Introduction

• 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

The Institutional Foundation Argument

• 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

Summary of Findings

• 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

Managerial Implications

• 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...

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