convert your business into a foreign-owned enterprise, therefore raising the demand for FDI. So the costs are extremely high, and you look at the recent developments in the Chinese current account, the dividend outflow, which didn't leave the country because it comes through the capital account, but the dividend as a debit item has picked up substantially from 1994 to 2000. In the long run, I think China will pay a very, very high price for this way of attracting FDI.
And I have to say, I have to add a few positives. In 1997, the Chinese Government began to allow privatization on a smaller scale. The Chinese Government has allowed private financing to private firms beginning in 1998. In 2001, Jiang Zemin welcomed private entrepreneurs into the Communist Party. You actually see a dramatic impact on the FDI front.
Labor-intensive FDI has fallen sharply. Export processing, which Nick talked about, increased dramatically since 1997, and Nick probably—I don't know if Nick knows these statistics. Export contract—export inflows, which basically is the buyer credit extended by a Hong Kong entrepreneur to a Chinese entrepreneur in China in Guangdong Province, in absolute terms it declined—it began to—in absolute terms. We are not talking about relative terms. It began to decline in 1989. 1989 is a significant year in China. There's a lot of political turmoil, and the government went after the private entrepreneurs, politically and financially. So the private entrepreneurs couldn't finance the production, relying on export contracts.
In the garment industry, out of 800 firms, 800 foreign joint ventures established in the 1980s, 500 of them were established in 1989 and 1990—two years that were not known for being friendly to FDI, but two years that were known for being hostile toward domestic firms.
So the private firms in those two years lacked property rights, security. They began to convert their operations massively into foreign-owned operations. Beginning in 1997, you see the reverse. You see export contracts began to increase dramatically, especially the export contract production engaged in by private entrepreneurs. The increase is from $60 million in 1997 to $500 million in 2000. We are talking about a dramatic increase by private entrepreneurs through contractual mechanisms—it's a contract; it's through contractual mechanisms—because the Chinese banks are more willing now to provide financing.
So all the contribution—I don't disagree with Harm about the contributions that foreign firms made to export production, but that contribution has occurred in the very specific institutional context which we need to pay attention to.
MS. TSENG: Thank you.
I think I would just like to add one point. You know, in my experience with working on China, the Chinese authorities are very pragmatic. In many ways, yes, it may be a costly way of financing investment. But at the same time, I think FDI allowed the government to overcome existing imperfections in the economic system, most notably the weak financial system. As we know now, the non-state sector accounts for something like 60 percent of GDP, but the bulk of domestic credit through the domestic banking system continues to go to the state-owned enterprises. So in a way, the availability of FDI allowed the financing for the development of the so-called non-state sector, and as Nick pointed out, with the increasing forward and backward linkages, these have led to a dynamic sort of change in the industrial sector.
So I think one needs to look at the question in terms of what Yasheng said about the institutional imperfections and FDI made that financing available and made the development of the non-state sector possible given the imperfections in the system.
Nick, do you have anything you want to add at this point? Okay. Can I—yes, please?
QUESTION: Actually, I have a question for Dr. Lardy. Now, it seems that after the WTO accession, China will significantly reduce its tariffs At the same time China will try to unify its taxation systems. So that means that will reduce incentives for foreign investors. So now my question is: Compared to other countries, especially Argentina and Brazil (?) that it will be creating a lot of disincentive to attract further FDI inflows. Thanks.
DR. LARDY: [inaudible] half, and now they're at 12 percent. They're going to 9 percent for the average tariff by the year 2005. So I think—I don't think there's that much foreign direct investment that's been trying to get behind a high tariff law. Obviously you can point to a few examples, but I don't think they account for a very significant—I haven't done the research so I could be wrong. But I don't think it accounts for a very large percentage of foreign direct investment.
And on taxation, I've always had a question. I know the Chinese are talking about unifying their tax systems, and there are a variety of pressures to do that. But there are certainly many governments that provide preferential taxation for various kinds of export processing activities and so forth. And I don't see what there is in the Uruguay Round treaty that prevents China from continuing to give more favorable treatment to foreign firms as opposed to domestic firms. I know it's undesirable from some points of view, but a lot of people are predicting that there's going to be unification of the income tax rate, and the Chinese are certainly talking about it, but I think we're going to have to wait and see how fast it will actually happen. And I'm not really—I've asked a number of WTO trade experts as to whether or not they really have to unify the rates, and I am not sure what the answer is, as is so frequently the case in trade policy.
QUESTION: The counterpart to FDI is the large domestic saving rates, which was not mentioned in the outlook. Is there an explanation as to why such large domestic saving rates exist? Is it because of lack of consumerism, which is not developed yet? But, more importantly, in the future it is not reasonable to expect that the rate will continue the rise that it has achieved so far, in which case then FDI could become more important there now. Any comment?
MR.RODLAUER:By the future, you mean, I suppose, the long-term future. I think we're often trying to see sort of what is the appropriate level of current account deficit for a country, and in a way we're asking ourselves what is the normal level of savings and investment of a country, and we do have a framework in the Fund to assess that. And from that perspective, China currently, given its stage of development, given the population characteristics, given the fiscal situation, I think it's natural to see this balance of savings and investment where they are now; but as they develop further, I think it's natural that, you know, over the longer future they will move into more of a current account deficit position. How large? We haven't done the work, but I think as China develops further, it will be natural that they start to develop a current account deficit position. But how large that is, as I say, I cannot tell you. And then the question arises: how this can be filled, and from a macro perspective, FDI certainly is a good way to finance it.
But for the next four or five years, which is sort of our more technical projections, we do not foresee a major dramatic change in the savings-investment balance for China.
MR.LARDY: I'd just offer the comment that if you just take the last two decades, I mean, your question hinted at maybe the savings rate is very high because there's nothing to buy, the kind of old forced savings argument that we had for planned economies. But over the last two decades, the availability of consumer goods has increased immeasurably, and while the national savings rate has not gone up very—it's gone up slightly, but the personal savings rate has actually gone up a significant amount. It looks like the composition of savings has changed somewhat. So at least in recent times we've had the coincidence of a huge increase in the availability of consumer goods and a rising personal savings rate at the same time.
MS. TSENG: Can I take a question from the back? Yes?
QUESTION:. I just had a question for Professor Huang and Dr. Lardy about development in the West. You mentioned that there's a significant amount of foreign direct investment in western China, which I was a little bit surprised at, but I was curious about the composition of the investment and whether it was government directed.
And for Dr. Lardy, after the WTO, how do you anticipate that development in the West will change?
PROFESSOR HUANG: When I say that there is significant amount of FDI going into interior regions, it is relative to the investments made by domestic firms in those interior regions. It's not relative to other regions of the country.
I think actually—I mean, this is a conceptual issue. The FDI relative to domestic investment I think is a better measure of sort of FDI activities. When Harm was talking about empirical studies that show that there is a close correlation between market size and FDI, I mean, basically China has a large market; therefore, it attracts more FDI compared to Mexico, compared to, say, Jamaica. So that's FDI that goes to China relative to FDI that goes to Jamaica. You know, to me that's interesting, but what I really want to emphasize is that a large and growing market should increase the incentives of foreigners to invest in China as well as domestic firms and domestic entrepreneurs to invest, because both of them should be optimistic about the future.
What you see actually in the 1990s is the opposite. What you see is that the SOEs are divesting from their production, and that's because of the intrinsic operating inefficiencies. Private firms, they can grow, but they lack financing to grow, and they lack legal protection. So what you see is FDI has increased dramatically, but the denominator has now increased to the same extent. That's not true for the United States and that's not true for many, many other countries when that ratio actually stays the same.
And I agree with—I'm sorry, this is probably not directly relevant to your question, but I agree with Wanda when she said that there's this positive dynamic effect of FDI. So what I was talking about was the causes of the FDI, and analytically, which would distinguish causes from the effects, FDI is like a medicine. So when you are sick, it's good to get FDI. It's good to get medicine. But it doesn't mean getting sick itself is good, right? These are totally two different things. For countries that don't have the kind of connections to Hong Kong, to Taiwan, to Macao, FDI is not a medicine. To them, the only option for them is to get their institutions, financial institutions, right.
I think it's very important for this body of institutions in Washington, D.C., to really think about getting the internal institutions right as opposed to getting FDI policies right. I think both of them should move forward on the same track, but there's a tendency always to emphasize FDI to the neglect of the importance of domestic institutions. And the western interior region is in part driven by the fact that efficient firms in the east, domestic firms, cannot invest in the west. And so if there's a business opportunity in Gansu Province, it is not being captured by a domestic firm. A Hong Kong firm captured that opportunity. It's not directed by the government.
DR. LARDY: I guess as a first approximation, I wouldn't see China's WTO commitments having a big impact on the regional distribution of foreign direct investment, because if you follow what I said about the new sectors that are opening up in financial services, telecommunications, and distribution, those are going to be driven very much by per capita income. So I would expect that those would be as concentrated in the east as the pattern of investment that has been more dominated by manufacturing in the recent past.
QUESTION: Thank you. It appears there's a growing concentration of foreign direct investment interest and a heavy concentration in not only the newly liberalized service sectors but also in high-tech sectors. And the irony of this, given that China is essentially—its comparative advantage is essentially low-cost labor, but it appears — [tape ends].
— engineers and scientific personnel. Obviously this creates a certain amount of consternation in other parts of Asia which have aspirations of being high-tech and post-industrial. So my question is: From an investor viewpoint, what are the unique attractions, and how is the flow of these types of high-tech and service sector investments going to parse between China and other parts, say northeast Asia? Sort of a comparative advantage question, if you will.
MR.LARDY: I agree there are some paradoxes in the patterns of investment and what's being produced in China. But I still think if you look particularly over the last decade or decade and a half, the structure of China's exports has moved very, very strongly toward labor-intensive goods. And even though we see computers and other things that have a kind of high-tech look to them, comprising a growing portion of the total exports—and I think it will increase—a lot of those goods are also quite labor-intensive and they rely a lot on imported components for the highest value-added portion. So at least as I see it, although we have a lot of new R&D activities undertaken by quite a large number of international high-technology firms on the manufacturing side, China has moved dramatically towards labor-intensive goods. And I think most of the commitments in its WTO obligations will continue to push it in that direction.
There may be some outliers. I mean, semiconductors is obviously a case that's gotten a great deal of attention recently. But in the overall scheme of things, I am very skeptical that China's going to be a significant producer of semiconductors, particularly at the high end. They're at least two generations behind. The gap, if anything, I think will continue to grow. They may—there's obviously a huge import requirement for the low-end chips that are going into so many electronic goods that are produced in ever larger quantities, so there may be some more of these commodity kinds of semiconductors produced domestically. I think roughly 90 to 95 percent of them are now imported. But the high-end stuff that's much more capital-intensive, the 12-inch production, is not going to be in China anytime soon.
PROFESSOR HUANG: What's very interesting about the high-end part of the investments is I think there are countries that ought to be concerned about China becoming more attractive. Many of these countries are in Southeast Asia, for two reasons: There's a spectrum of high end, right, so there's electronic components and stuff like that. They are higher end as compared with garments, but they are still sort of lower end within the high-end industries.
I think China will go after those things very, very significantly. And these are normal FDI, even though they are low-end and high-tech industry, but they are normal in a sense that traditionally what you see is FDI in the production of intermediate inputs. The stuff that goes inside the TV, the stuff that goes inside the computer, usually you see FDI there because that's the only way for a local production facility to get into the supply chain of the multinational corporations.
What you typically do not see is FDI in the labor-intensive final goods, like garments and things like that, which China also gets a lot. So there is sort of an anomaly there. But one of the reasons why, for example, Singapore and Malaysia should be concerned about China is that they are going after the same intermediate electronic production. And Japanese companies are beginning to move their operations from those countries to China. So that's reason number one. They are competing for the same capital.
Reason number two: I'm especially worried about Singapore and Malaysia because these are two economies that have not depended on local firms to generate growth. They are dependent very highly on FDI. And China is another very highly FDI-dependent country. And if they have a strong local firm say in Malaysia, China's growth will benefit that company. That company can sell goods to China. It can invest in China. I don't think Korea should be concerned. I don't think Japan should be concerned. It is precisely those economies that have in the past systematically promoted FDI at the expense of dynamic local firms that are going to suffer as a result of the WTO of China.
Amazingly, if you travel down to Southeast Asia, that's where you hear—you hear the complaints all the time, not complaints but concerns all the time that China is going to take away all our FDI. And I think this is in part because in the past you didn't allow your local firms to grow big; therefore, your local firms are not in a position to benefit from the Chinese growth, and now you are in trouble.
So I would be concerned if I were the policymakers in those regions.
MS. TSENG: One more question.
QUESTION:I'm particularly interested in the institutional story, and you have stressed a lot on the constraints on the mobility of domestic capital. At the same time, China has constraints on the mobility of labor. They're not watertight, but they're there. Is there any connect—does that have any bearing on what's happening?
PROFESSOR HUANG: Labor mobility is—you know, Nick can add to that. Labor mobility is much greater than capital mobility. On any single day, there are—at least that's the fable. There are 100 million Chinese on the road doing work.
So I think actually one of the reasons why labor has to be so mobile is precisely that capital is not mobile. So essentially labor has to follow where the existing industrial assets are rather than the other way around, which is that the industrial assets, labor-intensive industrial assets in Guangdong Province can really be located inward, but they cannot move because of the capital restrictions. So labor—something has to adjust, which would be the labor.
My own view is that the Chinese Government, I mean, it's—I agree with Wanda when she talks about the dynamic effects of FDI, but it's not automatic. I mean, the Chinese Government has to adopt proactive policies to deal with capital market inefficiencies on the regional side as well as between SOEs and private firms. And let me just say, the capital market segmentation along regional lines is a result of the SOEs, state ownership. It's not the result of the fiscal arrangements between central government and local government. Why? Because you are not willing politically to privatize the SOEs. What's the most efficient way of running SOEs? You gave that power to the local governments.
So the administrative control of the SOEs is a result of the desire to preserve SOEs. It has nothing to do with the tax arrangements. The tax arrangements arise—I don't know if you are familiar with the tax arrangements in China, which is the local firms controlled by local governments, their tax income goes to the local governments. That reduces the informational requirements of running SOEs because you gave the financial incentive to the local governments to run these SOEs better.
If you are willing to privatize these SOEs, these issues don't—they're not that important. And a lot of things have to come down to this SOE question now, and that doesn't go away automatically. You have to deal with it directly, explicitly, and that may require a political decision.
MS. TSENG: Yes, Harm?
MR. ZEBREGS: Another reason why limited mobility of labor is not a real concern for FDI is that labor is not in short supply, even though it's not perfectly mobile; whereas, capital is, especially for private enterprises.
MS. TSENG: I'm afraid I have to call this to a conclusion. I'd like to thank all of you for coming. If you have any comments and suggestions, please send it to our External Relations Department. It's available on our website.
I'd like to thank our panelists, particularly our outside speakers, Dr. Lardy, Professor Huang, for taking the time to join us on this Forum.
Thank you very much.
[Whereupon, the Forum was concluded.]
IMF EXTERNAL RELATIONS DEPARTMENT