Business Horizons (2005) 48, 297 302

www.elsevier.com/locate/bushor

Why a poor governance environment does not

deter foreign direct investment: The case of China
and its implications for investment protectionB
Shaomin Li
Department of Business Administration, Old Dominion University, Norfolk, VA 23529, USA

KEYWORDS
Governance
environment;
Foreign direct
investment;
Portfolio investment;
Rule-based governance;
Relation-based
governance;
China

Abstract It is widely believed that countries with a poor governance environment (e.g., weak laws and rampant corruption) do not attract foreign direct
investment (FDI); however, our study suggests otherwise. Using China as a case
study, this article argues that the prevailing theory that a good governance
environment begets FDI is incomplete. When faced with a poor governance
environment, investors choose direct investment over indirect (portfolio) investment because the former can be better protected by private means. In fact, China
attracts a large amount of FDI because of, rather than despite, its lack of a good
governance environment. In conclusion, this article offers strategies to better
protect investments and to chart through the pitfalls resulting from rapid changes
in the governance environment.
D 2005 Kelley School of Business, Indiana University. All rights reserved.

1. The puzzle
The prevailing theory on foreign investment is that
countries with good governance environments
(e.g., rule of law) tend to attract more foreign
direct investment, or FDI (Globerman & Shapiro,
2003; La Porta, Lopez-de-Silanes, Shleifer, &
Vishny, 1998). This theory, however, does not
explain Chinas recent large inflows of FDI; despite
its poor legal system and rampant corruption,

B
This manuscript was accepted under the editorship of Dennis
W. Organ.
E-mail address: sli@odu.edu.

China has still been able to attract huge amounts

of FDI. In fact, China is one of the largest FDI
recipients in the world, threatening to overtake
the number one position from the United States.
How can we explain this phenomenon? Although
the prevailing view does not offer a logical
explanation (e.g., Globerman & Shapiro, 2003;
Habib & Zurawicki, 2002), its proponents argue
that China attracts so much FDI due to its vast
market opportunities, despite its poor governance
environment. Recent research, however, shows
that such a view is misleading (Li & Filer, 2004).
Rather than helping investors navigate the market,
this view creates a mistaken impression about
investment in China.

0007-6813/$ - see front matter D 2005 Kelley School of Business, Indiana University. All rights reserved.
doi:10.1016/j.bushor.2004.06.002

298
China is, indeed, one of the worlds largest
recipients of FDI, but FDI is only one part of total
foreign investment. The other is indirect investment, or portfolio investment, including the purchase of stocks of listed companies and bonds in
secondary markets. In terms of either total foreign
investment or indirect investment, the largest
recipient, the United States, far surpasses China.
For example, in 2001, the United States received a
total of $556 billion in foreign investment, of which
$426 billion, or 77%, was indirect (portfolio) investment. In the same year, China attracted $45 billion
in foreign investment, of which only $1 billion, or
2%, was indirect investment (IMF, 2003). Chinas
stock market for foreign investors, known as the bB
sharesQ market, is lackluster and small. Despite the
large and fast-growing market, why do so few
foreign investors invest in stocks in its listed
companies or bonds, yet still rush to make sizable
direct investments? Compared to portfolio investments, FDI is more time-consuming, complicated,
and illiquid, thus exposing investors to greater
risks. In an attempt to solve this puzzle, we
examine how investments are protected in different governance environments.

2. Relation-based and rule-based

governance
In general, governance refers to the mechanisms
that an investor uses to control and protect his or
her investment. The type of governance and its
effectiveness depend to a great extent on the
social, economic, and legal environment of the
host country. Social institutions either facilitate or
constrain the type of governance mechanism a
firm can choose (Li, Park & Li, 2003); for example,
if the court is not impartial and judges are
corrupt, using formal legal means to protect ones
property rights may not be a viable option, save
illegal practices such as bribery. A good governance environment has the following common
features: an independent judiciary and legislation,
fair and transparent laws with impartial enforcement, reliable public financial information, and
high public trust (Globerman & Shapiro, 2003; Li &
Filer, 2004). The prevailing theory views such a
governance environment as conducive to economic
activities such as investment, whereas in the
absence of such a governance environment (e.g.,
the lack of rule of law), investments cannot be
protected (Globerman & Shapiro, 2003). However,
the prevailing view is incomplete; the absence of
a good governance environment does not dictate

S. Li
that there is a complete vacuum of protection
mechanisms.
When laws are opaque and unfair and the
government cannot enforce public rules impartially, people and firms predominately rely on
private relationships to govern social and economic
transactions. We call this a relation-based governance system, as opposed to a rule-based governance system (i.e., the good governance
environment) (Li, 1999; Li et al., 2003). In a
relation-based society, people rely on private
information and personal networks because public
information tends to be unavailable and/or unreliable. Relation-based societies usually lack public
trust; instead, they put great emphasis on personal
loyalty (Pearce, 2001; Li & Filer, 2004). As a result,
investors in relation-based societies tend to protect
their investments by private means, including
relying on insider information about prospective
business partners, private measures (from giving
poor references to kidnapping) to deter opportunistic behavior, and personal connections with the
authorities for protection.
Several examples are illustrative of the use of
relation-based governance in China. In 1992,
McDonalds signed a 20-year lease with the Beijing
municipal government to open a restaurant in a
prime location. But in 1994, the Beijing government told McDonalds to vacate, because a wellconnected businessman, Li Ka-shing, wanted to
build an officeshoppingresidential complex on
the same site. McDonalds, holding a valid lease,
took the Beijing government to court, but ultimately lost the case. It is well known that Li Kashing has been a close friend of Chinese Communist Party leaders for a number of generations;
thus, he was able to use his personal relationships
with Chinese officials to influence the legal
system in order to secure the site. In the end,
McDonalds defeat was hardly a surprise (Hill,
2003). Another example is that of Bengpu Milk
Products, a milk-product supplier in Anhui, China,
which resorted to collecting its payment by
private means. One of Bengpus clients, an icecream maker in Nanjing, refused to pay for the
milk powder the company had shipped. With the
Nanjing courts siding with the local ice-cream
maker and refusing to enforce payment, Bengpu
Milk Products had one of its subsidiaries order a
large quantity of ice cream and then seized all
the company delivery trucks as collateral. The
Nanjing ice-cream maker rushed to Bengpu, with
firearms, to settle the matter. Out-gunned by
Bengpu in its home base of Anhui, the ice-cream
maker was finally forced to pay its debt. Given
the ineffective and corrupt courts in China, such

Why a poor governance environment does not deter direct investment

private enforcement is not uncommon (Zhang,
2004).

3. Direct vs. indirect investment

The examples cited above show the commonality of
using personal relationships and private means to
settle disputes. Relation-based governance is effective when good relationships exist with the authorities; it can even be used to illegally confiscate
anothers property, as in the case of McDonalds vs.
Li Ka-shing. However, the effectiveness of relationbased governance depends to a great extent on the
mode of investment; namely, whether it is direct or
indirect (portfolio) investment.
In terms of governance, the key difference
between direct investment and indirect (portfolio)
investment is that direct investment allows direct
control by the investor. In this sense, relation-based
governance, which relies on private protection
mechanisms, is relatively more effective and
efficient for direct investment than for indirect
investment. In contrast, when people make indirect investments, such as purchasing stocks of
listed companies, they must rely on public information and public enforcement, both of which can
be particularly scarce in a relation-based society
such as China, where there is a dearth of reliable
public information and a low level of general trust
(Child, 2001; Li & Filer, 2004; Pearce, 2001).
Accounting and auditing standards are lower, the
operations of publicly listed companies are less
transparent, and financial information can be easily
altered by insiders (Cai Jing, 2001). In a well-know
Chinese case, the listed company Tiange, which
raises turtles (a Chinese delicacy), manipulated its
stock price by issuing false news releases, claiming
anything from flooding-induced shortages to miraculous recoveries, depending on whether the company wanted to either raise or lower prices (Huang,
2003).
Due to the lack of checks and balances, in a
relation-based system, the political system tends to
be dominated by a powerful ruler (the Chinese
Communist Party, in the case of China), and policy
tends to favor industry leaders and big business. As
a result, minority shareholders such as portfolio
investors are at a disadvantage, which explains
why, even though the pace of growth of the Chinese
economy is one of the worlds fastest, the overall
return on investment from Chinas stock market has
been dismal at best. For example, Hong Kongs
Hang Seng China Enterprise Index, which tracks the
stocks of some of Chinas best companies, has

299

fallen by one-third since its inception in 1993

(Shan, 2003). In a relation-based society, laws,
financial regulations, or accounting rules are
merely ink on paper. A recent study finds that even
after China promulgated the International Accounting Standards in 1998, there was no significant
improvement in accounting practices for listed
companies (Chen, Sun & Wang, 2002). For novice
foreign investors, such a market under Chinas
security exchange laws appears to provide investment opportunities; but for insiders, bringing a
company public is an opportunity to loot outside
investors. Based on the above analysis, I propose
that when foreign investors invest in a relationbased society, they tend to choose direct investment over indirect investment for better private
protection.

4. Relation-based countries tend to

attract more FDI relative to indirect
investment
To verify the argument that investors tend to
choose direct investment in relation-based markets, I conducted a simple statistical analysis to
examine the relationship between the governance
environment and FDI inflow, using the Governance
Environment Index (GEI) developed by Li and Filer
(2004) to measure the degree to which a country is
primarily rule-based or relation-based. The GEI
consists of five dimensions that are indicative of
the governance environment: political rights, rule
of law, free flow of information, public trust, and
corruption (see Table 1). The inflow of FDI is
measured as a percentage of the total foreign
investment (FI), which is the sum of FDI and
portfolio investment (IMF, 2003). I then plotted
the FDI inflow against the GEI for each country. The
results strongly support my proposal: the more a
country is relation-based, the more likely investors
will choose direct investment over indirect investment. In markets where public rules are weak,
investors will choose direct investment if they want
to enter the market because it affords them better
protection through private means. Foreign investors make direct investments in China because,
compared to indirect investments, direct investments can be better protected in Chinas poor legal
environment (Fig. 1).
A comparison between China and India further
illustrates this point. India and China are both large
developing countries, but India has a democratic
political system with checks and balances between
the three branches of government, universal suf-

300
Estimated governance environment index

Country

GEI

Country

GEI

Finland
Norway
Sweden
Denmark
Canada
Netherlands
Iceland
Australia
Ireland
United Kingdom
United States
Germany
Austria
Japan
Belgium
Spain
France
Taiwan
Portugal
Chile
Hungary
Italy
Slovenia
Uruguay

6.80
6.68
6.66
6.59
6.43
6.35
6.31
6.09
5.90
5.87
5.82
5.73
5.69
5.64
5.28
5.18
5.05
4.92
4.81
4.79
4.59
4.54
4.38
4.30

Czech Republic
Poland
S. Korea
South Africa
Bulgaria
Croatia
India
Argentina
Peru
Ghana
Romania
Mexico
Brazil
Philippines
Venezuela
Turkey
Ukraine
Nigeria
Colombia
Bangladesh
Russia
Azerbaijan
Pakistan
China

4.14
4.10
3.97
3.88
3.83
3.33
3.19
3.06
3.01
2.92
2.91
2.83
2.34
2.06
1.87
1.73
1.59
1.44
1.36
1.15
1.01
0.81
0.61
0.47

high = rule-based, low = relation-based, mean = 4.

The GEI consists of five dimensions: political right, rule of
law, public trust, free flow of information, and level of
corruption. The GEI is developed by Li and Filer (2004) based
on data from IMF (2003), World Bank (2002), Freedom House
(2003), Transparency International (2001), Gwartney, Lawson, Park, Wagh, Edwards, and Rugy (2002), Inglehart (1995
1997), and Reporters Without Borders (2003).
Source: Li and Filer, 2004.

frage, and a legal system based on the British

common law tradition which provides good protection of property rights (La Porta et al., 1998). In
contrast, China is ruled by a dictatorial Communist
Party with no checks and balances; it has a poor
legal system and a poor record of property rights
protection. On the governance environment index,
China ranks the lowest of all 48 countries, whereas
India ranks in the lower middle, at 31st. However,
China attracts about $50 billion FDI whereas India
only attracts one-tenth of this amount. This has
puzzled both the international business community
and analysts. I offer the following explanation.
If we look at the percentage of direct investment
to total foreign investment, China averaged 95% in
the late 1990s. Very little foreign investment in
China took the mode of portfolio investment. As for
India, about 57 percentage of total foreign investment was direct investment. India clearly has a
much higher level of indirect investment than does
China. An examination of the two countries stock
markets, a major venue for indirect investment,
reveals a similar pattern: the market capitalization

of listed companies as a percentage of GDP was

about 30% in India and below 20% in China in the late
1990s. Indias greater degree of rule-based governance encourages investors to make indirect investments. Furthermore, a substantial amount of
foreign direct investment in China is made by
overseas Chinese. Their cultural background and
family ties give them an advantage in Chinas
relation-based system, enabling them to quickly
and easily develop relationships with the right
government officials. After China opened up to
foreign investment in the late 1970s, investors from
Hong Kong invested the most among all countries
and regions, by far. For example, in 1993, Hong Kong
investors made $17.4 billion in direct investment in
China, more than eight times that made by U.S.
investors, at $2.1 billion. The second largest investment in China was made by investors from Taiwan,
at $3.1 billion (National Bureau of Statistics, 1994).
The facts that Hong Kongs economy is sixty times
smaller than that of the U.S. and that Taiwan and
China aim missiles at each other across the Straits
make these figures even more impressive. In general, the top investors in China tend to be people
who have a better understanding of relation-based
systems such as the Japanese, Singaporeans, Koreans, and Malaysians. More than 50% of FDI comes
from the Chinese diaspora, whereas the Indian
diaspora contributes only less than 10% of the
foreign investment in India (Huang & Khanna,
2003; National Bureau of Statistics, 1997).
The pattern is very clear: when foreign investors
invest in countries with poor governance environments, they overwhelmingly choose direct investment over indirect investment. This sheds new light
on the China puzzle. Investors choose direct invest90%
80%
70%

FDI/FI (%)

Table 1
(GEI)

S. Li

60%
50%
40%
30%
20%
10%
0%
0.000
2.000
Relation-based

4.000

6.000

8.000
Rule-based

Governance Environment Index

Figure 1 Governance environment and FDI. Note: The
scale of GEI is from 0 (most relation-based) to 8 (most
rule-based), with 4 = mean. FDI/FI = (foreign direct investment)/(total foreign investment). Calculated based on
the GEI and IMF (2003) data.

Why a poor governance environment does not deter direct investment

ment in China because of, rather than despite, the
absence of a good governance environment. Direct
investment gives them more control; thus, better
protection through personal connections. This finding explains why, in some highly relation-based
countries such as Rwanda, Kyrgyzstan, and Armenia, some 99% of foreign investments are in direct
investment, whereas the percentage is substantially lower in rule-based countries such as the
United States or Finland, which can only claim 23
and 6%, respectively (IMF, 2003). The commonly
held theory regarding governance and FDI fails to
recognize the differences between direct and
indirect investments, and between private and
public means of property rights protection.

5. Strategic implications
What can we learn from these findings? The
following three points may help investors better
formulate investment strategies in China and
navigate through the chaos of Chinas rapid transition from a relation-based to a rule-based system.

5.1. Protection tools

Investors need to develop systematic tools to
protect their interests through private means in a
relation-based society. This task is especially difficult for the very reason that relation-based societies lack transparent and fair rules. To effectively
protect their property rights in business transactions in China, investors should consider adopting
a three-step monitoring strategy. They are ex-ante
(before the investment), interim, and ex-post (in
case breaching occurs) strategies. Ex-ante screening helps investors choose partners who tend to
honor commitments, interim monitoring makes
sure that they are on track to fulfill their promises,
and ex-post monitoring deters opportunistic behavior and cheating. Cases show that without the three
monitoring capabilities, especially the ex-post
monitoring, there is a high probability that an
investor conducting business in a relation-based
society will be cheated (Li, 2004).

5.2. Beware of the double-edged sword

Relation-based governance is a double-edged
sword. It is clear that cultivating relationships is
necessary for business success in relation-based
societies. However, the following caveats apply
when using relationships to advance and protect
ones interests in such an environment. When one

301

uses relationships for protection from opportunistic

behavior or unfair competition from partners or
competitors, partners or competitors may do likewise. Further, they may have stronger relationships
in the country and may use these opportunistically
to the investors disadvantage, much like the case
of McDonalds vs. Li Ka-shing. Ironically, it was
widely known that McDonalds used guanxi (relationships or connections) to obtain its prime
location in the first place, only to find out later
that Li had even stronger guanxi. Furthermore, the
use of relationships may be unethical or illegal,
even in China. For example, giving a gift to an
official in exchange for a business license, bribery,
is considered a crime in China. Of course, one could
argue that the monopoly of licenses by the Chinese
government and the absence of fair rules to grant
licenses are the root-causes of bribery, which
explains why corruption is so rampant in the
country.

5.3. Understanding the chaotic nature of the

transition
We need to pay close attention to the transition
from relation-based to rule-based governance. This
transition is currently taking place in both the
economic and political systems in China, although
unevenly, with economic transition occurring at a
much more rapid pace. The Chinese government is
making considerable efforts to reduce relationbased business practices. Efforts include banking
reforms to eliminate relation-based banking, the
addition of the protection of private property rights
to the state constitution, and government divestment from business. The Economist (2001) has
called Chinas transition its bgreatest leap forwardQ. However, foreign investors should be aware
that the transition may increase the governance
risk, as existing relationships become less effective
and new rules are not yet fully functional. During
the transition, there may be a vacuum of governance infrastructure, as already witnessed in a
number of former communist economies in transition. A common scene on Chinas streets demonstrates such chaos. A visitor will be surprised to find
that on most major streets in Chinese cities, there
are automatic traffic lights (rule-based) as well as
policemen (relation-based) simultaneously directing traffic at intersections. The visitor will be even
more surprised when he or she realizes that the two
are often in conflict with each other. Drivers
(investors) may easily become confused, and
crashes may frequently occur.
For investors from rule-based countries, doing
business in China during this transition toward rule-

302
based governance is especially hazardous, as rulebased investors tend to take written rules at face
value. It is true that some of the new rules, such as
many commercial laws, are quite well written in
China. However, rule-based investors may not
realize that many of these rules are not yet being
practiced or enforced; they are, at this point,
merely ink on paper. The rule of stopping in front of
a red light is the same in all countries, and although
it is well respected on the streets of Berlin, it is not
in Beijing. Foreign investors should be aware that
the transition may increase instead of reduce, at
least in the short run, investment hazards, which
may provide opportunities for local financial intermediaries and other agents to cheat investors.
To continue the traffic control analogy, eventually human directing will be replaced by automated lights, and China will move toward rulebased governance in order to remain competitive
as its economy globalizes. Our analysis of China
illustrates such a typical transition. Currently,
most developing and emerging economies still rely
on the relation-based system; however, many of
them, including China, are taking their bgreatest
leap forwardQ to establish a rule-based system. For
these countries, the role of government is to
initiate and promote transition while minimizing
social and economic disruptions. Investors, especially those from rule-based economies, should
pay ample attention to how relation-based governance works, and be prepared to deal with the
incompatibility between the two modes of governance and the possible governance vacuum caused
by the transition.

Acknowledgments
I would like to thank Dennis W. Organ, previous
Editor of Business Horizons, for his valuable comments and suggestions. Thanks also to Darryl
Samsell for his research assistance and comments,
and Nancy Hearst for providing excellent English
editing. A summer research grant from Old Dominion University is graciously acknowledged.

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