#3059 - Week 16 Reading Selling China – Foreign Direct Investment During The Reform Era - Chinese Economic History Since 1850

• Deng Xiaoping – “greatest success…of enterprises run by villages and townships”

• Flexibility of reform gave an opportunity to innovative and hard-working entrepreneurs to create and expand businesses, which over time would eclipse China’s inefficient and wasteful state sector

  • E.g. price liberalization, opening up the country to FDI and overseas export markets, creation of central banking and tax institutions

  • Led to macro stability, elimination of shortages, and abatement of anticompetitive barriers

• However, there was a missing a strong commitment to private ownership as the dominant way to organize the production of goods, provisions of services and allocation of economic and financial resources

• Private ownership exists but:

  • Size in heavy industries and some services such as banking were miniscule

  • Operations of private firms are saddled with considerable regulatory, legal and financial constraints

• Although the privatization of SOEs has been accelerated since 1997, to this day the government has still not supported the privatization of large SOEs

  • The size of the state sector, while having declines dramatically relative to nonstate firms, has not declined in absolute terms

• Under identical macroeconomic conditions, whether a country gets more or less FDI relative to domestic investments depends on the competitiveness of its firms vs. foreign firms

• Well-designed financial and economic institutions will make indigenous firms more competitive

• It is unlikely that a massive amount of labour-intensive FDI would have been necessary if efficient local entrepreneurs had been able to access capital easily

• Poorly designed financial and economic institutions hamper local entrepreneurs from reaping the benefits of domestic and external market growth and may lead to greater investment opportunities for foreign firms

• The institutional foundation argument is that the operation of China’s financial and economic institutions also has a strong bearing on FDI

• Anomalous FDI patterns in China

  • 1) An inordinately high dependency on FDI relative to domestic investments and contractual alternatives

  • 2) A sharp rise in FDI inflows combined with a dramatic contraction of contractual alliances

  • 3) Dominance of FIEs in the production and exporting of labour-intensive industries

  • 4) A pervasive presence of FIEs and FDI across industries and regions

  • 5) Presence of very small foreign investors

Relative Foreign Competitiveness

• Industrial organization perspective on FDI is that FDI is a function of the relative competitiveness of foreign firms

• Why are domestic firms uncompetitive?

  • There shouldn't be a significant shortage of capital, as Chinese households each year save a large amount of their paychecks and deposit the money in Chinese banks

  • However, entrepreneurship itself does not equal firm competitiveness

    • Entrepreneurship has to be financed and has to have access to market and investment opportunities

    • Fruits of entrepreneurship have to be secure to motivate an entrepreneur to work hard and be innovative

    • “A clever woman cannot cook without ingredients”

Failures of SOEs

• Economically inefficient political pecking order that favours SOEs at the expense of private firms

• SOEs sit on top of potentially valuable assets, brand names, and marketing networks, but they generate low or negative profits

  • This makes them perfect acquisition targets

    • Between 1992 and 1995, MNCs acquired assets from SOEs via JV acquisitions, sometimes at a fraction of their replacement cost

Marginalization of Domestic Private Firms

• Because the SOEs received resources, innately efficient private entrepreneurs were denied the necessary capital to expand their own businesses

  • Explains why FDI has gone to some industries in which the Chinese have excelled for centuries

• Three consequences:

  • 1) Small foreign firms found weak competition in these industries and thus succeeded in establishing a production presence in these product segments despite the comparatively high fixed costs of investing and operation in China

  • 2) Chinese private entrepreneurs were left with no choice but to resort to the most expensive way of accessing capital

    • i.e. ceding equity controls over their own business to foreigners

  • 3) FDI allowed them to have some property rights security in a system in which they were politically and legally disadvantaged

• Labor-intensive and export-oriented FDI brings with it two things:

  • 1) Business opportunity i.e. an export contract

  • 2) Financing and a superior legal status

Economic Fragmentation

• Economic fragmentation drives up FDI demand by a number of channels:

  • 1) Prevents Chinese firms from being more competitive by artificially carving up a large national market into many smaller segments and reduces both the size of the market as well as the quality of market demand

  • 2) Increases the bargaining power of foreign firms in the same way as a ban on privatization

    • Domestic firms can invest only within their respective regions, while foreign firms, even some small ones, can choose from projects throughout the country

  • 3) Increases the demand for capital and makes foreign firms more valuable than otherwise would be the case

• There are two issues that managers of foreign firms often have to grapple with:

Operating Environment

• Because Western MNCs operate in capital and technology intensive industries, they tend to team up with SOEs when they invest in China

  • Foreign firms do not really have complete operating controls because of the JV acquisition format

• China’s political pecking order disadvantages its most dynamic firms, but nothing in this line of inquiry suggests that it should be smooth sailing for the FIEs

• While being treated better than private firms is good news it is hardly a substantial source of comfort considering that private firms in China receive the worst treatment

• SOEs still command advantages in regulatory and tax treatments compared with both FIEs and private firms, and this constitutes a serious problem for those FIEs that have to compete with the SOEs

Economic Performance

• Expectations were unrealistically high in the first place because foreign investors did not take into sufficient account the growth-dampening effect of many of the institutional distortions

• Between 1992 and 1997, as foreign investors poured massive resources into China, Chinese were eager to sell their assets, some at apparent discounts

• Alwyn Young: reveals the disturbing fact that Chinese economic growth may be inferior to what is indicated by the official statistics (Young, 2000)

  • Built in faults of the Chinese system in collecting and compiling data on price deflators

    • In China, the enterprises themselves are called on to report both nominal and constant values of output, which are then used by government statisticians to convert into price deflators

• Rawski estimates the Chinese growth rate to be half of that reported by the government (i.e. 3 to 4% vs. 7.3%)

  • Bases his calculation on the trend in energy consumption and passenger traffic, all showing either a sharp decline or modest growth (Rawski, 2001)

• The Economist magazine quotes Song Guoqing, a senior economist at the Stock Exchange Executive Council as saying that the real growth rate in 2001 was around 5 to 6 percent (“How Cooked Are the Books?”, 2002)

• As the FDI inflows were driven by opportunities created by the inefficiencies in the Chinese economy, the FDI effect was an increase in the overall efficiency of the Chinese economy

• The expensive foreign equity financing of Chinese private firms raises some troubling welfare issues

• Chinese banks supply generous credits to the SOEs

  • The SOEs misuse these funds and venture into economically wasteful projects

  • Their near insolvency forces them to liquidate their assets on the cheap, mainly to foreigners

  • The same funding mechanism causes Chinese private entrepreneurs to cede their business controls to foreigners in order to access the most expensive form of capital because of the severe credit constraints

• FDI from Hong Kong into China is essentially a process whereby efficient and market-savvy firms reap gains by arbitraging their ability to finance business entrepreneurship, not (at least not completely) to arbitrage business entrepreneurship itself

Market Imperfections vs. Institutional Imperfections

• What are the efficiency gains from having production and employment relations organized in a hierarchical and administrative manner as opposed to being organized on an arm’s length spot contract basis?

• There are certain infirmities associated with market transactions that prevent efficient arm’s-length exchanges, and these infirmities can be overcome only within a hierarchical organization

• The market “fails” not because of the intrinsic economic characteristics of the transactions in question but because of a deliberate political and policy choice made by a government to alter, influence or restrict market functions

Third-World MNCs

• More sources of contractual imperfections in an institutional imperfect economy

• Sources of contractual imperfections should be different in an institutionally imperfect economy

• FDI as an ownership arrangement, supplies more functions in an institutionally imperfect economy and therefore plays a more encompassing role in such an economy as compared with an economy beset only by market imperfection

• Both third-world and first-world...