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Foreign Direct Investment in China
Asia Observatory

16 November 2005

Foreign Direct Investment in China

Since China joined the World Trade organization (WTO), China's investment environment has greatly improved. Many multinational and international companies have considerably increased their investments in China over the past years. This trend of increased Foreign Direct Investment (FDI) is in contrast to the global FDI which is falling. From 2000 to 2003, annual FDI dropped from US$ 1,388 billion to US$ 560 billion, whereas over the same period China grew from US$ 40 billion in 2000 to US$ 53 billion in 2003. In 2004 the figure reached US$ 61 billion, rising 13 percent over 2003. In 2005 FDI continued to flow strongly and even though some figures this year indicated a drop, it is likely to at least meet last years figures. Foreign Invested Enterprises (FIE) have not only given a boost to the development of many industries, but in addition FIE's export and import account for more than half of the nations total, the taxes they pay make up to 20% of the total and they employ around 22 million workers. Source of FDI The biggest source of FDI for 2004 was still from Asia, at the top led by investors from Hong Kong or international companies through their Hong Kong entities: In the last couple of years, the flow of FDI has started to not only go into the traditional manufacturing ventures but also increasingly into the equipment manufacturing, electronic machinery, high tech, entertainment, retail and financial services. The reason for the growth in China is not only because of the preferential policies the Chinese government granted while opening the market to foreign investors, but also because China has developed into a key export base. Attractions for FDI In addition to its low industrial wages, China's manufacturing sector has made substantial productivity gains (improved infrastructure, increased automation) and shows a higher product sophistication being achieved by a better trained workforce and imported technology. Another precondition is the trend from 'made iníK' to 'made byíK' - The company label is getting more important than the product's local origin, enabling Western companies to move production to contract manufacturers in low cost countries. The pioneers of this development were sport shoes, garment manufacturers, and the computer industry, which are all supported by contract manufacturers (local and foreign owned). Preferential Treatments still exist for Foreign owned companies in China, in order to attract FDI. It is advisable to examine the exact plans of the China entity and which benefits can be found. For example, a manufacturing company that is exporting 100% of their goods overseas should consider establishing in a Free Trade Zone or the Export Processing Zone due to the facilities and services on offer. As the company is not selling onto the local market but is using China as a manufacturing base, components can be imported duty free, then processed. The China components can be added on duty free and then re-exported while claiming VAT back on the China-sourced components. Problems for FIE's Of course, an investment into a Foreign Country, and especially China, does not come without problems. Once overcome cross culture differences and governance issues, one of the main concern in China has become labor shortages. In the early stages of China's economic growth, Guangdong was the top job provider for rural migrants who headed for the booming urban centers. Guangdong and the Pearl River Delta is now facing a labor shortage of at least two million workers as migrant labor moves to better paying jobs in the Yangtze River Delta. The Pearl Delta is therefore not only in need of middle-level management and technical staff, but also factory assembly labor. Peasants from the poor central and western provinces are diverting to the Yangtze region after hearing from relatives that wages and working conditions are better than in Guangdong. For example most shoe and garment makers and electronic plants currently depend heavily on cheap labor. These labor-intensive factories might either have to move to inland regions for a long term strategy or close under intensified competition in the future. Power shortages have challenged tight production schedules in the last few years, and are expected to continue for the near future. Despite efforts of increasing supply, peak demand remains up and is likely to continue to outweigh supply. Another top concern for companies investing and or operating in China is the protection of intellectual property rights (IPR). The Chinese government has started to battle the problem by drafting new legislation in order to protect the rights of intellectual property owners but so far it seems to have not eased FIE's frustration. These challenges, together with benefits of the 'Go West" initiative of the government, have prompted Foreign investors to explore the opportunities in the Western and less developed Provinces rather than tier cities. Hong Kong as Base for the investment As seen in the 2004 figures, Hong Kong companies are still the main investors into China. Hong Kong is still used by many international companies as a base or headquarter for their China operation. The reason for this are easier set up procedures, liability and tax incentives. These are some of the benefits of a Hong Kong company: 1) The Hong Kong Holding Company is fully liable for the China investment and protects your existing company from all liability. 2) Dividends received by the Hong Kong Holding Company are tax free and can be used for further investment. 3) Royalties, license fees, rent etc. received by the Hong Kong Holding Company are tax free. 4) Manufacturing Profits: If the China company is a manufacturing operation and the goods are invoiced and sold through the Hong Kong Holding Company, only 50% of the profits are assessed as sourced in Hong Kong and therefore taxable. Profits from the sale of goods build up in the Hong Kong company and can be used for re-investment. Further Opportunities in New Markets After the rules for trading and distribution rights changed for FIE's in 2004, the implementations of the rules and the establishment procedures have delayed and proven to take longer and therefore delayed and frustrated many investors. As the next step for the commitments China made with its entry into the World Trade Organization, the following sectors will open for foreign investors on December 11, 2005: - Advertising: establishment of Wholly Foreign Owned Enterprises will be possible for media channels - Banking: foreign companies will be able to provide renminbi (RMB) services in further cities - Insurance: the minimum assets level to obtain an insurance brokerage license will be reduced - Courier services and freight forwarding: establishment of Wholly Foreign Owned Enterprises will be possible - Hotels: establishment of Wholly Foreign Owned Enterprises will be possible Mergers & Acquisitions: New regulations last year enabled easier process for Mergers & Acquisition activities. Instead of establishing new joint ventures or wholly foreign owned enterprises, investors may now acquire Chinese firms or shares in Chinese firms. The Future Due to the changes in regulations over the previous years, FIE's will continue to explore new directions and opportunities. FDI, even though expected to continue to flow into the export and manufacturing sectors, will also include newly opened markets and possibilities. Competition from China within the international as well as domestic Chinese market from not only local but also established FIE's, will redefine the strategies of Multinational cooperation for their China Investments.

by Klaus Koehler, Managing Director, Klako Group