EUROPEAN BUSINESS SCHOOL
International University Schloß Reichartshausen
Paper
Winter Term 2003/2003

Managing in the Global Economy

Foreign Direct Investment in China
An Analysis of the Current Reform Status

Christian Funke

Table of Contents

List of Abbreviations  II

1 Introduction  1

2 Market-oriented Reforms in the People’s Republic of China  2

3 Future Reforms Necessary to Safeguard Investments  4

4 Concluding Remarks  5

Appendix  6

References  13

List of Abbreviations
APEC Asian-Pacific Economic Confederation
CAGR Compound Annual Growth Rate
CCP China Communist Party
FDI Foreign Direct Investments
GDP Gross Domestic Product
IMF International Monetary Fund
PRC People’s Republic of China
TNC Transnational Corporation
UN United Nations
WTO World Trade Organization
WBG World Bank Group

1 Introduction

“China is considered by many as a great country for investment. Has China made enough reforms to justify significant investments? Which additional reform steps, if any, are needed to safeguard investments?”

In the following this paper will answer these questions. The People’s Republic of China¹ (PRC) has shown tremendous Gross Domestic Product (GDP) growth in absolute and per capita terms of 9.3% and 8.0% per annum, respectively, over the last 25 years since market oriented reforms were started in 1978 (see exhibits 1 and 2).² Its GDP per capita has quadrupled over this period reaching around 1,000 US$ in 2003. The market oriented reforms in China can be divided into two stages, dubbed “reforming the system” from for the first 15 years and “replacing the system” from 1993 onwards. ³ In the second stage a significant determinant of China’s success has been its policy of opening up the economy and attracting foreign direct investment (FDI). FDI grew with a CAGR of 26.7%, and the growth rates in the 90s have even been more staggering with FDI reaching about 50 billion US$ in 2002 (see exhibit 4). This FDI growth went hand in hand with growing imports and exports, reaching over 300 billion US$ in 2003 with a CAGR of 14.7% and 15.6%, respectively (see exhibit 5).

This paper aims at answering the question stated in the first paragraph by analyzing the specific market oriented reforms which have taken place in the two stages of the Chinese reform process in the second chapter. The paper argues that China definitely has made enough reforms so far to justify the significant FDI which has been flowing into the country. However, there clearly is a need for more reforms as China becomes more and more interconnected in a globalized world economy, especially with joining the World Trade Organization (WTO) in 2001. Those reforms necessary to continue the Chinese success story will be addressed in the third chapter, answering the second part of the question by analyzing reforms needed in the areas of the financial system, the rule of law, market liberalization and the governmental bureaucracy. The whole analysis will be guided by the analytical concepts of AHRENS 2002 as well as the institutional analysis in QUIAN 1999.⁴ The fourth chapter serves to draw a conclusion in order to give a recommendation whether further investments in China are justified or not. 

2 Market-oriented Reforms in the People’s Republic of China

Deng Xiaoping started the Chinese reform process in 1978. In order to analyze this process a stylized model of governance developed by AHRENS will be used and adapted for the specific case of China, looking at the different players and the realms in a governance structure (see exhibit 6).⁵

Especially interesting regarding the question of FDI in China is the attitude of the domestic political players, i.e. the Chinese central government, the China Communist Party (CCP) and the sub-national governments. One can say, that theoretically there could be a problem regarding FDI as in China there does not exist an independent judiciary or a legislature. The whole political sphere and therefore also the economy is dominated by the CCP and its leading figures such as most prominently Deng Xiaoping in the first stage of reforms or the current president Hu Jintao. However, the subnational governments (provincial, county, and township) are empowered in a system of regional decentralization of government authorities. This ensures a market-preserving federalism which limits the strength of the central government and the central CCP officials, limiting their ability to arbitrarily interfere in market processes.⁶

Leaving out the domestic non-political players⁷ and moving to the sphere of the foreign players, one can analyze that the opening of the Chinese economy is another important key to the success of the Chinese reforms. China is member of the most important international organizations such as the International Monetary Fund (IMF), World Bank Group (WBG) and WTO⁸, which puts significant international constraints on public policies in China. Especially China’s membership in the WTO will make it more attractive in the future for FDI, which will be addressed in the next chapter. However, its membership in the IMF and WBG is a significant factor signaling to foreign investors the political commitment the CCP was making in its way of reforming the Chinese centrally planned economy towards a “socialist market economy”.

[....]

1 Hereafter referred to as „China“. It has to be distinguished from the Republic of China, i.e. Taiwan.

2 Growth per annum is calculated as Compound Annual Growth Rate (CAGR).

3 This essentially follows the analysis in QUIAN (1999), p. 4-5.

4 See QUIAN (1999), pp. 1-49; AHRENS (2002), pp. 117-178 and 244-262.

5 See AHRENS (2002), pp. 177.

6 See QUIAN (1999), pp. 7-10; AHRENS (2002), pp. 252-262; TING (1999), pp. 11-15.

7 This sphere of players is not so important to the determinants of FDI and therefore neglected in this analysis due to space constraints.

8 The PRC is a member of the UN since 1971, of the IMF and WBG since 1980, of APEC since 1992 and of WTO since 2001. Overall it is member of more than 50 international organizations.