Foreign capital utilization in China : prospects and future strategy

39008 Foreign Capital Utilization in China: Prospects and Future Strategy The World Bank Beijing Office  Table of Contents Table of Contents................................................................................................................ 2 Executive Summary............................................................................................................ 4 Chapter 1 Introduction...................................................................................................... 13 Chapter 2 External Environment ...................................................................................... 18 2.1 Medium-term global economic prospects........................................................... 18 2.2 Robust recovery of private capital flows ............................................................ 20 Chapter 3 Foreign Direct Investment in China................................................................. 30 3.1 FDI in China ....................................................................................................... 30 3.2 FDI policies......................................................................................................... 35 3.3 Emerging problems of FDI policies.................................................................... 43 3.4 Summing up........................................................................................................ 47 Chapter 4 Maintaining an attractive investment climate .................................................. 48 Chapter 5 Leveling the playing field in taxation .............................................................. 55 Chapter 6 Improving the Composition of FDI.................................................................. 61 6.1 Directing more FDI in service sector.................................................................. 61 6.1.1 Why directing more FDI in services.............................................................. 61 6.1.2 Scheduled service liberalization: China's commitment to WTO accession... 64 6.1.3 Policy recommendations on attracting and reaping benefits from service FDI66 6.2 Maximizing technology transfer & directing more FDI in High-tech industry.. 70 6.3 Directing more FDI in Inland regions................................................................. 74 Chapter 7 Non-FDI Capital Flows: Liberalization and Risk Management ...................... 85 7.1 Why liberalize?................................................................................................... 85 7.2 Proposed China strategy: avoiding the hazards .................................................. 94 Reference List................................................................................................................. 100 Annex I. Approval Procedures for Setting Up a Foreign Funded Enterprise......... 114 Annex 2. Comparison of Investment Climate in 23 Cities..................................... 117 Annex 3: Benefit-cost ratio for various tax incentive instruments ......................... 119 2  ACKNOWLEDGEMENTS The report has been prepared by a core team led by Ms. Min Zhao (World Bank) and comprising of Messrs. Sudarshan Gooptu, Patrick Hanohan, Colin Xu and Dailami Mansoor. Overall guidance for the report was provided by Mr. Bert Hofman (Lead Economist for China, World Bank). The counterpart team of the Government of China was headed by Mr. Kong Linglong (Foreign Capital Utilization Department of the National Development and Reform Commission). The cooperation received from staff from the NDRC, especially Messrs. Fu Shan and Wu Chongguang, and officials from local Development and Reform Commission is greatly appreciated. Excellent research assistance was extended by Fei Wang and Henrik Larkander. Mss. Chen Jianqing and Niu Zijing provided able assistance with the administrative and logistical arrangements for the task team. Peer Reviews are Messrs. Richard Newfarmer (PRMTR-World Bank) and Yoichiro Ishihara (EASPR-World Bank). 3  Executive Summary China has been very successful in attracting Foreign Direct Investment (FDI). Attracted by the country's relatively good investment climate and low wages, and more recently by its growing domestic market, China received about a quarter of all FDI to developing countries over the last 10 years, and a record $60 billion in 2004, some 9.9 percent of the total FDI. In terms of share of GDP and investment, FDI made less of a contribution, with some 11 percent of total investment on average over the last five years, lower that countries such as Hungary, Czech Republic, Viet Nam and Singapore. Also as a share of GDP, China is not among the top receivers of FDI. Moreover, it is estimated that some 20 to 30 percent of FDI is not genuine FDI, but rather domestic investment rerouted through foreign countries to benefit from the special treatment foreign investment receives in terms of taxes and investment policies. Clearly, FDI has had many benefits for China. FDI accelerated growth by providing more investment capital, contributed significantly to the country's export success with over 57 percent of exports from foreign invested firms, and generated over 120 million jobs. Foreign-invested firms generally have more value added per worker, higher labor productivity, and higher profits than domestic firms. Evidence on technology spillovers is more limited, but industries with higher FDI seem to have higher productivity increases than other industries, suggesting a positive spillover. The benefits of FDI are unevenly spread across China's provinces. The coastal provinces have benefited in particular from the FDI flows, taking in almost 90 percent of total FDI, whereas the western provinces received less than 2 percent in 2004, despite the government's policies to encourage investments in these regions. FDI also remains heavily focused on industry, which took well over 60 percent of total in the 1990s, and some 75 percent in 2004, 71 of which in manufacturing. Services attracted a little over 20 percent of total FDI, but most of this was in real estate, whereas services such as banking and public utilities--key recipients of FDI in other countries--attracted only modest amounts. FDI in agriculture is negligible. 4  On current trends China is likely to continue to receive abundant FDI over the coming 11th Five Year Plan period. Developing countries are projected to receive some US$250 billion in FDI on average over the coming 5 year plan, and China can expect to receive some 30 percent of this. This puts China in a relatively comfortable position, and it would allow the country to opt for policies that encourage FDI to align more with the country's objectives. These objectives themselves are changing, and over the next five- year plan, China is likely to focus on a more balanced development. The "Five balances" call for growth that is more focused on domestic development, that is more evenly spread across China's regions, and that is less resource intensive. For FDI policies, this would imply that greater attention should be given to investments in domestically focused industries, to investment in the interior, and to investments with a higher level of technology. Some of the developments in FDI that the government desires will happen irrespective of policy. Accession to the WTO is opening up a whole host of activities previously closed for FDI, notably in services such as banking, distribution, and utilities. Further, rising wages and land prices in the East may well drive some FDI further inland when investment conditions are right. And China's increasingly skilled labor force is likely to attract gradually more industries with higher value added to the country. In addition, removing some of the existing policy biases, such as in taxation policies, special economic zones, and market accession will level the playing field between coastal and inland provinces and among sectors in the economy. However, China faces significant policy challenges in optimizing the use of FDI. Maintaining an Attractive Investment Climate China should continue to improve its investment climate. Increasing competition from other large emerging economies such as India, Brazil, Thailand and Mexico may limit China's share in world FDI, and if China desires to continue to attract large volumes of FDI, it must further improve its investment climate. While this climate is overall strong, it can be better, if China 5