China's current economic transformation is without doubt the greatest industrial revolution the world has seen. From nowhere, the nation's economy has become enormous, now accounting for about 12 per cent of global gross domestic product. In dollar terms its GDP is the sixth-biggest in the world--only slightly smaller than that of France and likely to overtake the UK's by 2006. After adjusting for price differences between economies, its GDP is second only to that of the US.
This phenomenal expansion raises several questions: what impact has it had on the world economy? Have economic liberalisation and foreign direct investment (FDI) been the main reasons for it? If so, what are the characteristics of the governments FDI policy? Has FDI been aimed at particular sectors? Lastly, and perhaps most importantly, has FDI improved Chinas industrial capability, or is it simply a veneer masking the country's continuing technological dependency on more advanced nations?
The country's increasing economic strength is inevitably affecting world trading patterns. It is now the fourth-largest exporter, with overseas sales recording a stellar 50 per cent rise in 2002-03, reaching $480 billion. Trade with the US accounted for well over 60 per cent of this, making China the largest exporter of goods to the States. Its growth surge is also affecting the import side of the international trade equation. China will soon become the world's third-largest importer after the US and Germany. This has helped to rekindle Japan's ailing economy and, more generally, acted as a locomotive for pan-Asian growth.
There are many factors that account for this remarkable boom, but three stand out as arguably the most influential. First, Chinas huge population has proved to be a powerful driver for change. The economy's successful growth profile has reversed traditional thinking on the demographics of economic development. Big populations are now seen as a boon rather than a bane.
From the demand perspective, China's middle class of 400 million constitutes a huge repository of purchasing power. Supply-side benefits also derive from big populations: the total population of 1.3 billion has unsurprisingly had the Malthusian effect of squeezing labour costs, with unskilled workers earning as little as 50 cents an hour. Improvements in productivity and the incessant expansion of the labour supply have recently led manufacturing costs to decline by 1 per cent a year, providing a strong lure for foreign companies.
The second key factor has been Beijing's economic liberalisation agenda. Here again Chinas development path has veered from the traditional route. It is unique in that communism and capitalism coexist. Although the government has encouraged a profit-driven culture, key facets of the command economy apparatus still work in tandem with it. Despite China's huge swathe of moribund state-owned enterprises, protected by the highly interventionist policies of the central planning regime, this hybrid has led to explosive growth. Although Chinas growth last year fell to 9 per cent, it was still more than four times better than that of the UK, Europe's top-performing economy in 2003.
The third key factor underpinning China's economic success is FDI. In 1990 it received $5.5 billion in foreign investment. By 2003 this figure had grown to $57 billion, making China the biggest FDI recipient in the world. Research suggests that foreign capital brings forth benefits through exposure to modern manufacturing methods, leading to increases in capital intensity and labour productivity. This in turn acts as a catalyst for industrialisation. Of course, FDI has its disadvantages, conventionally embodied in what's known as dependencia theory. This argues that foreign enterprise exploits the host economy's markets, promoting little in the way of skilled labour, subcontractor links and added value. In China, both the authorities and foreign companies have carefully measured the net effect of FDI and they seem to agree that the benefits outweigh the costs.
The United Nations conference on technology and development has estimated that more than 80 per cent of the Fortune 500 companies have invested in over 2,000 FDI projects in China. Moreover, because the government's policies foster further investment, FDI growth is expected to continue, with some economists predicting that during the next five-year plan (2006-10) FDI values will reach $100 billion a year.
Chinas FDI policy actually has its origins in the nineteenth century. In 1899 the US proposed to imperial China that it should adopt a menhu kaifang (open-door) policy. This initiative was designed to coax the country into exposing its market to overseas business, but history has shown that menhu kaifang was a false start. For 50 years, up to the advent of communism in 1949, FDI had a limited impact. There were some pockets of foreign investment--in the fledgling aircraft industry in the 1930s, for instance--but it was of marginal importance and constrained to Shanghai and the north.
Between 1949 and 1979 the opportunities for FDI became even more limited. Apart from its ill-fated industrial dalliance with the former USSR that started in the 1950s, the government effectively closed the door to multinational business. After the Soviet collaboration ended in the late 1960s, China was technologically isolated and its industrial frailties were then revealed. Obsolete equipment and techniques that had been imported in the 1950s still constituted the backbone of industrial capacity a quarter of a century later.
Something had to be done, and a change of heart eventually occurred in 1978. Modernisation was viewed as impossible in the absence of international co-operation, so the notion of developing a "market economy under socialism" was born. This time, policies were enacted to ensure that an open door actually meant an open door. For instance, the Act of Joint Venture Enterprises, endorsed by the National People's Congress in 1979, ensured the legal rights of multinationals, giving them access to China--albeit through joint ventures with local firms.
In 1986 wholly foreign-owned enterprises were at last allowed to operate, but only in certain areas. Also that year the State Council published its rules for encouraging FDI, listing 22 principles giving privileges to enterprises exporting products from the country and using advanced technologies. The policymakers saw the transfer of technology as crucial--indeed, it was the price of market access for foreign high-tech companies.
In 1995 a new guideline was published detailing the government's intention to promote FDI in designated high-tech sectors, including chemical fibres, microelectronics, precision machinery, biotechnology and energy development. Three years later the State Planning Commission named 18 mostly high-tech sectors where restoration of duty-free status on capital imports would apply.
China secured membership of the World Trade Organisation (WTO) in 2001 and the next year it finally allowed foreign investors to buy controlling stakes in domestically listed firms. Its commitment to the WTO's regime of economic liberalisation and deregulation has been substantial. In agriculture, across a transition period of five years, Beijing has pledged to reduce tariffs from an average level of 31.5 per cent to 17.4 per cent. For industrial products, it has promised to phase out quantitative restrictions and cut the average tariff from 24.6 per cent to 9.4 per cent by next year.
It has also agreed to sign the WTO's information technology agreement, resulting in the elimination of tariffs on telecoms equipment, semiconductors and IT products, but the most far-reaching changes are reserved for the local services sector. Restrictions hitherto facing foreign service providers in areas such as licensing, equity participation, geographic location, business scope and operations will he relaxed over time.
Significantly, the authorities have decided to open up telecoms, financial services, distribution and other service-related industries to FDI. Apart from improving market access, Beijing has also agreed to increase the transparency of its trade regimes. It plans to end all prohibited subsidies, liberalise trading rights and require state trading companies to operate in a commercial manner.
Liberalisation has clearly hastened investment inflows. In the past two decades China has attracted $400 billion in FDI--the third-biggest amount after the US and the UK--yet this constitutes only around 4 per cent of its GDP, compared with 39 per cent for the UK. Although China's FDI is therefore small relative to the size of its economy, its effect has been heightened by its focus on key sectors (see panel, opposite page). In 2002 manufacturing accounted for more than 70 per cent of the total contractual FDI value. Significantly, nearly 30 per cent of the foreign money was channelled into transport equipment, electronics, telecoms, computers and vehicles.
The targeting of strategic sectors or what the authorities call "pillar industries", has not happened by accident. It has been the deliberate policy of both Beijing and foreign companies. China's intentions are based on plan 863 (so named because it was introduced in March 1986). This plan has aimed to promote what it calls "dual use" industrialisation--the development of local capacity in sophisticated commercial technologies that can be applied to the defence industry.
FDI has been instrumental in the development of the pillar industries, which have in effect become foreign-owned and managed. These industries are integrated into the global technology value chain, but the absence of an indigenous high-tech subcontracting base means that little value can be added locally.
A study by Daniel Rosen, visiting fellow at the Institute for International Economics in Washington DC, supports this view. His research findings indicate flint China's high-tech exports are overwhelmingly produced by foreign enterprise ("Low-tech bed, high-tech dreams", China Economic Quarterly, No 4, 2003). These exports represented only 21 per cent of China's $32.5 billion of overseas sales in 2002 and were dominated by parts for IT products and mature goods such as DVD players and computer printers. This illustrates the dominant position of enterprises raider full foreign control in China's technology trade and the woeful inadequacy of locally generated research and development. For instance, as Rosen argues, China's 2001 US-registered patents amounted to 195, compared with over 87,000 for US patent receivers. In effect, around 80 per cent of China's technology production value is created "outside" the country.
Although China's industrial revolution doesn't seem high-tech or especially Chinese for that matter, by historical standards the country is only at the start of its industrial and technological transformation, which is a long process by its very nature. Beijing's strategy of not seeking to reinvent the technological wheel, of exploiting advances made elsewhere and of trying to leapfrog the traditional early stages of industrial development does seem appropriate. Fostering FDI as the vehicle for technology transfer is also the most cost-effective way forward, and the country will inevitably absorb the technology in time.
Even at this early stage of technological development, China is developing an aptitude for "reverse" FDI. Investment by Chinese companies in other countries amounted to a small but significant $2.7 billion in 2002 and they are on the threshold of becoming major multinational players in Asia and beyond. Consumer goods giant Haler, for instance, already has 13 overseas factories. Last year China's TCL agreed to take a majority stake in a joint venture with the French company Thomson to produce TVs and DVD players. This joint venture would bring TCL's production facilities in China, Vietnam and Germany together with Thomson's factories in Thailand, Mexico and Poland, and is expected to generate annual revenues of over $3.7 billion.
Chinese companies have even begun to extend their operations to the UK, although they have created fewer than 250 jobs in this country so far. But, against the backdrop of globalisation and increasing international competition, there are clear economic signs that the Chinese, with their massive economic clout, are definitely coming.
FDI DISTRIBUTION IN CHINA BY SELECTED SECTORS Number of Contractual projects FDI value ($m) Manufacturing 24,930 59,270 Electronics and telecoms 2,976 14,560 Electronic parts 245 3,774 Chemical manufacturing 1,587 3,771 Transport equipment 745 2,305 General machinery 1,185 2,133 Automobile manufacturing 537 1,639 Computer equipment 324 1,114 Source: Ministry of Commerce of the People's Republic of China (www.fdi.gov.ch), 2002
Ron Matthews is professor in defence economics al Cranfield University, where Zhang Yan is a visiting researcher…