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China–IndiaPathways of Economic and Social Development$

Delia Davin and Barbara Harriss-White

Print publication date: 2014

Print ISBN-13: 9780197265673

Published to British Academy Scholarship Online: January 2015

DOI: 10.5871/bacad/9780197265673.001.0001

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The Challenges of China and the International Economy

The Challenges of China and the International Economy

(p.65) 3 The Challenges of China and the International Economy

Peter J. Buckley

British Academy

Abstract and Keywords

This paper examines the role of China in the international economy and the changing relationship between the two. China is currently undergoing a transition from investment and export-led growth to an economy more based on consumption expenditure. This involves a major readjustment of the domestic economy and its international relationships. Foreign direct investment which has been a key stimulus to growth and to exports is now being diverted to serving the domestic consumer and is also being encouraged to relocate from the coast regions to Western China. These strategies imply a shift from “made in China” to “created in China” which involves a move from cheap labour intensive production to higher value activities. This must be conducted in the face of a relative slow down in Chinese growth and the effort to correct the imbalances such as income distribution and coastal/inland inequalities. Current turbulence in the global economy notably the Eurozone exacerbates policy difficulties.

Keywords:   global economy, foreign direct investment in China, Chinese outward foreign direct investment, Chinese multinationals, international trade

ANY ECONOMY’S INTERACTION with the international economy reflects both internal and external changes. It is a fact that, for instance, the difference between savings and investment is identical to the difference between export and imports. So, in examining China and the international economy we need to pay particular attention to the interaction between events in contemporary China and also to changes in the international economy. This is clearly a massive task, and so this chapter concentrates in particular on the role of foreign direct investment (FDI) in linking China to the global economy. FDI involves the control of foreign assets from a particular host country, and in the Chinese case this has two interesting aspects—the important role of inward FDI in modern China and the more recent, but equally fascinating, case of Chinese outward FDI. China has become not only one of the most important host countries for inward FDI but also one of the top five foreign direct investors outside China.

Contemporary China faces a large number of challenges. These include maintaining growth (in particular to maintain (urban) employment), restructuring the domestic economy while moving into higher value activities, competing in the global economy, absorbing and harnessing the IT revolution, innovation, managing the high level of foreign control in the domestic economy while internationalizing Chinese-owned companies, managing societal disparities, institutional reform (particularly of all levels of government), coping with the drastic changes in media relations, environmental challenges, demographic changes, and absorbing the increasing resource costs of growth.

It could be argued that, as all of these issues are interrelated, all of them have an international dimension, and that would be correct. This chapter concentrates in detail on two issues: inward FDI and outward FDI, and the internationalization of Chinese companies. There are particular and direct (p.66) implications for growth and employment, restructuring, global competition, innovation, and resource costs arising out of the effects of both inward and outward FDI.

The first section of this chapter examines inward FDI in China and its relationship with domestic policy. The second part looks at the issues through an examination of outward FDI. A third section looks at underlying trends affecting China’s long-run international position, and this is followed by a conclusion.

Inward FDI to China

Micro-Economic Background

China is undergoing transformation from an export-orientated economy to one based more on domestic consumption. In policy terms, this has amounted to allowing or encouraging wage increases. Minimum wages in many provinces and cities have been rising. The policy intent here is to encourage industries to move west into the interior of China. This is achieved both by raising costs in the coastal provinces, or at least allowing them to rise, while providing incentives to invest in central and western China. This has led to rapid rates of growth in inland Chinese provinces such as Sichuan and Hunan. There has been a massive increase in infrastructural investment to facilitate this development. It is notable, however, that investment still accounts for over 40 per cent of Chinese GDP.

The new role that inward FDI is intended to play is to shift towards serving the Chinese consumer rather than aiming at export-orientated investment. This needs to be managed with care because of the income distribution issue. In fact, household income as a share of GDP has declined from around 55 per cent in the early 1980s to around 34 per cent in early 2011. Reversing this trend involves a massive restructuring effort, which will have profound implications for China in the next decade. It is complicated by the fact that much of consumption is geared towards luxury consumption, and this may exacerbate the already skewed income distribution measured at individual province and regional levels. Reform of the banking sector will increase consumption because the spread of lending and deposit rates gives low returns on savings and constrains household consumption. The central control of interest rates exacerbates this problem, and it is an indication of the interrelated nature of the issues facing China that control of interest rates cannot be relaxed without affecting the foreign exchange markets, which are a major concern for China. An appreciation in the Chinese exchange rate would increase domestic consumption and (p.67) discourage exports, but again this represents a balancing act, because of the number of Chinese jobs currently connected to the export industries. Reform of the banking sector is also an urgent need, because consumer financing is currently underdeveloped. A further constraining factor on increasing consumption is that many Chinese families maintain a high level of savings because of worries about health care. Reform of the health-care sector and more health-care insurance would have a significant effect on increasing domestic consumption.

Capital Market Imperfections

In increasing domestic activity, one crucial imperative is to improve the domestic capital market. For our purposes here, it is of considerable interest to note that imperfections in the capital market in China currently have perverse effects. The abundance of capital made available to state-owned enterprises (SOEs) enables them to undertake many investments, including, of course, foreign investments, while the private sector is constrained by lack of access to capital. We should remember here that small and medium enterprises (SMEs) account for fully 80 per cent of the urban labour force. To release China’s full potential, these firms need fairer access to capital in order to be able to invest and innovate.

Policy Reassertion is a Response to Complaints of Foreign Investors

The recent reassessment of strategy towards inward FDI is a response to complaints, arising, among others, from General Electric, Siemens, and BASF (some of the oldest-established foreign investors in China). Policy has begun to respond to the EU Chamber of Commerce in China call to ‘remove red tape’ and create a ‘level playing field’. To some extent this is ironic, in that it is possible to regard past policy as biased in favour of foreign investors in China. This is another of those balancing acts that need to be performed in China—the dynamism of much of the Chinese economy is based on inward FDI, now there is a need to reenergize the domestic sector, but this needs to be done without alienating existing foreign direct investors.

There have been a number of specific complaints made by foreign investors. These include:

  1. 1. Not opening up the service sector in accord with World Trade Organization (WTO) agreements: examples include telecoms, travel computer reservation, travel agents, and banking. A particularly egregious example of this is petrol stations, where, in order to operate such a facility, there (p.68) is a need to own an oil refinery in order to obtain a wholesale licence. However, oil refineries are ‘strategic assets’, and it is impossible for foreigners to obtain such a licence.

  2. 2. ‘Standards’—it is a common complaint among foreign direct investors that restrictions on their activities are brought about by insisting on (possibly ‘Chinese’) standards. The foreign investment community has requested that the WTO should be notified of such requirements to comply with standards.

  3. 3. Legal issues—state secrets and commercial secrets laws are difficult for foreign investors to negotiate, and their impact is not always known in advance.

  4. 4. The retrospective introduction of income tax law in December 2009 alarmed many foreign investors.

  5. 5. This was compounded by the government’s announcement to ‘buy Chinese’. The concern was that the promotion of ‘indigenous innovation’ would mean that only products patented in China would be bought by government agencies. In the face of intense protests, this provision has been considerably watered down.

  6. 6. Certification—the EU Chamber of Commerce, backed by a large number of significant foreign direct investors, felt that business licence requirements were ‘vague and unprecedentedly broad definitions of public security and critical infrastructure’ in the certification of products. This is an example of the Chinese government’s obsession with security conflicting with its desire to achieve economic growth, and this links strongly with the desire to achieve long-term restructuring of the Chinese economy without decelerating the rate of growth.

Policy Changes in China towards Foreign Investment

In response to these changes the top decision-makers in China (including the then Premier Wen Jiabao and the then Vice-President Xi Jinping) have moved to reassure foreign investors in China. These statements made it clear that all enterprises registered in China according to Chinese law are Chinese enterprises. Their products are made-in-China products. The equal treatment to foreign-invested enterprises in government procurement would be continued. A key point of national strategy is intellectual property rights protection, which has been previously weak but now is being strengthened, not least because China now has a considerable investment in intellectual property rights of its own. There would be a focus on innovation, upgrading industrial infrastructure, and advances in technology.

(p.69) Long-term Structural Shift in the Chinese Economy

Underlying many of these issues is the desire of the Chinese government to move the economy from producing labour-intensive products to higher value added activities. This is also expressed in the change of phrase, from ‘Made in China’ to ‘Created in China’. This expresses the need to move from simple production based on cheap labour to design and innovation-intensive products. If such a transformation is to occur, then there is a need to improve the ‘soft infrastructure’ of China. In particular, this means huge investments in human resources and innovatory capacity. Indeed, this is the intent of the National Medium and Long-Term Talent Development Plan (2010–2020). Around this plan are suggestions that many creative Chinese should be lured back to their homeland to assist in the upgrading of design, production, marketing, financing, and branding of Chinese products. This may have the ring of a protectionist policy to the ears of foreign direct investors in China, but it should be remembered that all threats are also opportunities, creating massive demand in China for automation services, innovation-related activities, and environmental services and products. Consequently, the desire to move to ‘Created in China’ has secured a large inflow of research and development facilities of foreign firms. It is an interesting issue how far the research and design facilities are solely targeted at the Chinese market and how far these are truly global facilities.

The recent reaction of foreign direct investors suggests that this shift has been communicated to them and that they are responding with alacrity. Companies announcing expansions in China recently include Walmart, Coca-Cola (with a large R&D facility), HSBC, and BMW, all of whom are aiming not for export but to service the Chinese market. It is interesting that global car producers are now focusing on smaller cities and rural demand in China, with products that include new energy vehicles, hybrid electrical vehicles, hydrogen fuel cells, and pure electric cars.

The optimists among Chinese policymakers and observers are already beginning to predict that the next shift in Chinese policy will be towards encouraging smaller Chinese businesses. Such a policy could be carried out in parallel with this major structural shift, but this clearly represents a major undertaking in industrial restructuring.

Implications for Foreign-owned Companies in China

The current environment for foreign investment in China has therefore undergone a considerable shift in response to the needs of long-term restructuring. This has several implications for foreign companies, both those that are already present in China and those that are considering investing there. (p.70) First, as outlined above, there are new opportunities for foreign companies. Second, there is increased pressure to localize, which means that, third, foreign companies are likely to be treated equally and equivalently to Chinese companies if they achieve local identification. Investment in high value added activities, particularly innovation and R&D, is now particularly favoured, and there is immense competition from Chinese cities and provinces to attract it. Local support is even more vital in achieving success in China. Individual governors are incentivized to bring in foreign investors. This means that the choice of location in China is more important than ever. Foreign investors need to consider the choice of city or province as a prime factor in their investment decision.

Does this therefore mean that the era of low wage investment to China is over? This is unlikely to be the case, as labour productivity is likely to grow faster than wages for some time, but the era of privilege for foreign investors in low value added activities is over and opportunities will be restricted to fewer areas, and, of course, these will be in the inland provinces where infrastructure is weaker and associated costs are higher. As mentioned above, this trend will be accelerated by the recent increase in minimum wages, which in some provinces is as much as 30 per cent.

The improvement in intellectual property protection will make China more attractive as a foreign investment destination for activities involving the management of knowledge. The realization that the property rights regime has improved may take some time to impact on inflows and Chinese government policy, and the legal framework will be carefully monitored by potential foreign investors to ensure that there is no backsliding on this issue.

Finally, attracting talent in China has become a key issue. A recent survey shows that college students broadly prefer SOEs to foreign investors. However, several really high-profile foreign investors remain popular. Talented Chinese people now have the opportunity to choose well-paid and rewarding jobs, and the consequence of this is that labour mobility is unprecedentedly high in skilled occupations.

Chinese outward FDI

A major impetus for the growth of Chinese outward FDI arises from the recycling of China’s massive export surplus. A high proportion of China’s foreign exchange reserves are invested in US Treasury Bonds. China has foreign exchange reserves of approximately US $3.2 trillion. (This is equivalent to excess savings as discussed above.) This is, of course, related to China’s undervalued exchange rate against the dollar, which has led to China being vilified as a ‘currency manipulator’ by the USA, even though the renminbi/yuan has appreciated by (p.71) more than 20 per cent since July 2005. In terms of the structure of Chinese external trade, it is important to remember that ‘processing trade’ accounts for more than 50 per cent of China’s export revenue. This is largely the result of the activities of foreign-owned firms in China, and because of the narrow profit margins on the supply activities in China, processing activity does not greatly enhance local value added in China.

Outward FDI by Chinese companies is another way of utilizing these reserves. FDI is a means by which Chinese firms can obtain control of the assets they acquire, whereas other forms of investment (foreign portfolio investment) do not entail control. An alternative to FDI is to support Sovereign Wealth Funds to acquire foreign assets. The prime vehicle for this is the China Investment Corporation (CIC), which has assets under management of US $400 billion and has built an extensive portfolio abroad (CIC, 2011). This piece concentrates on outward FDI by Chinese companies.

Outward FDI from China—scale

Chinese FDI is still small in global terms, but is frightening to the rest of the world. The stock of FDI from China was US $298 billion in 2010 (UNCTAD, 2011). However, Chinese FDI has experienced extremely rapid growth since 2003. China’s stock of outward FDI has grown from US $4.5 billion in 1990 to US $27.8 billion in 2000 and US $298 billion in 2010 (UNCTAD, 2011).

In fact, even by 2010 China’s FDI outflow was still very small in world terms, as it is only 5.1 per cent of the global total. China’s FDI stock was only 1.4 per cent of the world total in 2010. However, these figures may significantly underestimate outward investment by Chinese companies, because many of their deals are financed outside China. In addition, we need to add in the outward direct investment that emanates from Hong Kong. Hong Kong’s outward stock was US $949 billion in 2010. It is not possible simply to add the outflows or stock from China to that of Hong Kong because some of this FDI is in the form of ‘round-tripping’, where Chinese firms invest in Hong Kong in order to reinvest in China, usually in a different province. In addition, much of Chinese outward FDI is targeted at tax havens, and has its ultimate destination back in China.

The available figures are therefore fraught with danger for the uninitiated, but on any serious account Chinese FDI is still a relatively small player on the world scene. Moreover, Chinese OFDI and Chinese multinationals are often not in direct competition with Western multinational enterprises (MNEs). The location of Chinese MNEs is often in peripheral regions and countries with little head-to-head competition with Western MNEs. Just this point is made by de Jonquières (2012), who argues that ‘Chinese companies necessarily focus (p.72) heavily on regions where their western competitors are not already entrenched or are, for one reason or another, barred from operation’ (p. 4). As he is focusing on extractive firms, he further points out that the ‘effect of “Chinese companies’” international expansion is not to “lockup” supplies, but, rather, to augment at the margin those available on world markets’ (p. 4). He further notes that most crude oil that Chinese companies extract is swapped or sold on world markets—as little as 10 per cent is shipped back to China.

The threat of China taking over the world is clearly a chimera, at least as far as outward FDI is concerned.

Transformation of SOEs

A high proportion of Chinese outward FDI is that of SOEs. A section above alluded to the bias in the capital market against private companies, and this is manifested in the relative ease by which SOEs can obtain investable funds in order to undertake foreign ventures. This is not a uniform picture, however, in that some private companies are favoured by decision-makers in government and financial institutions, and similarly have access to capital at below equilibrium cost rates. The continued reform of SOEs is likely to include further international investments, and one beneficial result of this is their exposure to competition and international standards.

Need for Skilled Management

A key requirement for successful internationalization of companies is skilled management. Chinese foreign companies are not well endowed with skilled and internationally experienced managers, nor do foreign managers find it easy to work in Chinese companies, however reputedly internationalized. It is a wellknown phenomenon that international companies need to build their top level management in parallel with their internationalization. China is making rapid strides to build a cadre of internationally aware managers by establishing new training programmes, such as setting up Masters degrees in International Business. In parallel with this, Chinese companies that internationalize will need to adapt what is still a fairly insular culture in order to be able to compete globally and to understand foreign consumers and buyers.

The jury is still out on the success or otherwise of Chinese companies that have begun to internationalize. It is to be expected that Chinese companies will make many mistakes as they attempt to internationalize simply because of naivety and a lack of understanding of the various foreign environments to which they are exposed. This not a factor unique to China—every set of companies that internationalizes has to learn by its mistakes. There is a great deal of anecdotal evidence as to the mistakes currently being made (p.73) by Chinese companies in Africa, and there is consequently the need for more studies where Chinese firms are compared with other multinational enterprises.

One further vital question determining the success of the internationalization of Chinese companies is the degree to which they are able to innovate. This is part of a wider question of how far China can switch from simply making basic products to being a long-run innovator. This question goes to the root of many of the issues around the current organization of Chinese society and polity. There is an argument that innovation is not rewarded in China, and indeed that innovators and entrepreneurs are actively discriminated against and discouraged for political reasons. The obsession of the communist party with the control of information clearly militates against innovatory activity. Control of certain aspects of the Internet, for example, may not be compatible with the freedom of entrepreneurs to adopt new ideas. Lack of innovation will inhibit development, and if not corrected will ultimately stymie the further internationalization of Chinese companies.

Underlying Trends Affecting China’s Long-run International Position

The need for innovation and creative talent is, therefore, a key problem affecting China’s long-run international position. In order to improve its global position, China needs to move from attracting financial capital to attracting human capital. In spite of the encouragement to overseas Chinese to return to China, there is still a net export of highly qualified personnel from China. In order to compete in the long run, China needs to build internationally recognizable brand names. Building brand names is a long-run process which requires continued and sustained investment in product and service quality. It is too early to expect China to have succeeded in this in the short period following its opening up to the world economy, but there are serious concerns about design and quality issues in Chinese production and service activities, so this is a long-run concern.

Demography, of course, is a key long-term issue. The concern about the ageing population that ‘China will get old before it gets rich’ encompasses a growing anxiety in Chinese society. The 60-plus age group has grown to 167.14 million (12.5 per cent of the population) because of increasing life expectancy and the one-child policy (which is currently under questioning and revision). This provides opportunities for both foreign and domestic companies to invest in health care opportunities, which, apart from first-tier cities, is poor.

(p.74) A long-run shift from ‘hardware’ to ‘software’ requires major changes in the Chinese economy. Investment remains at 45 per cent of GDP, and there are huge infrastructure projects currently being undertaken in high speed railways, airports, education, research and development, public health, energy conservation, environmental protection, and social welfare. This is necessary to move China from an investment-driven economy to a talentdriven one. In parallel with a shift from investment to consumption, this means the rapid growth of services and non-tradable goods in which China has not yet been successful.


‘For 18 of the past 20 centuries, China has boasted the biggest economy in the world. Many Chinese see the past 200 years of underdevelopment and colonial occupation as an aberration that must be addressed’ (Financial Times, 3 Dec. 2002: 17).

Becoming the largest economy in the world now represents a major challenge. China has reached the second position in purchasing parity terms, largely by utilizing standard procedures of production and low value added export-orientated manufacturing, mainly undertaken with the agency of inward FDI. To continue to grow at the historically unprecedented rates that China has achieved in the recent past now requires a radical change in economic structure if China is to avoid the middle income trap. This is against a relatively unpromising labour situation, with increasing militancy and expectations, unemployment among college graduates (6 million each year), and increasing manufacturing costs in coastal regions.

The international position of China is entwined with all these issues as this chapter shows. Inward FDI is likely to continue and possibly to increase somewhat, although its nature will move away from export-orientated manufacturing to more differentiated products and services for the Chinese market. Chinese outward FDI faces a number of challenges, which rely upon the domestic economy becoming more capable of innovation and producing high level human resources. All of the challenges that the domestic Chinese economy faces have international ramifications, and developments in the international economy will codetermine China’s future economic path.


Bibliography references:

CIC (China Investment Corporation) (2011) Annual report. 〈 http://www.china-inv.cn/cicen/include/resources/CIC_2011_annualreport_en.pdf> (accessed 5 November 2012).

(p.75) De Jonquières, G. (2012) What power shift to China? European Centre for International Political Economy Policy Briefs, 4/2012. 〈 http://www.ecipe.org/media/publication_pdfs/PB201103.pdf> (accessed 5 November 2012).

UNCTAD (United Nations Conference on Trade and Development) (2011) World investment report 2011. 〈 http://unctad.org/en/Pages/DIAE/World%20Investment%20Report/WIR2011_WebFlyer.aspx〉 (accessed 5 November 2012). (p.76)