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Week 16 Reading Selling China – Foreign Direct Investment During The Reform Era Notes

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"Selling China - Foreign Direct Investment During the Reform Era" - (Huang, 2003)



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 o E.g. price liberalization, opening up the country to FDI and overseas export markets, creation of central banking and tax institutions o 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: o Size in heavy industries and some services such as banking were miniscule o 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 o 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 o 1) An inordinately high dependency on FDI relative to domestic investments and contractual alternatives o 2) A sharp rise in FDI inflows combined with a dramatic contraction of contractual alliances o 3) Dominance of FIEs in the production and exporting of labour-intensive industries o 4) A pervasive presence of FIEs and FDI across industries and regions o 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?

"Selling China - Foreign Direct Investment During the Reform Era" - (Huang, 2003) o 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 o 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 o 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 o Explains why FDI has gone to some industries in which the Chinese have excelled for centuries

Three consequences: o 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 o 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 o 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: o 1) Business opportunity i.e. an export contract o 2) Financing and a superior legal status Economic Fragmentation

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

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