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Foreign Direct Investment in China

Hong Kong China Business

Week 3

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How To Explain Foreign Direct Investment?

• The Hymer-Kindelberger proposition: there must be market imperfections if FDI is to take place

• The location approach: different places have different advantages in terms of costs and revenues

• The ‘internalisation’ approach: firms need to make some transactions internally

• Dunning’s ‘eclectic’ model: the OLI model

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1. the imperfect market approach (Hymer-Kindleberger)

Departure from perfect competition in good markets (product differentiation, marketing skills)Departure from perfect competition in factor markets (access to patented knowledge, discrimination in access to capital and skill differences embodied in firm)

1. the imperfect market approach (Hymer-Kindleberger)

Departure from perfect competition in good markets (product differentiation, marketing skills)Departure from perfect competition in factor markets (access to patented knowledge, discrimination in access to capital and skill differences embodied in firm)

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Internal/external economies of scale (including those from vertical integration) Government intervention (particularly those from restricting output or

input)

In short, this approach suggests that:

the MNC must possess firm-specific advantages that are internationally

transferable.

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2. the location approach

Emphasised on the specific factors or advantages of a host economy.

(a) a large domestic market(b) cheap labour supply leading to “offshore production” facilities(c) good geographical location(d) incentive packages

2. the location approach

Emphasised on the specific factors or advantages of a host economy.

(a) a large domestic market(b) cheap labour supply leading to “offshore production” facilities(c) good geographical location(d) incentive packages

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3. the internalisation approach

The advantages of internalisation (and therefore of control by the firms versus the market solution) include:

exploitation of market power by discriminating pricing

avoidance of bilateral market power: transaction problems

avoidance of uncertainties in the transfer of knowledge between parties: the need to protect brands and technology

avoidance of potential government intervention, e.g. tariff

3. the internalisation approach

The advantages of internalisation (and therefore of control by the firms versus the market solution) include:

exploitation of market power by discriminating pricing

avoidance of bilateral market power: transaction problems

avoidance of uncertainties in the transfer of knowledge between parties: the need to protect brands and technology

avoidance of potential government intervention, e.g. tariff

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Dunning's Eclectic Approach: The OLI Model

• A synthesis of :

• imperfect market approach: foreign direct investors must have “ownership” advantages (something they own that gives

them an advantage over local firms) - technology, management skills and routines, brand names

location approach: there must be a reason for using the ownership advantage in a new location

internalisation approach it must be better to transfer the advantage internally within the firm, instead of

licensing it to another firm

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II. Foreign direct investment in the PRC By the end of 1998, over 227,800 FDI projects has been registered in China. Foreign ventures were estimated to be responsible for about 41 % of China's total exports in 1997

1. Forms of FDI: (Equity) Joint ventures Co-operative operation (Contractual Joint ventures) Wholly foreign-owned ventures Joint exploration

“Three foreign-invested enterprises” = first three forms

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Joint venturesTwo basic types:

(i) Equity joint venturesTwo or more firms join together to form a new firm. It is a limited liability company, whose profit distribution is determined by the equity contributions of various parties.

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Via a contract, two or more firms agree to undertake some economic activities.

Investment in a contractual joint venture does not determine profit sharing. The rights, liabilities and obligation of the various parties are determined in a contract, as is each party's share of the goods produced and profits generated.

Legal liability is unlimited and rests with the parties involved.

(ii) Contractual joint ventures (Co-operative operations)

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Different contractual formsa. Processing and assembly agreementThe Chinese party provides a factory, power and labour, whilst the foreign party normally supplies raw materials or knock-down parts. The equipment may be provided by either side. The foreign party takes the finished goods for sale in his own markets.

b. Compensation trade (also known as product buyback)The foreign party provides any combinations of services, equipment, training know-how and technology, and receives payment over a two-to-five year period in the form of goods produced as a result of his contribution. This method is usually used to upgrade the existing enterprises.

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Foreign wholly-owned companiesForeign companies are permitted to establish wholly-owned subsidiaries in China.

Joint ventures used to be the more widely adopted form but now the option of wholly-owned venture is gaining popularity among foreign direct investors.

No. of firms 1986 1992 1997

Equity joint venture 3233 55826 134885

Contractual jt venture 4403 14180 33413

Wholly foreign-owned 138 14365 67197

Joint exploration 41 n.a. n.a.

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2. Investment incentives

(a) exemption and/or reduction of the following

i. income tax

ii. land use fees

iii. construction tax

iv. withholding tax on remitted profits

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(b) other preferential treatmentsi) priority access to water, power, gas, heating, transport and communications facilities and/or at prices consistent with those paid by state-owned enterprises

ii) foreign employees permitted to pay in RMB for accommodation, food transportation, communications, medical and other costs

iii) investors may purchase domestic enterprises, stocks and bonds, and directly purchase real estate and land use rights

iv) might sell the (consumer) products in the China market

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3. patterna. by industry

manufacturingreal estate and hotels

b. by place of originHong KongJapanTaiwan

Two distinct types of FDI into China:A.Chinese Family Business Investment: small, low-tech, export-oriented, in the South, labour-intensive assembly work, short-term focus- Hong Kong in the 1960s, moved over the border - profitable

B. Western and Japanese: larger, wider range of industries, China market-oriented, more capital-intensive, long-term focus, not too profitable

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4. foreign involvement in service sectors: a big issue for WTO

a. accountingb. advertisingc. legal servicesd. surveying

The PRC government has been more selective towards FDI with emphasis on the attainment of hi-tech and foreign exchange income generating capabilities in PRC. 5. opening up the retail and wholesale sectors (gradually)

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III. Possible Benefits of the FDI to the PRC

1. supply of capital2. supply of necessary and more advanced

technology

3. supply of entrepreneurship4. transfer of marketing skills, promotion of

manufacturing exports5. creating linkage effects, promoting local

industrial development

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6. generating tax revenue

7. Improving income distribution through the payment of higher wages and generation of employment

8. Increasing the PRC's international contact through the global network of foreign firm

9. Stimulating INSTITUTIONAL CHANGES. Reform of the legal system, accounting system, was originally driven by the recognition that foreign investors required improvements. But then the improvements spread to all firms in China

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IV. Role of HK HK is the largest direct investor, especially in the southern provinces of PRC. This is explained by rising labour and rental costs, geographical, kinship and historical reasons. The investment mainly concentrates on light industries.

There has been some criticism of the “low-tech, sweatshop” nature of HK FDI into China. But it is well suited to the PRC’s comparative advantage.

IV. Role of HK HK is the largest direct investor, especially in the southern provinces of PRC. This is explained by rising labour and rental costs, geographical, kinship and historical reasons. The investment mainly concentrates on light industries.

There has been some criticism of the “low-tech, sweatshop” nature of HK FDI into China. But it is well suited to the PRC’s comparative advantage.

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V. The PRC direct investments in HK1. background

Meanwhile, PRC has increased its overseas investments substantially since 1979. In1982, the amount was only US$ 80 million. It then increased nearly 65 fold to US$ 5.13 billion, with investments in more than 120 countries & regions in 1992. With an amount of US$ 3.7 bn, the PRC was the third largest direct investor in the manufacturing industry of HK in 1991, after US and Japan. The investment has been mainly in transport equipment, chemicals, electronics and clothing.

V. The PRC direct investments in HK1. background

Meanwhile, PRC has increased its overseas investments substantially since 1979. In1982, the amount was only US$ 80 million. It then increased nearly 65 fold to US$ 5.13 billion, with investments in more than 120 countries & regions in 1992. With an amount of US$ 3.7 bn, the PRC was the third largest direct investor in the manufacturing industry of HK in 1991, after US and Japan. The investment has been mainly in transport equipment, chemicals, electronics and clothing.

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Moreover, with an overall stock investment coming to US$ 12 billion, PRC is reported to be the largest source country. Whilst the Bank of China group has the greatest investment of around US$ 5 billion, others are estimated to have invested at least US$ 7 billion. The firms are now undertaking diversified investment activities, in addition to the manufacturing industry, to import and export, hotel, real estate, infrastructure and construction.

Moreover, with an overall stock investment coming to US$ 12 billion, PRC is reported to be the largest source country. Whilst the Bank of China group has the greatest investment of around US$ 5 billion, others are estimated to have invested at least US$ 7 billion. The firms are now undertaking diversified investment activities, in addition to the manufacturing industry, to import and export, hotel, real estate, infrastructure and construction.

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2. Problems:a. incentive incompatibilitygovernment officials as the managers of the Chinese companies in HK b. agency problemsdifficult to monitor the behaviour of managers of the Chinese companies in HK by the mainland authorities

2. Problems:a. incentive incompatibilitygovernment officials as the managers of the Chinese companies in HK b. agency problemsdifficult to monitor the behaviour of managers of the Chinese companies in HK by the mainland authorities

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VI. Policy and Prospects1. the PRC

a. attraction of the big MNEs,. especially those from developed countries

b. more selective towards the hi-tech firmsc. continuing improvement in the legal and

infrastructure frameworkd. open up the retail sectors

VI. Policy and Prospects1. the PRC

a. attraction of the big MNEs,. especially those from developed countries

b. more selective towards the hi-tech firmsc. continuing improvement in the legal and

infrastructure frameworkd. open up the retail sectors

2. HKa. attraction of the firms from the PRCb. compliance of those firms with the HK laws

2. HKa. attraction of the firms from the PRCb. compliance of those firms with the HK laws