My paper will address the development of the Chinese economy and in which way the regulation of foreign direct investment (FDI) helped China to overcome a financial trough and to swing themselves up to one of the biggest players on the global market. Therefore, my guiding question will be “How has the Chinese regulation of FDI from the late 1970s until the 2000s boosted the economy of the country?”. My topic and research question are relevant because the economic evolution China has been through is unique, even though its growth model was like those of other Asian or Communist countries and other states like the UDSSR failed to transition their market into a more liberal system. The astonishing success story that China has written was greatly influenced by the opening to FDI whilst still having restrictions on it to channel it into the right sectors for developing the country. This essay is based on the neoclassical growth theory which seems to fit the most since the three driving factors of this theory are labour, capital and technology, which are all important factors of China's economic growth. To explain its case, I will mainly use academic literature from researchers specialized on Chinese economy, a scientific article and a study. I will use data from the Worldbank and from various surveys that Long (2005) evaluated to point out and underline the growth of China's economy. I found that FDI clearly helped to spur the rise of the Chinese economy, even though the study of Ford (2010) did not find direct benefits of FDI in China in the long run but admits positive indirect effects. My findings in this paper are therefore that the applied regulative measures were effective at the time but might not be sustainable if they wanted to use this set of regulations in the future.
China's Problematic Situation
Until the late 1970s China was a country with almost no trade and a very low GDP - not just per capita but in total - compared to developed states.
To understand how crucial the regulation policy on FDI by the Chinese government in terms of promoting economic growth was, it is necessary to understand the situation of China before their tremendous growth, because it was not a lack of financial resources that hindered the Chinese economy to grow but rather the low technological standard and trade policy in the country. Before the liberalization of the Chinese economy it was very similar to the system of the UdSSR and a demand-economy in which only twelve state-owned companies controlled the foreign trade and had monopolies on it (Naughton, 2006). China imported to decrease shortages or to access products they could not produce and most importantly technology. But this was, in fact, a problem since the Chinese currency was set arbitrarily and was by far overvalued until 1986 when reformers made it possible to sell the above plan foreign currency earnings on a secondary market and a more realistic value was adopted. The overvaluation made it difficult to export and generate foreign exchange. For companies that were not a state- owned foreign trade company as well as for natural persons it was also nearly impossible to get the permission to exchange the Chinese Renminbi. China soon lacked foreign currency to pay for their imports and foreign technology like production machines. Therefore, they had to adjust their strategy to generate the foreign exchange to cover their expenses.
The Liberalization Process
Export Processing Contracts
They decided to gradually approach the liberalization of their economy. The main goal was to bring foreign currency into the country and the government's depots but without letting foreign firms into the domestic market because that would have led to an interference of world market prices with the planned prices of the Chinese 5-year-plan system. That would have in consequence caused problems for the state-owned industry that benefitted from the Chinese socialist price system and from which the government harvested most of its budget. The only way to achieve this main goal would be to encourage exports - which were until 1979 mostly just seen as a means to pay for imports but were not very popular in the demand economy of China.
Consequently, due to the lack of foreign currency to import advanced technology and thereby expedite the industrial progress of the country the Chinese system had to open to cross-border trade. To gain access to foreign exchange through foreign trade the government decided to allow export-processing in 1978. Foreign companies (especially from Hong Kong) could use the manpower of the PRC to manufacture their goods in mainland China whilst always owning them. In that way the restrictive legislation on imports could be overcome. The Chinese manufacturers would earn a fee and the finished product would not be taxed due to the special regulations (Naughton, 2006).
Opening the Door to Foreign Business
The first step of legislation in favour of FDI was the law of the People's Republic of China on joint ventures using Chinese and foreign investment in July 1979, which opened the door for foreign investors with the restriction to form a joint venture to enter the Chinese market, in that the foreign investor does not own more than 50 percent of the shares (Ford, 2010). But the country's decision makers were afraid to make mistakes during the establishment of another trading system and that the home-based economy would be put under pressure through the possibility of FDI and the engagement in companies.
Therefore, they decided to erect a variety of tariff and non-tariff barriers as they slowly dismantled their planned trading system. Firstly, they put up high tariffs to protect the domestic market. Long (2005) states an average tariff level of 55,6 percent in 1982 which would stay high but decline slowly in the next decade. In 1992 the Worldbank found the unweighted mean tariff to be at 43 percent and the trade-weighted tariff at 32 percent in China. According to Naughton (2006) those numbers were not unusual for protective developing countries, even though it seemed odd for a country that put so much effort into appearing as a state that makes its way into a liberal system. Secondly, China worked with a set of non-tariff barriers such as the limitation of trading rights which still belonged mainly to the state-owned foreign-trade companies. Those were as well the only ones who were granted the right to import for the domestic market and therefore had access to it. Export-processing manufactures were only granted exceptional rights for imports but were restricted to goods needed for production and kept from sensitive goods like fertilizer or staple foods. (Naughton, 2006)
Taxation System and Exemptions
For direction and protection measures China used various taxes to lead FDI to the place where it was needed to gain the benefits the government wanted from letting it in. Companies had to pay corporate income tax as well as tariffs and since 1994 a 17 percent value added tax (VAT). For specific sectors of the economy like the automobile industry there was an excise tax of ten percent. This would decrease the profits of export production of foreign companies drastically in comparison to production at home which is why China used a tactic of exemptions and reimbursements for export manufacturers. If producers imported materials for the means of reexporting, they were exempt from VAT and were reimbursed the 17 percent (Long, 2005). Therefore, export producers had an incentive to rather import raw materials for their production instead of being in a competition with domestic producers. If the imports were used to produce for the Chinese market, the full amount of taxes and tariffs had to be paid. Further tax exemptions for foreign investors will be found in the section “The Introduction of Advanced technology”.