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China Maintains its Allure for Foreign Firms

by | January 28th, 2014 | 03:48 pm
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On the surface it looks like life is getting more difficult for foreign enterprises in China. Although China remains one of the fastest growing economies in the world, double digit growth has been replaced by 7.7 percent growth in 2013.  At the same time, a slowdown in demand for luxury products, greater scrutiny by Chinese regulators, and rising labor costs have created a perception that China has lost its allure for foreign companies. In fact the truth is quite the opposite.

China remains one of the most attractive destinations for foreign direct investment in the world. China’s share of global FDI stock has doubled in the last five years alone. According to the UN World Investment Report, in 1990, China’s share of global FDI stock excluding Hong Kong was ninth in the world below Mexico and Brazil. In 2012, China’s stock of foreign direct investment excluding Hong Kong was the third largest in the world, below only the United States and the European Union.  China’s share of global FDI stock will continue to grow this year. Similar to 2012, slowing growth in China’s FDI stock this year is likely to be matched by even slower growth in the rest of the world, such as the European Union.

Graph 1 - FDI

Foreign companies remain attracted to China because it still has superior returns. The income generated by foreign enterprises in China is among the highest in the world. For example, the returns generated by FDI stock in China averaged 9.4 percent between 2002 and 2012, compared with only 5.8 percent for investment in the United States. Even as the Chinese economy slowed last year, returns were still around 9.1 percent.

Graph 2 - FDI

Foreign companies are also gaining more control over their investments in China than ever before. Whereas in the past most investment into China was confined to joint ventures today 76.2 percent of investment flows are in the form of wholly foreign owned investment.

Graph 3 - FDI

Moreover, foreign companies can now invest in more diverse businesses in China. Where in the past the vast majority of investments were confined to the export manufacturing sector, today manufacturing represents only two-fifths foreign investment inflows while the service sector share is now over half of new FDI inflows, ranging from retail to business services. If the promises of the Shanghai FTZ are realized, the opportunities for foreign companies in the service sector could expand even further in the near future.

Graph 4 - FDI

It is true as China rebalances some foreign firms – like their domestic counterparts – will need to adjust their business model. The gains from using labor cost savings for increasing profits in low-valued added export manufacturing have waned. Goods and services consumed domestically are increasingly competitive and require foreign firms to engage with local and national regulators to a greater degree than ever before. However, the growing anxieties have been more than compensated for in terms of opportunities in domestic services and high value added manufacturing in China. There are currently no signs that China will be knocked off its position as one of the leading destinations for foreign investment in the world.

Comments (2)

Thank you for your thoughtful comments. Of course you are right, the issue of “allure” does depend on the industry. However, I am looking from a broader perspective. The opportunities for foreign firms in China have increased over time. This is reflected in China’s growing share of global FDI stock. There is little evidence that any perception of recent difficulties have curbed China’s importance as a leading destination for FDI inflows.

Exhibit 1 is from the UN’s World Investment Report. Exhibit 3 and 4 are from China’s Ministry of Commerce. The data on returns are sourced from China’s State Administration of Foreign Exchange (SAFE) and the United States Bureau of Economic Analysis (BEA). The returns in diagram 2 are the income generated from FDI over the stock of FDI.

It is reasonable that a developing economy should have higher returns. The economy is growing faster. It is also important to keep in mind that these are not risk-adjusted. Investors would likely need greater returns to compensate them for the risk of operating in developing economies. The key here is whether comparative or relative to historic averages there is no dramatic decline in the average return for foreign companies in China. This is why many foreign companies continue to invest in the country.

Ryan Rutkowski January 30, 2014 | 10:36 am

Reply

of course you are right as is the Economist article which presumably sparked this piece but is not mentioned. But the problem with this analysis as well as the Economist is that the real issue of allure depends upon the industry, the cost structure (firm and industry dependent), and even the area in China in which foreign firms are operating. Also what is the source of the data for the charts above–some of the data sources on the profitability of foreign firms in China have many serious methodological issues. In any event, thanks for your many interesting and informative blogs.

Jean-Marc Blanchard January 29, 2014 | 8:59 pm

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