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The Impact of Foreign Direct Investment on the Economic Growth of China Veronika Volochayeva FIN 621 Cleveland State University April, 2011

The focus of this paper is to analyze the impact of foreign direct investment (FDI) on the economic growth of China. Chinas GDP is the second largest globally, after the United States. This has not always been the case, happening only recently in 2001, when it surpassed Japan. To reach this point, China has taken in tremendous amounts in FDI, increasing its productivity particularly in the export manufacturing sector. This paper seeks to offer ample evidence that Chinas growth has been largely fuelled by FDI through capital formation, export promotion, technological and skill transfer, increased tax revenues. It also seeks to show that the increased growth has also fuelled inflows of FDI into China through the creation of a larger middle class, encouragement of economic reforms and increased infrastructure spending. A Brief History of FDI in China During its Reform Era China was draped in the iron curtain under Mao Zedong, up until 1979. Deng Xiaoping started to take the curtain down that same year by opening up the Chinese economy for very limited access by foreign entities. The principal aim was to import technology and know-how in some limited industries where there the same was lacking locally. The rest of the economy was jealously protected from foreign competition. These conditions persisted for 12 years, with FDI concentrated in such industries as hotel development and tourism, where Chinese firms were absent, and in those where local firms lacked requisite technology, such as in oil exploration and refinery. The next major phase in reforms occurred in 1992, attracting a hoard of real estate investors. The Chinese government was keener on export manufacturing, and further policies guided FDI in this sector to account for 60% of all inflows by 1994. These were the beginnings of an upward trajectory in FDI inflows, rising from $11.1 billion in 1992, to $33.8 billion in

1994, to 44.2 billion in 1997. The three years after that saw a dip in inflows to 38.4 billion by 2000, attributable to the Asian financial crisis; before 2001, a large portion of FDI inflows came from other Asian countries, notably Hong Kong and Japan. The surge resumed in 2000, rising to $49.3 billion over the next 2 years, during which time China joined the WTO. 2004 was the year in which the most dramatic surge started, seeing an increase from $55 billion in that year to $79 billion in 2005. The 2 years between 2006 and 2008 saw inflows rise from $78 billion to $147.8 billion, before the 2007 global financial crisis brought this sharply down to $78.2 billion (Yuqing Xing, 2010). What attracted investors into China for the better part of the last two decades was the availability of cheap land and labor, coupled with government incentives, all working to enable lower-cost manufacturing. A large domestic market was also a factor. This is however increasingly changing as labor costs go up and land along the coastal regions becomes scarcer. Investors are now putting more of their money in high-technology ventures, off-shoring such functions as complex industrial designs and manufacture of airplane wings. The process has been aided by extensive labor reforms that have given workers better rights overall. The legal system has been overhauled and employers can now be sued, laws and regulations are now transparent, investment approval procedures have been streamlined, thus allowing in more competitors, and a sound financial system which has made access to a flow of finance across borders more efficient, aided by technology. FDI as an Engine for Chinese Economic Growth Tuan, C., & Ng, L.F-Y. (2007) Markusen & Venables (1999) say that FDI in China has been the engine for economic growth in China in four major ways; by

enhancing capital formation and employment augmentation, by promoting manufacturing exports, by bringing in special resources in terms of skilled labor and international brand names, and driving technology transfers coupled with spill-over externalities. FDI has fuelled infrastructure developments through increased tax revenues, and expanded the domestic market through job creation. This section expounds on these points. Enhancement of Capital Formation The fixed capital investment in economic growth has been considered one of the basic principles in economic. FDI is of special interest for its supposed positive effects on growth (Qi, 2007). In 1980, the ratio of FDI inflows to Chinas Gross Domestic Investment was negligible. This had changed to 7% by 1992, and up again to 36% by 2004 (UNCTAD, 2007). As with any type of growth, Chinas has been fuelled by capital investments, and the increasing ratio of FDI to GDI is testimony to the extensive impact that foreign capital has had during the reform years. The country takes a disproportionately large share of overall FDI, coming second overall after the U.S. Among developing countries, it received between 25% and 33% of all FDI throughout the 1990s, according to Fung, Iizaka & Tong (2002), rising steadily from about $19 billion in 1990 to over $300 billion by 1999. Having said this, it is noteworthy that not all capital investments are equal; some types of investment result in greater productivity than others. In Chinas case, the FDI into export manufacturing has had a much greater impact on economic growth than the local investments, especially as regards the creation of employment. Fung, Iizaka & Tong (2002) note that during the first half of the 1990s, industrial establishments accounted for 84% of all Foreign-Invested Enterprises (FIEs), and 72% of all FDI. This slowed to 73%

and 58% respectively in the second half of that decade. Particularly, textile and garmentrelated industries had 13,000 firms in 1995, accounting for more than 25% of all FIEs and more than 20% of all FIE output. These heavy industries are extremely labor intensive, allowing more Chinese to be absorbed into the labor market and become bigger consumers. FDI has promote Manufacturing Exports In 1980, Chinas export volumes were worth $18 billion, ranked 26th in the world. 47% of these comprised manufactured goods. By 2005, exports had improved to $762 billion, the 3rd highest in the world, with manufactured goods accounting for 93% of these. Of these exports, 58% were made by FIEs. FIEs are those firms which have foreign capital invested in them, either as joint ventures or as wholly-owned subsidiaries. The 58% attributed to them in 2005 was worth $444 billion (Yuqing Xing, 2010). This stark contrast in the ratio of exports by FIEs and those by local entities is self-evidence of how FDI has fuelled growth in China. Skill, Knowledge and Technology Transfer Managing complex industrial processes and global supply chains requires expertise that was simply absent in Communist China when it was closed to the world. As FDI flowed into the export manufacturing sector, there was clear need for expertise to run these operations. Additionally, a need was created for professional services to support these operations, some of which had to be imported. In the end, a lot of human capital flowed into China, accompanying the FDI. This had a number of effects on the economy; first, the expatriates created a new high-net worth consumer market segment, boosting production for local consumption. Secondly, they transferred their knowledge and skills

to locals, and the diffusion created yet more capacity for productivity. Finally, the apparent gap in local supply of critical human capital prompted educational institutions to initiate cutting-edge engineering and science-based courses that created a local pool of talent, one of the best in the world today. In a manner similar to human capital, technological transfer has also diffused into the Chinese economy, prompted the development of local talent, and called for additional services to support the technology in the local setting. Another externality of technological and human capital transfer is increased competition, where producers have to possess a competitive advantage cost, quality, etc to stay in business. This especially applies for government-owned enterprises, which historically have been known to be corrupt and inefficient. Overall, the economy is boosted. Increased Infrastructure Development With $444 billion in exports in 2005, FIEs contributed significantly to Chinese revenues, and continue to. In fact, tax revenues from FIEs 4% of the total in 1992, and by 2004 had hit 21%. In 2008, China was planning to make $586 billion in infrastructure development, with focus on development of rural roads, railways and technology (Yuqing Xing, 2010). It was part of the countrys stimulus package following the 2007 global financial crisis, but was only made possible by the large revenues collected from FIEs. Good infrastructure, of course, is critical for communication and transportation of goods to market, and is therefore backbone for economic growth. Why FDI is a Consequence of Economic Growth Capital is attracted by the opportunity to make profit. In the case of China, the billionperson market more than sufficient opportunity for producers of numerous consumer

goods, from clothes to home care products and housing. This section explains how economic growth has attracted more FDI to China by creating a burgeoning middle to upper class, encouraging positive policies and further reforms and promoting infrastructure development. Creation of a Larger Domestic Market According to International Monetary Fund statistics, Chinas per capita GDP in 2010 stood at $ 7,518, adjusted for purchasing power parity, the 93rd in the world. This is a tremendous improvement from the $181.19 in 1979. Similarly, per capita disposable income has risen dramatically over the same period. This is best exhibited by the boom in the luxury goods market. Bottled water was inaccessible to ordinary Chinese as of 15 years ago. By 2008, the industry was forecasted to double in size to a $10.5 billion industry. Tap water in China is considered extravagance; that industry was set to grow 29.3% to $11.9 billion in 2008. The motor vehicle industry is now a $200 billion industry. The increased incomes are attributable to higher wages paid out to more people working in professional services and employed in the export manufacturing industry. As a result of these increased incomes, there is greater demand for more and higher-value goods, presenting investors with the opportunity for returns if they flow in FDI. In this way, the economic growth has created a virtuous cycle that includes increased FDI. Improved Infrastructure The improved economy increased GDP, GDP per capita, disposable income per capita, etc have all worked to increase the revenue base for the Chinese government. As mentioned earlier, the government has been, and continues to, invest very heavily in the infrastructure roads, rails, ports, airports, communication infrastructure, etc necessary

to make doing business in China much easier. Better infrastructure reduces the cost of doing business, especially that of taking products to market, meaning a better opportunity for profit-making. This has worked to further attract FDI. In conclusion, FDI has been the principal source of the phenomenal growth of the Chinese economy since 1979, by enhancing capital formation, promoting manufacturing exports, transferring knowledge and skills and increasing tax revenues. In these ways, it has been a cause of economic growth. At the same time, FDI has also been fuelled by the economic growth it has helped create, because of the new middle and upper class, as is evident in the growth of the luxury goods markets. The economic growth has also encouraged the Chinese authorities to make the business environment increasingly favorable, culminating in its joining the WTO in 2001. The increased tax revenues owing to economic growth has also played a part in attracting FDI, as it has been channeled toward infrastructure development to ease the cost of doing business. With all these in mind, it can only be concluded that FDI has been a major cause of economic growth in China during the reform years.

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