Foreign Investment in Rapidly Growing Countries: The Chinese and Indian Experiences

Citation preview

Foreign Investment in Rapidly Growing Countries The Chinese and Indian Experience

Edited by

H.S. Kehal

Foreign Investment in Rapidly Growing Countries

Also by H.S. Kehal DIGITAL ECONOMY: Impacts, Influences and Challenges (co-edited with Varinder Pal Singh) FOREIGN INVESTMENT IN DEVELOPING COUNTRIES

Foreign Investment in Rapidly Growing Countries The Chinese and Indian Experience Edited by

H.S. Kehal

Editorial matter and selection © H.S. Kehal 2005 Introduction and Chapters 1–11 © Palgrave Macmillan Ltd 2005 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2005 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–4168–8 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Foreign investment in rapidly growing countries : the chinese and indian experience / H.S. Kehal, editor. p. cm. Includes bibliographical references and index. ISBN 1–4039–4168–8 1. Investments, Foreign—China. 2. Investments, Foreign—India. 3. International business enterprises—China. 4. International business enterprises—India. 5. China—Economic policy. 6. India—Economic policy. I. Kehal, Harbhajan, 1942– HG5782.F685 2004 332.67
3
0951—dc22 10 9 8 7 6 5 4 3 2 1 14 13 12 11 10 09 08 07 06 05 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

2004054709

In memory of my parents Chaudhry Harkishan Singh Kehal and Sardarni Harnam Kaur Kehal who have taught me to be positive and enthusiastic for the success of new endeavours

This page intentionally left blank

Contents List of Tables

ix

List of Figures

xi

Preface and Acknowledgements

xii

Notes on the Contributors

xv

List of Abbreviations and Acronyms

xx

Introduction Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney 1 The Anatomy of a ‘Growth Miracle’ Earl A. Thompson 2 Foreign Direct Investment: A Brief Overview of the Micro Issues Sumon Kumar Bhaumik 3 China’s Experience with Foreign Direct Investment: Lessons for Developing Economies Leonard K. Cheng 4 A Normative Model to Evaluate China’s FDI Regime Ramin Cooper Maysami and Wayne Lim 5 China’s Development: Foreign Direct Investment, Accession to the WTO and Future Perspectives Jurgis Samulevicius and Tong Xiaoshuang 6 Issues of Japanese Affiliates in Chinese Economy Takeshi Otsu

xxiv

1

23

46

64

101

119

7 Technology Upgrading Strategies and Level of Technology Adoption in Japanese and US Firms in Indian Manufacturing Rashmi Banga

137

8 Digitalization and Foreign Direct Investment: An Indian Case Study Madhu Bala

153

9 The Causal Nexus between Foreign Investment and Economic Growth in India K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj

168

vii

viii Contents

10 Trends and Determinants of Foreign Direct Investment in Emerging Economies of Asia Rekha Mehta and Santosh Bhandari 11 International Mobility of Human Resources of Science and Technology and its Complementarity to Foreign Direct Investment and Economic Development in Asia Vincent F. Yip Index

180

198

217

List of Tables A2.1 A2.2 3.1 3.2 3.3 4.1 4.2 4.3 4.4 4.5 4.A2.1 4.A3.1 4.A4.1 4.A5.1 5.1 5.2 5.3 5.4 5.5 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12

Choice of entry mode Spillovers from FDI Roles of foreign firms in China’s economy, 1991–2000 Sectoral shares of contracted FDI, 1985–2000 Shares of realized FDI, leading provinces and municipalities, 1979–2000 China’s annual GDP growth, 1991–2000 Chinese FDI inflow by country of origin, 1992–2001 Sectoral share of total FDI through agreements and contracts, 1995–2001 Summary of FDI determinants highlighted in the literature Assessment of China’s FDI regime The MAI Agreement WTO investment rules Extract from corporate tax rate survey, January 2002 Comparison of administrative efficiency selected countries China’s total FDI, 1979–97 Top regions/territories investing in China, January–September 2002 China’s FDI, 2002, by types of FIE China’s FDI, 2000, by selected large sectors China’s FDI, average for 1985–97 Profitability of Japanese affiliates, 1996–2001 Profitability of Japanese affiliates, by affiliate type, 1998–2001 Japanese affiliates, reasons for underperformance, 1999 and 2001 Japanese affiliates, managerial problems Japanese affiliates, obstacles to gaining market share in China, 1997–2001 Japanese affiliates, methods of payment, 1999–2001 Japanese affiliates, distribution channels, 1997–2001 Japanese affiliates, relative frequency of payment method Japanese affiliates, cost reduction measures Japanese affiliates, production costs Japanese affiliates, personnel problems Japanese affiliates, complaints about FDI policy changes, 1997 and 1999

ix

36 39 47 53 54 65 67 68 72 88 90 93 96 97 104 106 106 107 108 122 123 123 124 125 126 127 127 129 129 129 130

x

List of Tables

6.13 Japanese affiliates, problems with government policy, 1999 and 2001 6.14 Expected changes in China’s FDI policy 7.1 Average number of Japanese, US and domestic firms in Indian manufacturing industries, 1995–6 to 1999–2000 7.2 Average proportion of Japanese and US equity invested in manufacturing industry, 1995–6 to 1999–2000 7.3 Ownership structure of Japanese and US firms in four manufacturing industries 7.4 Univariate analysis of technology upgrading strategies and technology acquisition index in Japanese and US firms 7.5 Least squares regressions 7.6 Technology adoption in Japanese and US firms 7.A.1 Average share of technology upgrading strategies and technology acquisition index in Japanese and US firms 7.A.2 Factor score coefficient matrix 7.A.3 Correlation matrix 9.1 Trends of FDI flows, selected host regions, 1989–2001 9.2 Trends and pattern of FDI, by category, 1990–2002 9.3 Trends of FDI flows and balance of payment indicators, 1990–1 to 2001–2 9.4 The Granger-causality test results: FDI and Index of industrial production 9.5 Dickey–Fuller test results 10.1 FDI inflows, 1985–2001 10.2 FDI net inflows, 1991–2001 10.3 Inward FDI flows to capital formation, 1985–2000 10.4 FDI performance index of emerging economies of Asia, 1994–2001 10.5 FDI potential index of emerging economies of Asia, 1991–2001 10.6 Linear regression results of FDI with various determinants for the emerging economies of Asia 10.7 Log linear regression results of FDI with various determinants for the emerging economies of Asia 10.8 Multiple log linear regression results of FDI with various determinants for the emerging economies of Asia 11.1 Correlation between FDI and foreign student enrolment in the USA, 2001 11.2 Low-FDI Asian countries, Student numbers, 2001 11.3 China and India: selected FDI indicators, 1999–2001

131 133 144 145 145 146 148 149 151 151 151 173 174 175 176 176 185 186 187 188 189 193 194 195 204 205 212

List of Figures 4.1 Realized capital and actual FDI inflows, 1984–2000 4.2 Distribution of actual FDI, by region 5.1 Sales of personal computers in China, 1990–2000

xi

66 69 113

Preface and Acknowledgements It all started in the early 1990s. The first step to producing a book on foreign investment was made when I was offered a contract to edit a book on Foreign Investment in Developing Countries (Palgrave, 2004). I am most grateful to Mr T.M. Farmiloe for his encouragement and for sowing the seeds. The chapters were assembled from top professionals, academics and practitioners from all over the world specializing in the field of foreign investment. For reasons beyond my control, the book could not be published at that time, but persistence pays, and has its own rewards. In 2003, I was given a fresh contract by Ms Amanda Watkins, Senior Commissioning Editor. She deserves and receives my highest appreciation and regard for her encouragement and goodwill. Ms Kerry Coutts, Editorial Assistant, Economics, Business and Management, ably supported my endeavours throughout. A fresh call for chapters was issued in the summer of 2003, and the response from contributors was overwhelming. Proposals for chapters were received from top scholars, professionals and academics from all over the world and were included in the book Foreign Investment in Developing Countries and in the present volume, to which authors from various backgrounds and with first-hand knowledge of the theory and practice of foreign investment in China and India have contributed. I wish to thank all the contributors for their excellent contributions. A special vote of thanks is also due to Professor Earl A. Thompson for accepting our invitation and making a highly valuable contribution within very tight delivery schedules. All of the contributors also served as reviewers for other chapters, and assisted the Editor in producing a wonderful product. The chapters went through a double-blind review process. Irrespective of having their own congested schedules, the reviewers responded promptly and enthusiastically to all my requests. However, some individuals need a special mention, as their help set the benchmark. These include: Professor Vincent F. Yip, University of San Francisco; Professor Takeshi Otsu, Seijo University of Tokyo; Dr Mark Wade, University of Tennessee; Dr Andrew Sumner, University of East London; Dr S.K. Singh, XLRI, Jamshedpur; Emeritus Professor Akira Ishikawa, Aoyama Gakuin University; Dr Naoko Shinkai, Economist, Development Studies, Japan Bank for International Cooperation Institute, Tokyo; and Dr Richard Dawson, University of Waikato, among others. A special vote of thanks is also owed to those who provided us access to their networks, introducing us to potential authors and contributors and encouraging us to persist with the project to its successful completion. They are too numerous to mention by name. xii

Preface and Acknowledgements xiii

In addition to the contributors and reviewers, the production of a book needs immense technical and organizational help. Here a special mention must be made of Harender Haresh Samtani for his technical help in the editing process and also for his very valuable contribution through his computing and linguistic skills. His presence, perseverance and contribution to the development of this book have significantly raised its quality. The countless hours he spent have been rewarded by the excellence of the contributions received. His personal contribution in organizing the huge amount of information was instrumental in keeping order among the deluge of papers and information. He was also of great help in the review process by ensuring that the schedule was adhered to and following up various loose ends. His organizational skills deserve a special mention and should be highlighted. His constant presence and persistence encouraged and strengthened my resolve to see this project through. I also wish to acknowledge the unselfish help and technical support provided by Varinder P. Singh and Dr Kiranjit Sohi during the final days of the project. The journey on this path over eight years has been very arduous, I take this opportunity to express my sincere thanks and gratitude to my family, who have been supportive and patient throughout this venture, without which this project could not have been completed successfully. I am highly grateful to my wife Harbans Kehal, my children and other members of the family for great moral support that bolstered me throughout the long gestation period of this project. Without their forbearance, understanding and enthusiasm, I could not have brought it to fruition. A collaborative project like this cannot exist in a vacuum, and cannot be kept running without enormous support and help of many kinds. It is appropriate to acknowledge all of those people who I know have directly or indirectly shaped this work by contributing to its successful production. Many friends in Sydney and other countries have provided the inspiration and support by reading and commenting on drafts. Mr J.S. Sawhney deserves special mention and also Professor Tejpal Singh and Dr G.S. Sidhu for providing valuable and constructive comments. Thanks also to the many others too numerous to mention by name who spared their valuable time. This book is a culmination of hard labour over fifty years of learning, teaching, researching, sharing and imparting knowledge of economics and related subjects in developing countries and also in Australia, Japan and other developed countries. Particular mention must be made of the intellectual enrichment received from discussions with colleagues from Japan: Professor Minoru Harada, Kyushu University; Professor Saburo Saito, Fukuoka University; Professor Ken-Ichi Tanaka, President, Kitakyushu University; and many others who shared their ideas, insights and technical knowledge with me during my frequent sojourns in Japan. Interactions with professionals, academics and researchers at professional meetings and gatherings including the Western Economic Association

xiv Preface and Acknowledgements

International, Business and Economics Society International, International Food and Agribusiness Management Association, Indian Ocean Research Network, the Economic Society of Australia, the Australian Institute of International Affairs and many other professional organizations. My students spread all over the world always come handy for sharpening my arguments. Discussions with Dr P. Dass, University of Manitoba, on various aspects of FDI strategy have clarified many issues. A special environment at the University of Western Sydney also facilitated my work on this project. The cooperative attitude of all my colleagues has had a direct impact on the successful completion of this task. Special thanks go to the publishing team at Palgrave Macmillan who via their timely emails prompted me to always meet my deadlines and keep the project on schedule. I hereby acknowledge their help for their unstinting support to this project. H.S. KEHAL

Notes on the Contributors Madhu Bala is an Associate Professor of Economics at Indira Gandhi National Open University (IGNOU), New Delhi, India. Dr Bala is a gold medallist in MA Economics and received her Doctorate from Jawaharlal Nehru University, New Delhi. Her areas of interest include development economics, India–Australian studies and research methods. She has authored many publications in national and international books and journals. Her most recent book is the Cement Industry in India: Policy, Perspective and Performance (2003). She is currently coordinator of two international collaborations (IGNOU and the World Bank and IGNOU and Manchester Metropolitan University). Rashmi Banga is an Associate Professor in Department of Economics of Jesus and Mary College, Delhi University and is also associated with Indian Council for Research on International Economic Relations (ICRIER). She has submitted her doctorate thesis to Delhi University and holds Mphil and Masters degrees in Economics from the Delhi School of Economics. Her areas of interest include international economics, with emphasis on trade and FDI; WTO issues; productivity analysis; labour market issues; and corporate governance. She has presented papers in many International Conferences and she is a board member of the Academy of International Business (AIB Chapter on India). Her publications have appeared in journals such as World Development, the Journal of International Economic Studies, Economic and Political Weekly, etc. she has also contributed to an edited volume for Palgrave Macmillan. Santosh Bhandari is a Senior Lecturer of Commerce at Bhupal Nobles’ PG College, Udaipur, Rajasthan, India. She specializes in marketing and human behaviour and has 10 years’ teaching experience in undergraduate and postgraduate classes. She has published four articles and is a life member of the All India Commerce Association, and the All India Accounting Association. She is currently working on a University Grants Commission-sponsored Project on ‘Marketing of Hotel Services’. K. Sham Bhat received his MA degree in Economics from Calicut University in 1981 and his PhD degree in Economics from Cochin University of Science and Technology in 1986. He has more than 20 years of teaching and research experience and has published more than 60 articles in national and international journals and two books. He is currently a Member of the Planning Commission, Government of Pondicherry, Heading the Department of Economics, Pondicherry University and also Chief Editor of the Asian-African Journal of Economics and Econometrics. xv

xvi Notes on the Contributors

Sumon Kumar Bhaumik is a Lecturer of Economics at Queen’s University Belfast. He is also a Fellow of the Centre for New and Emerging Markets at London Business School, and a Research Fellow of William Davidson Institute, Ann Arbor, Michigan. He is on the editorial boards of Emerging Markets Finance and Trade and The Eurasian Review of Economics and Finance. His areas of research are corporate governance, financial markets and firm-level strategies. Leonard K. Cheng is Professor and Head of Economics in the School of Business and Management at the Hong Kong University of Science and Technology. He received his BSoSc from the Chinese University of Hong Kong, and his MA and PhD from the University of California at Berkeley. His research interests are in international trade and investment, currency crisis, applied game theory, industrial organization and high-tech industries. He has served as Associate Editor for the Journal of International Economics and the Pacific Economic Review, and as Guest Editor for the Review of Industrial Organization. He has published articles in leading international academic journals, book chapters and two books on Hong Kong’s economy. In addition, he has co-edited a book on global production and trade in East Asia and another on the management and performance of China’s domestic private firms. Ramin Cooper Maysami is an Associate Professor at the School of Business at the University of North Carolina at Pembroke, USA. His previous teaching experience includes an Associate Professorship at Nanyang Business School and an Assistant Professorship at the University of Illinois at Springfield, USA. His research experience is multi-disciplinary and crosses geographic borders. His main area of research is regulation of financial institutions and markets, with secondary interests in entrepreneurship and economic education. He has published on issues related to and concerning Singapore, Malaysia, Thailand, South Korea, China (and Hong Kong), the Middle East, Mexico and the USA, in total, more than 50 articles in academic refereed journals and professional/trade publications. Harbhajan S. Kehal is a Senior Lecturer in Economics at the University of Western Sydney, New South Wales, Australia; previously he completed his PhD at the University of Western Australia, Perth. His research interests centre around the digital economy, foreign investment in developing countries and the economic relationships of Australia with Japan and other countries. Chapters based on his research have appeared in books published in Australia and other countries. He is Associate Editor of the World Review of Science, Technology and Sustainable Development. He has co-edited a book on Digital Economy: Imputs, Influences and Challenges. Wayne Lim is a Master of Business (by research) candidate on a full academic scholarship at Nanyang Technological University, Singapore. He

Notes on the Contributors xvii

graduated with a Bachelor of Business from Nanyang Technological University in 2000. Prior to the commencement of his graduate studies, he was a credit analyst with Skandinaviska Enskilda Banken AB, Singapore Branch, and took charge of a portfolio of corporate clients in Asia. His research interests include monetary, developmental and international economics, with a special focus on East Asian economies. Currently, he is conducting a comprehensive analysis of the impact of deposit insurance on bank stability in developed countries and countries with well-liberalized financial systems. Rekha Mehta is an Assistant Professor of Economics at J.N.V. University, Jodhpur, India. She did her postgraduate work at Rajasthan University and holds an MPhil and a PhD from the J.N.V. University. She has taught undergraduate and postgraduate subjects at Bangur College Pali from 1992 and since 1996 at J.N.V. University. She is a life member of the Rajasthan Economic Association and the Indian Economic Association. Her main research interests are macroeconomics and international economics and economic growth and development. She is also the author of Saving Behaviour in India and has participated in national and international conferences. Takeshi Otsu studied economics at Keio University, Tokyo, Japan, where he received his BA in 1990 and his MA in 1992. In 1999, after gaining a PhD in International Economics and Finance from Brandeis University, USA, he became an Assistant Professor at Keio Economic Observatory, Keio University, Tokyo, where he participated in projects studying economic growth and environmental problems in Asian regions and China. He was also an assistant researcher at a private policy institute, the 21st Century Policy Institute, Tokyo. In 2000, he took up a lectureship at Hitotsubashi University, Tokyo teaching undergraduate courses in econometrics and graduate courses in applied econometrics. In 2003, he became Associate Professor at Seijo University, Tokyo, teaching undergraduate courses in macroeconomics. K. Durai Raj completed his MS degree in Applied Economics and is currently pursuing his MPhil degree at Pondicherry University, working in research in the area of international economics. Jurgis Samulevicius works as a Lecturer of Micro- and Macro-economics at the Department of Social Economics and Management in Vilnius Gediminas Technical University of Lithuania. He graduated from the Vilnius University and postgraduated in the Kiev Institute of Trade. After graduating in Master Studies in Vilnius University, he worked in the Institute of Economics of the Lithuanian Academy of Sciences as a senior researcher. The results of his multiple researches have been presented in more than 80 publications. His most recent publications in English are: Introduction to Macroeconomics (Vilnius 2001) and Introduction to Modern Economics: Macroeconomics (Vilnius,

xviii Notes on the Contributors

2003). His research interests include foreign investment in developing countries, environmental economics and management, the economics of European integration and the digital economy. Harender H. Samtani has three masters’ degrees in the fields of management, finance and accounting. His interests lie in the fields of international finance and trade. He has had a rich and varied professional experience derived from various roles in a multinational bank before moving to the academic fraternity, where he has held a research position. Well versed in the business scenario in India, he is currently focusing his research towards recent economic developments. He has been actively involved in the editing of this book and played a key role in its development. Jagjit S. Sawhney retired from the Indian Economic Service after a highly successful career. He was an Additional Economic Adviser to the Ministry of Commerce, Government of India and also held many other responsible positions in the Indian public service. He maintains a deep interest in economic research and has published a number of articles and research papers. He actively joined with the editor of this book in reviewing the contributions. C.U. Tripura Sundari completed her BSc in Computer Science at the Women’s Christian College affiliated to Madras University. She received her MSc Degree in Economics in 2000 at the Madras School of Economics, affiliated to Anna University Chennai. She is now a full-time PhD scholar at Pondicherry University, engaged in research work in the area of international economics and regional economics. She is actively involved in the preparation of the ‘Pondicherry Vision 2020’ document and has published several articles in national and international journals. Earl A. Thompson received his Bachelors degree at UCLA in 1959 and his economics MA and PhD from Harvard in 1961. His next three years were spent as Assistant Professor of Economics at Stanford University, where his formative ideas were developed. Perhaps the one for which he is best known is his 1966 paper establishing the first demand-revealing mechanism for collective goods. A second was a 1968 paper describing various inefficiencies resulting from the perfectly competitive production of collective goods. A third, from which Chapter 1 of this volume springs, was a pair of JPE papers (1974 and 1979) establishing an efficiency rationale for a country’s evolved tax system. These papers, and many others, can be downloaded from http://www.econ. ucla.edu/thompson/. He has been a UCLA Professor since 1965. Tong Xiaoshuang is a final-year student for his bachelor degree at the Vilnius Gediminas Technical University of Lithuania. His study programme is business management, and his specialization is marketing management. He has been involved in studying international business strategies in the

Notes on the Contributors xix

developing countries. His bachelor thesis will focus on the development of China’s economy from the overview of FDI, China’s accession to WTO, the IT and digital revolution and the vision of China’s economy in long-run perspective. Vincent F. Yip is an international lecturer and consultant with wide global experience. He received his PhD in Materials Science (USC, 1973) and his MBA (USD, 1976). He was Chief Scientist and Administrator of the Singapore Science Park during 1980–9, and served as Singapore’s Deputy Ambassador to the EC in 1989–91. He has consulted in China, the USA, Europe, Mexico and Egypt for clients such as the World Bank, the Asian Development Bank and UNDP. He was awarded the French Government decoration Palmes Academiques in 1989 for his international contribution to France’s scientific/ technology fields. His teaching and research fields include technology policy, cross-cultural management, international talent flow, product management and project management. His latest research project on the SocioCultural Aspects of e-Business in China is being done in cooperation with Professor Alev Efendioglu of USF’s SOBAM.

List of Abbreviations and Acronyms 802.11 technology ADVT APEC ASEAN ASI AT&T B2B BCC BEEM BOI CAGR CCOIC CCP CCPIT CEE CEO CFETC CIETAC CIFIT CJV CMAC CMC CNNIC CPE DoT DSU EDTZ EJV EPZ ERP EU FDI FIE FIPB

Wireless LAN technology Advertisement intensity Asia-Pacific Economic Cooperation Association of Southeast Asian Nations Annual Survey of Industries (India) American Telephone and Telegraph Company Business-to-business network Beijing Conciliation Centre Bureau of Entry–Exit Permit Management (China) Board of Investment (Sri Lanka) Compound annual growth rate China Chamber of International Commerce Central Communist Party (China) China Council for the Promotion of International Trade Central and Eastern European (countries) Chief executive officer China Foreign Exchange Trading Centre China International Economic and Trade Arbitration Commission China International Fair for Investment and Trade Contractual joint venture China Maritime Arbitration Commission Computer Maintenance Corporation China Internet Network Information Centre Centrally planned economy Department of Telecommunications (India) Dispute Settlement Understanding (WTO) Economic and technological development zone (China) Equity joint venture Export processing zone (India) Effective rate of protection European Union Foreign direct investment Foreign-investment enterprise Foreign Investment Promotion Board (India) xx

List of Abbreviations and Acronyms xxi

FSU FYA GATS GATT GDP GMAT GNI GRE H1B HKD HR HRST HSIP ICSID IIE ILO IMF INMARSAT INR IPR IS ISCO ISDN ISP IT ITA JCIPO JE JPY JV LDC M&A MAI MDG MFN MIGA MNC MNE MOFTEC MoU MPS MTNL

Former Soviet Union First-year allowance General Agreement on Trade in services (WTO) General Agreement on Tariffs and Trade Gross domestic product Graduate management aptitude test Gross national income Graduate record examination Temporary professional work visa (USA) Hong Kong dollar Human resources Human resources of science and technology Hsinchu Science-Based Industrial Park (Taiwan) International Convention for the Settlement of International Disputes Institute of International Education (New York) International Labour Organization International Monetary Fund International Mobile Satellite Organization Indian rupee Intellectual property rights Information services International Standard Classification of Occupations Integrated service digital network Internet service provider Information technology Indian Telegraph Act Japan–China Investment Promotion Organization Joint exploration Japanese yen Joint venture Less-developed country Merger and acquisition Multilateral Agreement on Investment (OECD) Millennium development goal Most favoured nation Multilateral Investment Guarantee Agency Multinational corporation Multinational enterprise Ministry of Foreign Trade and Economic Cooperation (China) Memorandum of understanding Ministry of Public security (China) Mahanagar Telephone Nigam Ltd

xxii List of Abbreviations and Acronyms

NASSCOM NIE NIIT NOC NRI NSF NTD NTP OECD PC PCA PII PPIC PRC R&D RBI RIA RMB S&T SAARC SAFE SAPTA SAT SESTAT SETC SEZ SFCV SFJV SIA SIA SME SOE SSB TIE TNC TOEFL TRIMS TRIPS TSMC UC UNCTAD USA/US USD

National Association of Software and Service Companies Newly industrialized economy National Institute of Information Technology No objection certificate (Pakistan) Non-resident Indians National Science Foundation (USA) New Taiwan dollar National Telecom Policy (India) Organization for Economic Cooperation and Development Personal computer Principal component analysis Pollution-intensive industries Public Policy Institute (California) People’s Republic of China Research and development Reserve Bank of India Regional integration arrangement Renminbi (China) Science and technology South Asian Association for Regional Cooperation State Administration of Foreign Exchange South Asian Preferential Trade Agreement Scholastic aptitude text Scientists and Engineers’ Statistical Data System State Economic and Trade Commission (China) Special economic zone (China) Sino-foreign cooperative venture Sino-foreign joint venture Secretariat for Industrial Approval (India) Secretariat of Industrial Assistance (India) Small and medium-sized enterprise State owned enterprise State Statistical Bureau (China) The Indus Entrepreneur Transnational corporation Test of English as a foreign language Agreement on Trade-Related Investment Measures (WTO) Agreement on Trade-Related Aspects of Intellectual Property Rights (WTO) Taiwan Semiconductor Manufacturing Company University of California United Nations Conference on Trade and Development United States US dollar

List of Abbreviations and Acronyms xxiii

USSR VPN VSNL VW WEF WFOE WFOV WIPO WOS WTO

Union of Soviet Socialist Republics Virtual private network Videsh Sanchar Nigam Ltd Volkswagen Co. World Economic Forum Wholly foreign owned enterprise Wholly foreign owned venture World Intellectual Property Organization Wholly owned subsidiary World Trade Organization

Introduction Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney

There are eleven chapters in this book. Chapter 1 (Earl A. Thompson) presents an excellent analysis of the phenomenon of foreign direct investment (FDI) as an important instrument of economic development in the framework of the conventional model of cross-border FDI flows. The remarkable recovery of Germany and Japan during the post-Second World War period has hardly any similarities with development taking place in the developing counties such as the People’s Republic of China, India and other Asian countries. While Germany and Japan were at the forefront of technological development and economic growth even before the Second World War, the so-called ‘underdeveloped countries’ have had to start from a scratch. Even with high rate of saving and investment, these countries would have found it hard to progress without technological back-up from the developed countries. Herein lies the relevance of FDI more than making investable funds available to these countries. In addition to investment and technology, what is essential is human and natural resources, infrastructure, legal and financial institutions and above all a development culture that provides the right atmosphere for growth to proceed. This general environment has perhaps only now reached a critical mass for FDI to come and play its role. Several paradoxes arise in an empirical study of ‘growth miracles’. These prolonged, exceptionally high-growth experiences were all preceded and accompanied by significantly increased outflows, not inflows, of foreign investment. This, however, is paradoxical only within a Keynesian framework. A more traditional economic framework tells us that, unlike large foreign-investment outflows, large foreign-investment inflows induce diminishing returns and crowding-out that prevent the capital movement from creating a prolonged growth experience. However, ‘growth miracles’ present more serious paradoxes, puzzles that no conventional theory can explain. Nevertheless, the only thing unconventional about our paradoxresolving model, besides our assumption of the economic rationality of the policy makers of less-developed countries (LDCs), is our recognition of an external diseconomy that arises from the private accumulation of capital xxiv

Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney xxv

coveted by a government’s military adversaries. Such accumulations impose losses on those who bear the costs of defending the government. The externality applies in particular to imports of consumer durables and justifies substantial tariffs on these imports. Hence, when dominant countries demand that a dependent country lower its tariffs, the accommodating dependent country would suffer growing defence problems if it did not ameliorate the effects of its lower tariffs. An optimal response for the dependent country is to overvalue the currency, thereby inducing import exchange controls that emulate a tariff system. Most dependent countries have adopted this response. But import exchange controls were denied to the post-war Japan and Western Germany. The only way for these countries to restrict imports was to undervalue their currencies, which required them to devise methods of artificially stimulating their outflows of foreign investment in order to increase the domestic prices of foreign currencies and, quite incidentally, create export booms. Similarly, after an aggressive China exploded a nuclear bomb in the late 1950s, the USA denied it the right to employ import exchange controls to suddenlymore-dependent Korea, Singapore, Taiwan and Hong Kong, who then immediately switched to the same currency-undervaluing policy that had created the Japanese and West German ‘growth miracles’. More recently, the demise of the USSR made India and China more economically dependent on the USA, who induced these countries to so substantially weaken their import exchange controls that they similarly created large net foreign-investment outflows and correspondingly undervalued exchange rates. Quite predictably, these countries have become the latest ‘growth miracles’. Many countries where large concentrations of private wealth are dissipated through various forms of rent-seeking do not have the capacity for such growth. There, ruling elites will rationally refuse to subsidize the large increases in foreign investment required of ‘economic miracles’. Such rational refusals, although not without costs, are what account for the bust of the fledgling Southeast Asian ‘growth miracles’. More generally, the extended terms-of-trade losses resulting from prolonged foreign-investment subsidies are not justified by welfare economics, which complements the message of the dependent-country politicians by telling us that such policies unambiguously decrease domestic welfare. ‘Growth-miracle’ countries continually and substantially sacrifice for their trading partners. Microeconomics does not approve of the ‘growth-miracle’seeking policies of macroeconomists: countries, like people, must be careful what they ask for. Chapter 2 (Sumon Kumar Bhaumik) also relies primarily on traditional economic analysis, but concentrates on micro issues, particularly those concerning the motivation of the multinational corporations’ (MNCs) decision to invest in a foreign land. Obviously maximization of profit can be the only principal objective driving the decision for cross-border investment.

xxvi Introduction

Any country offering the best opportunities for profit making will acquire priority in its favour. An MNC would like to maximize its hold on its technology and would be least interested in parting with it. The opportunities offered to it in terms of making money without losing an undue hold on its technology will be the prime determining factor in its decision to invest. On the contrary, the objective of the host country will be to secure technological spillover with as little loss of economic welfare for its people as possible. Between these two objectives, the right atmosphere for investment will have to emerge. FDI by itself is sufficient neither for economic development nor for welfare maximization of the host country. It is the development dynamics of the host nation that will in the ultimate analysis decide the outcome of the entire development activity both domestic and from abroad. Much of the economics literature examines the determinants of the quantum of FDI, and hence focuses largely on appropriate government policy and development of institutions such as protection of intellectual property rights (IPR). As a consequence, little reference is made in debates and discussions to the significant industrial organization, strategy and international business literature that have explored the decision making process of MNCs, and therefore shed light on what these firms look for in countries in which they can potentially invest. The aim of this survey chapter is to bring to the fore the discussion about these micro-issues. Specifically, this chapter discusses the motives, objectives and behaviour of MNCs that are the unit of decision making in the context of FDI. Section 1 provides an overview of the debate about FDI, which is largely macroeconomic in nature. It argues that this debate does not provide an insight about the process of FDI, and that in order to better understand the drivers of FDI one has to explore the motives and strategic decision making process of MNCs in the context of entry into overseas markets and/or production locations. Section 2, discusses the rationale for FDI, from the point of view of the MNC, essentially reviewing the OLI paradigm and its implications. Section 3 focuses on the choice of the mode of entry of MNCs into the host countries, an important determinant of the nature and extent of spillovers. The literature argues that this decision depends on the balance between the two types of costs associated with doing business in the potential host country – the agency costs associated with the interaction of the MNC and a potential local partner, and the transaction costs associated with procuring resources and selling the product to potential customers. Section 4 examines the life-cycle of joint ventures ( JVs) which is the preferred mode of entry of many developing country governments, because of the perceived link between JVs and technological spillovers. Examination of the largely theoretical literature suggests that the presence of informational asymmetry and agency problems involving a MNC and its local JV partner usually results in the dissolution of a JV (with or without the dissolution of

Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney xxvii

the firm itself) once the MNC has acquired a significant amount of knowledge about the local business environment. Section 5 highlights the caveats associated with technology transfers and spillovers from FDI. The literature suggests that the evidence regarding the spillover effects of FDI is mixed: while some industries in some countries have unambiguously benefited from the presence of MNCs, such experience has not been replicated in many other contexts. Section 6 concludes the chapter, and the appendices provide a summary of the key empirical papers examining the determinants of the choice of mode of entry by MNCs as they enter new markets, and the determinants of the extent of FDI-related spillovers. According to the World Investment Report 2002, as of 2001 there were 65,000 MNCs in the world, with about 850,000 affiliates around the globe. They accounted for 54 million employees and USD 19 trillion in sales. It is, therefore, not surprising that economists have explored in detail the phenomenon of FDI. Chapter 3 (Leonard K. Cheng) emphasises the role of FDI in bringing about global divisions of labour not only in production of different goods and services but also in the process involved in a single product. It also details the historical development of China’s policies regarding foreign investment and the actual achievement of China in becoming the single largest recipient of FDI. The chapter points out that FDI is not merely an additional source of funds for investment but, more importantly, provides better technology, superior managerial skills and linkages to international marketing networks. China took a very pragmatic view of encouraging FDI particularly in labour-intensive, low-technology consumer goods. This policy helped generate widespread employment and also rapid development in the designated areas besides building up export surpluses and phenomenal export growth. Chapter 3 analyses China’s experience in attracting FDI over the period of 1979–2000, draws some lessons for developing economies from this experience and compares the case of China with those of ASEAN and India. The chapter begins by reviewing the evolution of China’s FDI policy and performance in four successive phases. The initial phase (1979–85) was one of experimentation. The second phase (1986–91) was characterized by the introduction of measures to address the difficulties faced by foreign investors and to improve the general business environment. In the third phase (1992–7), China reaffirmed its ‘open door policy’ and adopted broader and bolder measures of liberalization. In the fourth phase (1998–2000) it dealt with the challenges of the Asian Financial Crisis. Three important analytical and empirical issues are addressed: (1) Did foreign firms transfer only low and old technology to China? (2) Was there a serious threat of monopolization and control of the Chinese market by foreign firms? (3) What was the relationship between FDI and economic growth?

xxviii Introduction

Answers to these questions have obvious policy implications. There was evidence that the relatively superior technology possessed by leading MNCs was indeed transferred to China, that FDI contributed to an upgrade of Chinese industries and exports and that foreign firms contributed to the emergence of efficient Chinese firms. Despite this, the control of China’s market by foreign firms, as measured by their shares of revenues, value-added, and assets, was relatively small. Statistical analysis of data on FDI and economic growth at the provincial level shows that there was a positive two-way relationship between FDI and economic growth, and that FDI was a significant factor in explaining the differential growth rates of Chinese regions and cities. Promotion of export-oriented FDI was a common strategy of economic development adopted by both China and ASEAN, and their effort resulted in rapid economic growth. Nevertheless, they differed in terms of the major sources of FDI and their restriction on foreign ownership (i.e. China had a more liberal attitude toward wholly foreign owned firms). In contrast to both China and ASEAN, India’s foreign investors were primarily attracted by its domestic market. Much FDI in India took the form of merger and acquisition (M&A), but in China FDI was predominantly greenfield investment. India’s experience with FDI was less positive than that of China and ASEAN, perhaps because of the foreign investors’ failure to exploit India’s abundant labour supply for export. Chapter 4 (Ramin Cooper Maysami and Wayne Lim) traces the history of FDI in China following the liberalization initiated by Deng Xiaoping in 1979. The wide-ranging policy shift from complete isolation from the most of world combined with public control and means of production to an ‘open door’ policy for foreign investment and allowing a comparatively free hand to private enterprise had a salutary effect on the rapid growth of FDI into China. Chapter 4, however, points to the various negative effects of FDI and the obstacles that may slow down FDI inflow. The biggest concerns about development through FDI relate to accelerating regional disparities and environmental degradation, besides the rapid depletion of China’s natural resources. Policies need to be evolved to guard against these ill effects while effort also needs to be made to meet the requirements of foreign investors regarding protection of IPR and strengthening of neutral legal systems and bureaucracy. The archaic banking, insurance and exchange rate regimes also need effective reform. The fortunes of the Chinese economy have been on the rise since the 1990s, primarily as a result of the ‘open door’ policies of Chairman Deng Xiaoping and his successors. The country has impressed the world as it has joined the list of those experiencing the ‘East Asian Miracle’. In the 1990s, for example, its year-on-year GDP growth was an astounding average of more than 8 per cent, and China has become a hotbed for foreign investment. In September 2001, China officially became a member of the World Trade Organization (WTO), and this is expected to provide a further boost

Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney xxix

to its economic development as well as the acceleration of its economic integration with the global economy. Open economic doors in most cases mean free capital flow; does it have such a meaning for China? There are sceptics who question whether the scene is set for free flow of capital into and out of the Chinese economy. Chapter 4 evaluates China’s FDI regime by examining whether the Chinese government has pursued the constituents of a normative model that encompasses the often-cited causal factors in a ‘successful’ FDI regime. The study also investigates the existence of its effective enforcement and application. The chapter begins by stating the trends in FDI in China by country of origin and the receiving sectors and regions of the Chinese economy, before reviewing the relevant literature and international agreements leading to the identification of the contributory factors in a successful FDI regime. The normative model constructed includes selected factors based on the preponderance of evidence in the FDI literature and amalgamates them with relevant features of several agreements from two international economic bodies – the Organization for Economic Cooperation and Development (OECD) and the World Trade Organization (WTO). For example, there have been two broad categories of policies which are likely to affect the level and impact of FDI on the host economy: economic policies that are largely under direct domestic control and those that are not controllable by the host economy (Velde 2001). The former encompasses both industrial and macroeconomic policies. Relevant industrial policies expected to affect inward FDI, for example, include promotion, targeting and image-building, financial and fiscal incentives, efficient administrative procedures and rules on ownership, encouraging development in key sectors, taxation, developing export platforms, training of employees, encouragement of research and development (R&D), performance requirements and interaction with research institutions and other firms. The macroeconomic policies affecting FDI inflow are labour market policies, development of financial markets, sound macroeconomic performance and prospects, trade policies and export promotion, competition policies, the availability of infrastructure and privatization opportunities. Chapter 4 incorporates the above-mentioned point of view as well as other views offered in the literature to identify the following factors as those contributing to the success of an FDI regime: (1) (2) (3) (4) (5) (6) (7)

Production factors Support facilities and infrastructure Domestic market effects Global market influences Investment promotion policies Laws and government policies Quality of administration

xxx

Introduction

(8) Political and social stability (9) Exchange rate regime. Equipped with this framework, the chapter proceeds to evaluate China’s success in attracting FDI with respect to these contributing factors. Chapter 5 ( Jurgis Samulevicius and Tong Xiaoshuang) examines the impact of China’s entry into the WTO. It indicates that the initial impact of reduction in tariffs may be an influx of industrial and agricultural goods adversely affecting China’s trade, but in due course competition will lead to improvement in technology and the competitiveness of Chinese products and will help the general population in the provision of better quality products at lower prices. The growth of the information technology (IT) industry is particularly expected to pick up as China begins to honour its commitments under WTO. Since the 1990s, close attention has been paid to China’s economy, which has had the highest rates of growth in the world economy. China is acknowledged as an ‘Asian tiger’, as a country of socialist market economy on the one hand, and of totalitarian capitalism on the other. Another big economy, Russia, is ready to follow China’s lead: rumours about the planned ‘Chinazation’ of the Russian economy are spreading. The purpose of chapter 5 is to show how China has modernized the economy and in a very short period of time changed its orientation from central management towards one which is market oriented. FDI has been one of the major factors sponsoring the boom of growth in China’s economy. China is by far the largest recipient of FDI among the developing countries, and the legal forms of FDI in China and its ‘open door’ policy since 1979 are analysed to show not only the relationship between China’s economic development and FDI, but also to reveal its composition, structure and future trends. China’s successful accession to the WTO is characterised as a cornerstone in China’s move to a market oriented economy. The benefits of the accession to the WTO are examined with reference to the business environment of Chinese firms and industries and Chinese exports and imports. Chinese economists predict that WTO membership will create 12 million jobs in sectors such as textiles, toys and footwear. It is also stressed how China’s entry into the WTO will influence global economic development by becoming a ‘new engine’ that could promote the world economy if the three major economy pillars (USA, EU and Japan) found themselves in a recession. At the end of the chapter FDI in China is described from the IT and digitization perspective. China’s IT industry is expected to aggregate 7 per cent of its GDP. Attracted by the market potential all the global IT giants have come to China with the aim of making the country a part of their global strategy. China’s high-technology strategy, internet and e-commerce policies are then discussed in detail. The chapter also outlines some guidelines for

Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney xxxi

China’s economy in the long run, with respect to the fact that it threatens to become the world’s largest by the year 2020. Conclusions concerning a vision of China’s economy ‘starting from local to global’ are then provided. Chapter 6 (Takeshi Otsu) discusses the aspect of foreign investment in a country where cultural value system and the business environment is greatly different from that where the FDI originates. Japanese investors found to their chagrin that Chinese business practices – particularly those relating to distribution channels, credit recovery, fund-raising from financial institutions, price and quality competitiveness, etc. – were vastly different from those they were familiar with. Investors from Hong Kong and Taiwan, who were familiar with Chinese practices, had a clear advantage over other investors. What is true about Japanese investors also applies to investors with no Chinese background. The lessons that can be drawn from this analysis are for foreign investors as also for the host country. Whereas it is the responsibility of the host country to create the business environment common in the investing countries, the investing firms must also try and understand the environment in the host country in order to be able to make best of the existing situation. The Chinese economic reforms successfully attracted a large amount of FDI from all over the world in the 1990s. This FDI contributed to a rapid economic growth. A large number of Japanese companies also established their affiliates in Asian countries, and Japanese FDI flowed into China in the mid1990s. Chapter 6 attempts to contribute to understanding what needs to be done for further economic development in China by observing issues of the Japanese affiliates. The analysis here is based on the survey data (1997–2001) provided by the Japan–China Investment Promotion Organization in Japan. The survey questionnaires include questions on various market and institutional conditions, and provide a unique opportunity to investigate the business environment of the Japanese affiliates in China. It is argued that Japanese affiliates should have economic and institutional issues common to other foreign affiliates of non-Chinese origin because of the similarity of their FDI pattern in China. The issues identified are the underdevelopment of the distribution, credit recovery and the market competition channels, the administrative transparency of the government and the frequent change of China’s policy and laws. The main conclusions are that: ●

Firstly, the gradual liberalization of the distribution sector has given leeway for the Japanese affiliates to deal with the credit recovery problem as well as the underdevelopment of the distributional system. The affiliates use foreign-funded distributors to avoid the credit recovery problem. Otherwise, they ask for prepayment. The distribution system is covering all regions in China. Further reforms in these two fields need to be made because a reliable credit system and an efficient distribution system underline the development of all market economies.

xxxii Introduction ●

●

Secondly, market competition is fierce in China. Although the economic liberalization in China expands business opportunities of the foreign affiliates, it also implies withdrawal of preferential policy measures such as preferential taxes. Foreign affiliates will thus face much fiercer competition in return for expanding business activities. Because a large part of production costs is attributable to the procurement costs of intermediate goods such as parts and materials, it is crucial for local procurement of cheap intermediate goods and labour to be attained. Here, the main issue is quality. It is difficult to find good experts and managers in China and the relatively high defect rates of products and low quality of intermediate goods worsen the affiliates’ performance. Finally, the Chinese government’s policies and laws tend to be subject to frequent and sudden change in the course of the economic reforms. Such a sudden change is inevitable to a certain degree, but is a burden to foreign affiliates. To reduce confusion in the market and keep a steady economic growth, the Chinese government may need to notify firms of changes of rules well in advance and make administrative procedures transparent.

Chapter 7 (Rashmi Banga) makes an interesting comparison between firms with Japanese FDI and those with the American FDI in respect of technological spillover and its adoption in the Indian economy. The conclusions are fairly mixed, as in some respects the Japanese firms lead in technology transfer while in some other respects the American firms take the lead. It seems that level of technology transfer is driven by the business needs of the firm in question, and its country of origin makes hardly any difference for the transfer of technology it achieves. FDI in developing countries is sought because it is expected to augment investible resources – and, more importantly, it is expected to improve technological standards, skills, efficiency and competitiveness of the domestic industry. It is also expected to bring ‘relatively’ later technology into the industry. However, the question raised in Chapter 7 is whether foreign firms from different source countries differ with respect to their level of technology adoption in the same industry of the host country. Studies have found that the costs of intra-firm transfer of technology may differ between different types of technology transferred and between different modes of technology transfers. This gives us reason to believe that FDI that come from different sources, with different types of technology and different modes of transferring technology, may entail different costs of transferring technology. And this may lead to differences in the extent of technology adoption in the affiliates of foreign firms from different countries of origin in the same host country. This issue is of great relevance for small and medium-sized firms (SMEs) who, in an attempt to upgrade their technology, collaborate with foreign firms and therefore need to choose between foreign firms of different countries of origin. It therefore becomes important to study the technology behaviour of foreign firms with respect to their country of origin.

Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney xxxiii

The two source countries of FDI chosen for the analysis are Japan and USA and the period of analysis considered is 1994–5 to 1999–2000. The analysis is undertaken at three levels: ●

●

●

Firstly, an univariate statistical criterion (i.e. Mann–Whitney U-test is used to find whether the technology up-grading strategies differ between the Japanese and US firms Secondly, to compare the extent of technology adoption in the firms an index of technology adoption is prepared using PCA Finally, an attempt is made to compare the factors that determine technology adoption in Japanese and US firms, using panel data estimates.

The results show that technology up-grading strategies with respect to embodied technology, disembodied technology and R&D expenditures differ significantly between the Japanese and US firms operating in Indian manufacturing. It is also found that after controlling for firm-specific and industry-specific effects, not only the ownership of foreign firms but the degree of foreign control in a firm also has a significant impact on its extent of technology adoption. Japanese firms are found to have higher level of technology adoption as compared to US firms. Japanese firms that have, on an average, higher control of the parent firm; are larger in size; more capital-intensive and more profitable and tend to have a higher level of technology adoption after controlling for industry-specific effects. On the other hand, US firms that have higher control of the parent firm and are more export-intensive in nature and are found to adopt higher levels of technology. Industry-specific effects are found to be significant for US firms but they are not significant for Japanese firms. Chapter 8 (Madhu Bala) focuses on the impact of FDI on the information and communications technology (ICT) sector of India. Significantly, it is this sector that has gained most from the inflow of FDI. While the impact on the other sectors has been nominal, the ICT sector was not only the major recipient of the FDI but was also the major beneficiary of the technology spillover. The flow of FDI helped the sector to leapfrog into the world technology forefront and be ranked among IT powerhouse regions. Notwithstanding these achievements, there are serious gaps in the ICT sector in India and the ‘digital divide’ is all too visible. Except for a few states the rest of the country is not in a position to take advantage of the digital revolution. The divide also pervades across the sectors, where except for a few industries the rest of the economy is devoid of the benefits of advancement in the ICT sector. This chapter emphasizes the need for a set of policies that could remove the difference in digitalization between sectors and states. The flow of FDI can help greatly in bridging this gap, which will in turn help uplift the use of technology in sectors left behind in the race for digitalization. Similarly, the lagging states need the adoption of positive policies for the attraction of FDI so that they are able to keep pace with the advancing states.

xxxiv Introduction

The IT revolution in the 1990s led to a renewed debate on the role of ICT in development and the existence of the ‘digital divide’ between developed and developing countries. The 2001 World Telecommunication Development Report (2002), while defining the present-day digital world as ‘Private, competitive, mobile and global’ has acknowledged the existence of a ‘digital divide’. Numerous measures have been suggested to tackle this, and FDI is one such measure. Various research studies have shown that FDI is presently determined more by the level and extent of digitalization in the recipient country as compared to the traditional factors such as savings and investments (in classical models), technical progress (in neoclassical models) and R&D, human capital, accumulation and externalities (in new growth theories). Developing countries have now begun to acknowledge the existence of a ‘digital divide’ and to take suitable initiatives to bridge it by adopting a combination of strategies including attracting FDI. Brazil, China and India are examples of such FDI-attracting countries. Chapter 8 deals with India as a case study. It points out that despite the Indian ICT industry recording incredible evolution and explosive growth over the 1990s, a number of research studies argue the extent and seriousness of the ‘digital divide’ in India. There are lots of efforts by government and private sector at both policy and infrastructure level. However these efforts are drops in the ocean and a lot is still required. Therefore this chapter looks into the issue of the ‘digital divide’ at both national and international level. Despite the limitations of the data, the chapter attempts an estimation of an extended Cobb–Douglas model, and tries to prove that FDI (in ICT) assists in bridging the ‘digital divide’ by adding to human capital development and in the process to overall economic development. The regression model estimated in this chapter shows us that while digitalization contributes to the economic growth of India FDI contributes significantly to the growth of human capital. Chapter 9 (K. Sham Bhat, Tripura Sundari CU and K. Durai Raj) calls for the following policy options to enhance economic growth through FDI: There is a need for further liberalization of FDI and a Granger-Causality test was employed to examine the causal nexus between foreign investment and economic growth in India. The Dickey–Fuller test was also employed to examine the stationarity of the series. The data series were on a quarterly basis and collected from various issues of the Reserve Bank of India Bulletin, the World Investment Report and the Centre of Monitoring the Indian Economy for the years 1990–2002. The analysis revealed an independent relationship between foreign investment and economic growth in India. The possible reasons for such a relationship are: (a) In India, foreign investment is only 0.9 per cent of gross domestic product (GDP) and its high transaction cost in the form of corruption and unnecessary regulatory requirements

Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney xxxv

(b) The lack of full integration of capital and financial markets (c) Higher levels of economic growth may not attract foreign investment due to lack of stability of the Indian rupee in international markets for outward oriented trade policies. ● strengthening the regional economic integration through organizations such as ASEAN and NAFTA. ● Maintenance of the stability of the Indian rupee in terms of foreign currency. Chapter 10 (Rekha Mehta and Santosh Bhandari) analyses the flow of FDI to various Asian countries over time and concludes that the trend has shifted from the ASEAN-5 to emerging economies such as India and China. However, the flow to countries other than China has not increased significantly. China has dominated FDI flow and the trend is likely to continue for some time to come unless other countries create a very favourable environment for FDI to flow in. Efforts in this regard are being made by many countries, especially India, but the results of these efforts have yet to be seen. A review of evidence on resource flows to emerging countries points to a rising trend. Until the 1990s, FDI flows were quite minimal, and most countries in south Asia were not seen by international investors as attractive investment destinations. In the 1990s, however, these countries started to attract FDI under the impact of the globalization of business. Emerging economies improved their share in terms of total FDI inflows to the world, developing countries and Asia over the period 1985/1990–2001. Despite this growth, FDI as a proportion of the GDP of emerging economies remain very low. Both the inward FDI performance index and the inward FDI potential index have been studied in Asian countries, and an econometric analysis has been undertaken, in the context of the emerging economies, using two determinants of FDI – the size of the market and the openness of the economy. The flow of FDI in Asia has shifted over time from the ASEAN-5 to the emerging economies, but despite this growth FDI as a proportion of GDP of the emerging economies remains low. China has accounted for an impressive share of FDI inflows to the emerging economies. The FDI performance index calculated by UNCTAD shows that the performance of China, India, Pakistan and Sri Lanka in 1999–2001 is no better than 1994–6, but the potential index of China and India increased from 1991–3 to 1999–2001. FDI policy in different emerging countries has also been studied. A range of measures has been implemented to enhance FDI, including provision of various tax duty and other incentives, removal of restrictions on repatriations of profits, establishing current account convertibility, relaxation of ownership, restrictions and non-discrimination in favour of domestic investors with fast tracking of FDI approvals. Different determinants such as a lag of GDP, a lag of per capita income and openness were also studied. All the

xxxvi Introduction

variables in different countries were found to be significant but results showed that per capita income was an important determinant. Chapter 11 (Vincent F. Yip), the final chapter, makes very interesting analyses of the trends in human resource mobility and FDI. For many years the USA has been a centre of higher learning and scientific research, and there has been a long-standing desire by students from Asian countries (India, China, Taiwan, South Korea, Singapore and Hong Kong) to seek admission to American universities and institutions of higher learning. Most of these students preferred to settle in the USA for better conditions of work and living. However, with the growth of FDI in their countries of origin these technocrats began to return to their homelands, either as entrepreneurs or as scientific manpower. The largest number of foreign students from a single ethnic group came from China, Hong Kong and Taiwan. With the increase in the flow of FDI in China and its emergence as one of the largest recipients of FDI, the return flow of scientific manpower from the USA to China became very significant. One of the major forms of technology transfer – the return of top scientific human resources – has begun to play a significant role, and establishing enterprises in third countries is increasingly becoming common. Whereas the earlier phase of human resource migration from third world countries to the USA was regarded as a ‘brain drain’, it has now turned into a ‘brain circulation’ where scientific know-how in the form of human resources is moving from one country to another in search of entrepreneurial opportunities. The phenomenon of large-scale FDI movement has further strengthened this flow. In discussing investment and development issues of developing countries, the proper management of human talent could potentially be more important than resource, market, financial instruments, infrastructure and even the political system of a country. This is especially relevant in today’s global digital economy where technology transfer often is highly dependent on human factors. While it may not be possible to determine an incontrovertible casual relationship between FDI and human capital in terms of a concrete correlation of statistics and data, Chapter 11 explores the phenomenon of the migration of human resources of science and technology (HRST) and its effect on FDI and economic development of Asian countries. The ‘Asian boom’ that started in the 1970s coincided with the largest tide of foreign students sent from Asia to the developed countries, especially the USA. However, only in the 1990s did in-depth discussions and empirical research, notably that by the OECD on understanding the relationship between the mobility of these crucial HRST and FDI inflows–outflows and the economic development of their sending and host nations in general began to be produced. As physical capital and skills go hand in hand, so FDI and international transfer of HRST can be seen as complementary to each other. Entrepreneurs in technology are accomplished migrants who create

Harbhajan S. Kehal, Harender H. Samtani and Jagjit S. Sawhney xxxvii

cross-border networks and channel their skills and the capital they muster between nations, the best examples being the highly visible and successful ethnic Chinese and Indian venture capitalists and entrepreneurs in Silicon Valley. A comparison of figures for the Asian nations with the top ten FDI inflows shows there is undeniably a complementarity between the FDI inflow and the number of students the developing Asian country sends to the USA, the largest recipient of international students. Three case studies of how international movement of HRST can effect enormous economic and social-political changes are also examined: ●

●

●

Firstly, the successful return flow of HRST to Taiwan and now mainland China Secondly, the Indian diaspora and its large impact on the Indian software industry Finally, Singapore’s effort in mustering international and local HRST for nation-building.

In fact, in all three cases, returned HRST’s pivotal role in the home country often extends beyond the economic realm into social, cultural and even political arenas. There is no doubt that in today’s world, HRST has become a major determinant of FDI and economic development, and there is a movement away from one-way human capital loss by sending nations, (‘brain drain’) into a mutually beneficial scenario (‘brain circulation’). International mobility of HRST stimulates FDI and skill–technology transfer between sending and host nations, creating a ‘win–win’ situation for all. Talent is now the name of the game. References 1. Velde, World Telecommunication Development Report 2001. 2. World Bank, World Investment Report 2002, Washington, DC, World Bank, 2002. 3. World Telecommunication Development Report, Washington, DC, 2002.

This page intentionally left blank

1 The Anatomy of a ‘Growth Miracle’ Earl A. Thompson

1

Introduction

Questions and paradoxes Many economists (e.g. Lucas 1993) have argued that ‘growth miracles’ in less developed regions can easily arise out of increased innovation based upon inflows of foreign direct investment (FDI) from the technologically most advanced regions. As pleasing as this thought is to most Western observers, empirical studies (e.g. Kim and Lau 1992; Young 1992, 1995; and numerous country-specific studies) have systematically found that total input expansion rather than technological change explains virtually all of the growth in most recent high-growth experiences. In view of these studies, several economists (e.g. Ventura 1997; Radelet and Sachs 1998) have argued that the ‘growth booms’ from the mid–late 1980s through the mid–late 1990s (although subsequently largely aborted) can be theoretically and empirically explained by sudden increases in the profits from investments within the country. However, none of the familiar stories explains the predominant outflows of foreign investment, direct as well as indirect, that have accompanied all but the most perishable of modern growth booms. Almost from the start, these relatively durable ‘growth booms’ have featured ‘export-led’ growth; they have not featured systematically positive net inflows of either direct or indirect foreign investment. Thus, starting from abject poverty in 1948, Japan and Germany became the world’s two largest creditor nations in less than forty years. Since the early 1990s, China has similarly been generating substantial outflows of net foreign investment. While sudden leaps in domestic savings rates might explain the pattern, no serious scholar has argued that these initially quite poor countries suddenly became hyper-abstemious. What, then, was the economic shock that created these durable ‘growth miracles’? How did it generate such durably high rates of national economic growth? Why did many of the booms suddenly cease? It seems that recent literature on ‘growth miracles’ has continued an old tradition of raising more 1

2

Anatomy of a ‘Growth Miracle’

questions than it answers. The standard literature, however informative, fails to identify a systematic cause of the modern era’s repeated instances of persistent and unprecedentedly high national growth rates. A related question arises in the minds of welfare economists. Almost all authors on the subject – academic as well as lay – write approvingly of these hyper-booming, non-inflationary, economies. But these authors may be overly impressed by macroeconomic evidence, which concentrates on empirical observations of growth rates and aggregate accumulations of national wealth. Traditional microeconomic theory, or welfare economics, tells us that investment and savings subsidies decrease welfare in full-employment equilibria. Although recessionary economies may benefit from increases in domestic real investment demand, the crowding-out effects that occur in full-employment equilibria prevent us from seeing any systematic social benefits from an investment subsidy. And the welfare effects of subsidies to savings, foreign investment, or current exports feature a significant termsof-trade loss. Indeed, basic economics since the time of Bickerdike (1906) informs us that subsidizing exports, even if only indirectly, is a sure way to reduce a country’s equilibrium welfare due to the induced deterioration in the country’s terms of trade. Does a ‘growth miracle’ really increase the booming country’s ex ante welfare? Besides the above questions, the economic literature fails to note, let alone resolve, a fundamental paradox. After the USSR broke the US monopoly over nuclear weapons in 1948, we would have expected Japan and West Germany – easily the two most highly insecure and coveted neighbours of the USSR at the time – to respond to their extraordinary insecurity by saving and investing less. Traditionally, ‘borderlands’, territories lying in between two enemies, are relatively undeveloped ‘buffer zones’ because of the insecurity of investments in such regions. The heightened insecurity of post-1948 Japan and West Germany should have substantially lowered their growth rates relative to their similarly war-torn neighbours. But the opposite occurred. Savings and investment – domestic as well as foreign – dramatically increased. Despite the substantial restoration of their pre-war industrial base by 1960 and continued national insecurity from the 1960s up to the late 1980s, this exceptionally high growth continued. Why? Furthermore, once the prospective savings and investments of Japanese and German families had finally became safe from foreign confiscation with the end of the Cold War in the late 1980s, their ‘growth miracles’ abruptly died. This is the reverse side of the same paradox. Similarly, the ‘four Asian tigers’ – Singapore, South Korea, Hong Kong and Taiwan – that arose in the early–mid-1960s to rival the growth rates of Japan and West Germany were all neighbours of an increasingly expansionist China. What happened during the formative, 1958–65 period was that China introduced nuclear weapons and became much more of a military threat to her already insecure neighbours. One would think, again using

Earl A. Thompson 3

conventional economics, that these relatively threatened countries would have substantially decreased their relative savings, domestic investment and growth rates. Instead, the opposite happened. Why? Another paradox is that the classic ‘growth miracles’ arose at a time when simple economics would predict the opposite of the large export surpluses that were observed. In particular, simple economics would predict that postSecond-World-War Japan and West Germany, like Western Europe, would borrow from abroad to rebuild their decimated economies and rapidly move towards their pre-war consumption levels. Both effects would have created a large balance-of-trade deficit and influx of foreign investment. The opposite of these domestically efficient changes occurred in the growth-miracle countries. Why? ‘Growth miracles’ and foreign investment Once we have understood the phenomenon of the modern ‘growth miracle’, we will know not to expect any such ‘miracle’ from foreign investment. In particular, once our background theory and its supporting historical evidence are explained we shall show that the premier growth miracles are the rational consequence of rationally increased outflows rather than inflows of foreign investment. We will then know that theory supports history in giving us reason to expect little in the way of ‘growth miracles’ from inflows of foreign investment. Nevertheless, inflows of FDI typically deserve a subsidy because they do generate: (1) Some, albeit relatively small, cultural and technological externalities (2) Rationally stronger military ties with the investing foreign countries. Indeed, these externalities have been almost universally responded to with subsidies to FDI (UN Conference 1998). However, observed subsidies may be too large or too small; the welfare economics that might justify further expansions in these subsidies is empirically quite ambiguous. Moreover, even if we consider only macroeconomic effects, a substantial increase in subsidies to foreign investment inflows would generate: (1) Diminishing returns in the case of heterogeneous capital and crowdingout in the case of homogeneous capital, which would almost certainly combine to prevent anything resembling a growth miracle (2) Domestic currency appreciation, which would substantially cool the underlying export boom that has been at the heart of every one of our ‘growth miracles’. We must, of course, consider the largely ill-fated, Southeast Asian and Latin American high-growth experiences that concentrated from the collapse of

4

Anatomy of a ‘Growth Miracle’

the Soviet Union in the mid–late 1980s until the mid–late 1990s. These investment and export booms were indeed accompanied by heavy inflows of FDI. However, we shall find that these booms were endogenous effects of an adaptive expectation, especially by foreign investors, of the consequences of virtually the same government policy that had generated the earlier ‘growth miracles’. These temporary booms were fuelled by expectations of ‘growth miracles’ that were largely erroneous because, as we shall see (pp. 18–19), the later counties had much different underlying capacities for economic development than the earlier ones. What disappointed these expectations was a lack of recognition of the fact that the longer-term macroeconomic effects of ‘growth-miracle’-inducing policies depend critically upon the characters of the underlying societies. Without understanding this dependence, one cannot understand why most of these countries did not – and, even after full recovery, will not – macroeconomically respond well to the ongoing policy. Consequently, policy makers who – out of external pressure or a misapplication of macroeconomics – desire to create such ‘miracles’ had best delve more deeply into the classic ‘growth miracles’. For most of the world’s nations, such miracle-imitating policies are not only both microeconomically and macroeconomically harmful; they are typically quite politically disastrous. Dependency, tariff-rationalizing externalities and economic ideology Comparison with the conventional economic model Our rationality-based explanation of ‘growth miracles’ will necessarily take us beyond conventional economic theory. Nevertheless, the only thing unconventional about our economic model, besides our assumption of the economic rationality of the policy-makers of the world’s less-developed countries (LDCs), is our introduction of an externality that is ignored in conventional theory. Despite the easily demonstrated realism of the externality and corresponding generalization of standard theory, the theory will not sit well with conventional or establishment economists, who are typically unwilling to accept the economics-depreciating consequences of recognizing the existence of this externality. Nevertheless, we shall see that if economists had acknowledged this externality, and correspondingly understood the way that it has influenced modern international institutions, international economics today would be an entirely different subject. And the highgrowth economies featured in this chapter would have been readily predicted rather than amazing economists into calling them ‘miracles’. Background: dependency and involuntary trade liberalization One of the remarkable features of the ‘miracle economies’ we are discussing is their dependency on the USA and western Europe. These latter, militarilydominant, countries could have efficiently imposed high protection fees on

Earl A. Thompson 5

their otherwise self-defended military inferiors and allowed them to do their own thing. However, following a policy tradition established in midnineteenth-century Japan and southeastern China, they chose instead to insist that their dependencies lower their trade barriers, thereby opening up trade opportunities that had previously been restrained by very high tariffs. The fact that these early incidences of externally imposed trade liberalization arose during a period in which the West was captured by Classical economics indicates what we shall confirm below, that ideology rather than objective thought has been the basic source of free-trade-inspired policy impositions. The dependent countries may have had good economic reasons for their previously high tariffs. Chapter outline Section 2 indicates that the dependent countries have indeed had very good, externality-internalizing, reasons for their high-tariff policies. Section 3 examines the issue of externally imposed trade liberalization in the postFirst-World-War, post-Second-World-War and post-Cold-War contexts in which free-trade imposition became increasingly institutionalized in the West. In particular, it describes the optimal, and immediately observed, response of Western dependencies to the hegemon’s imposition of artificially low tariffs. This response is to adopt current-account foreign exchange controls in which rations of import licences duplicate the price and quantity effects of the original tariffs. The effect of these import exchange controls is to maintain the country’s currency at its original, pre-tariff reduction, value rather than having the currency fall with the increased import demand that would otherwise have been occasioned by the tariff reduction. Indeed, the official excuse for employing these import licences is to prevent the underlying excess demand for foreign currency from reducing the country’s initial, typically pegged, currency value. Although exchange controls are somewhat more costly to impose than tariffs so that slightly freer trade arises, we can hardly expect the Western hegemons to passively accept this import–exchange-control reaction to their imposed tariff reduction. The hegemons’ typical reaction is to insist – often successfully – that the dependents depreciate their ‘overvalued’ currency in order to create market-clearing currency prices. But an identifiable group of dependents will predictably resist the intended trade expansion by increasing their money supplies, which works to restore the original, lower, foreign exchange revenues by raising the costs of their exporters and thereby works to again restore the original equilibrium. This leads the Western hegemons to insist on another currency devaluation, which induces another currency expansion, etc. until the marginal cost of inflation through resource costs to the dependent country rises to where it is equal to the marginal benefit of inflation through its trade-discouraging effect. The result is stable,

6

Anatomy of a ‘Growth Miracle’

rational, hyperinflation. Other, more trade-tolerant, countries substantially accommodate the early devaluation requests in order to avoid this costly resolution of the conflict with the hegemon. Section 3 also points out that there is an exceptional case in which the free trade-imposing hegemons simply insist that a dependent country never employ exchange controls. If the dependent country also possesses a very high defence externality, the only way it is going to be able to discourage consumer durable imports is to make them expensive by creating an artificial scarcity, an artificially high market price, of foreign currency. Since it is better to earn interest on a foreign currency than simply to hoard it, this amounts to a policy that induces the country to choose artificially high outflows of foreign investment. This simultaneously induces the country to adopt artificially high savings rates. With the country’s additional savings going into foreign investment, the country is protected against diminishing returns and can go on productively investing until it becomes a dominant force in the world market. At the same time, the induced export boom and low real wage rates, although welfare-decreasing, complement the savings increase with an increase in profits and aggregate demand that supports a virtually continual macroeconomic boom. Section 4 then shows that such dependents, who again are not given the opportunity to overvalue their currencies by employing current-account exchange controls, do indeed restrict their imports by significantly undervaluing their currencies. This second-best, loss-minimizing, strategy – which requires the dependent country to radically increase its foreign investment levels – creates a ‘growth miracle’. Section 4 discusses these cases at length. For now, simply consider the above-mentioned example of the free trade impositions on various nineteenth-century Chinese and Japanese coastal regions. Exchange controls were simply not employed prior to the First World War. Hence, these regions could respond only by greatly increasing their levels of foreign investment, thereby rationally generating the precursors of our post-Second-World-War ‘growth miracles’, the most recent examples of which are present-day China and India. Section 5 explains the 1990s temporary Southeast Asian and Latin American, booms as an application of the above theory of externally induced currency undervaluation. Nevertheless, in contrast to China and probably India, we find that a long-term accumulation of extraordinary national wealth is not available to most of these countries for they lack a basic ethical precondition for achieving a high level of economic development.

2

Defence externalities and optimal tariffs

Critique of the conventional economic analysis of free trade The near-universality of effectively high tariffs by dependent nations has been traditionally taken by economists and other social thinkers to be a

Earl A. Thompson 7

reflection of: (1) The inefficient political influence of special economic interest groups (2) The unavailability of more efficient, first-best, modes of taxation (3) Widespread economic ignorance. However, as elaborated in Thompson and Hickson (2001:106–9), none of these tariff rationalizations is defensible. Regarding the political influence rationalization, high tariffs have often been regularly imposed upon imports for which there is no obvious protective effect (i.e. no clear import substitute) and correspondingly, no identifiable political support from an economic interest group. Moreover, political structures vary dramatically over time and location; yet tariffs have remained a stable, virtually universal, institution for several thousand years. Finally, there is no reason for domestic interest groups to take their political transfers in a systematically inefficient form, especially when lump-sum transfers are readily available. Regarding the second-best taxation argument (or ‘revenue argument’) for tariffs, numerous non-protective tariffs have also been regularly prohibitive, generating no tariff revenue whatsoever for the tariff-imposing country. And theoretically first-best taxes such as land taxes are abundantly available but seldom employed by national governments even when populist political pressures support the adoption of such taxes. The only inference remaining in the standard set is that the tariff-imposing countries are systematically ignorant. However much comfort such an inference may give to the sellers of economic ideology, a universally observed policy cannot have evolved in widespread ignorance of the benefits of a policy alternative when, in fact, that alternative has been repeatedly tried. In short, none of the conventional tariff rationalizations is defensible. An alternative, efficiency-based, defence externality theory of tariffs The alternative theory of international trade and finance developed in this chapter is based on the easily established phenomenon of ‘defence externalities’. These externalities arise whenever a state accumulates capital that is coveted by potential aggressors against the state (Thompson 1974, 1979). When an individual in the state accumulates coveted capital, she imposes a cost on the state, which must then expend additional resources on military defence in order to maintain the security levels of others in the state. This externality rationalizes virtually the entire structure of our evolved national income tax structures along with its numerous exemptions and ‘loopholes’ (Thompson 1974, 1979), and the broad history of taxation as well (Thompson and Hickson 2001, chapter 3). The latter study (especially pp. 172–86), on which the current subsection is about to heavily draw, rationalizes the structure and broad history of tariffs. Tariffs are an optimal way for a country to internalize the defence externalities resulting from the importation of consumer durables.

8

Anatomy of a ‘Growth Miracle’

Consumer-durable imports should be taxed because they: (1) Add to the country’s coveted capital stock and therefore its overhead defence costs (2) Cannot be practically taxed to internalize this negative externality with anything other than an import tariff.1 Producer-durable imports, the taxes on which have been rarely significant (Taussig 1892; Bhagwati 1978), do not call for a tax because the country’s domestic income or wealth tax already internalizes the defence externalities with respect to such capital. The reason this optimal tariff argument is not applied to imports of perishable consumer goods is simply that there is no defence externality for consumer perishables, which do not exist long enough to attract potential aggressors against the state. Correspondingly, peacetime imports of almost all consumer perishables, like industrial machinery, have almost always received extremely lenient tariff treatment. (Also, peacetime tariffs on raw material imports, which are not expected to remain in that form for long, have uniformly been way below the tariff rates on the finished consumer goods producible from these materials (e.g. Yeates 1974).) Consumer durables are thus the only goods that have historically borne significant tariffs! Certain regions of the world are unusually secure. They can accumulate capital without fear of attracting military aggressors. Very low profits taxes and tariffs are appropriate for such regions. Here, as in the medieval trade fairs, seventeenth-century Amsterdam and various modern ‘freeports’, we do indeed find very low profits taxes and tariffs, and initial growth to the point of very high ground rents in the secure area. Such regions are predictable centre of free trade and wealth. In contrast, governments facing very high defence externalities would not survive long without high profits taxes and high effective tariffs; they would so overaccumulate capital that they would soon fall easy prey to military aggression. Significant trade restrictions are vital to the survival of governments with very high defence externalities. Creating a centre of high growth and wealth out of a region with a very high defence externality, now that is a ‘miracle’, the one we’re about to explain.

3 The external imposition of low tariffs: cause and effects The cause Colonization, where a dominant country manages and defends a dependent territory, seldom means that the dominant country will impose low tariffs on foreign imports into the colony. Any expansion of capital within the empire means more defence effort by the dominant country. Nevertheless,

Earl A. Thompson 9

trade between a colony and a dominant country is typically quite free. The dominant country defends the capital wherever it is located within the empire; so total defence costs are not significantly affected by a relocation of property within the empire. However, a dependent country may have to supply its own defence against the military threats of other countries. This normally occurs when a colony is ostensibly ‘freed’ by its dominant country or when a country loses a war to an aggressor that chooses not to occupy the loser. The efficient response by the dominant country is to collect lump-sum rents from the dependent countries and allow the dependents to raise their own tariffs, except that tariffs against imports from outside the sphere of influence should also be added by the dominant country to reflect its cost of aiding in the defence of the dependent. However, free trade ideology may reverse this optimal policy. In particular, the dominant country may eschew the lump-sum protection payments in favour of inducing the dependent to charge lower overall tariffs. Although inefficient, this does expand the market for the dominant country’s exports (thereby generating a benefit through uniformly superior terms of trade) and makes the dependent pay by depreciating the latter’s terms of trade and imposing higher defence costs on them. (Also, if the dominant country is an exporter of military equipment or emergency aid to the dependent, then the trade-induced increase in the insecurity of the dependents increases the demand for the hegemon’s military outputs.) Nevertheless, this ideologically inspired policy is not an efficient way to collect rent. The initiating post-First-World-War policy imposition The ideologically inspired ‘Versailles system’ imposed such inefficient rents upon the losing countries at the end of the First World War. While granting substantial autonomy and self-defence responsibilities to the defeated nations, the new hegemons imposed artificially low import tariffs upon them. The designers of the system employed economic ideology to rationalize it as beneficial to all countries despite the hegemon’s obviously redistributive terms-of-trade benefits from its external imposition of artificially low tariffs and the induced increase in the defence costs of the nowdependent nations. Except for a temporary hiatus – the uniquely successful Dawes Plan era from 1924 through 1927, during which lump-sums were paid to the dominant countries out of tariff revenues so that they had a unique incentive to relax their ideological impositions and permit significantly higher tariff rates – post-First-World-War Europe suffered from the dependents’ subsequently high costs of avoiding these tariff reductions and increased defence expenditures, which were surely contributing causes of the Second World War. Despite these negative experiences, ideology is a powerful force, one that does not objectively respond to experience; the hegemons’ imposition of artificially low tariffs on dependent nations rapidly spread to other ostensibly independent nations after the Second World War.

10 Anatomy of a ‘Growth Miracle’

This policy expansion worked by inducing other nations to adopt artificially low tariff schedules in return for the right to export to the dominant countries as ‘most favored nations’ – i.e. without facing discriminatorily high tariff rates (League of Nations 1936). The General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO), supported by the International Monetary Fund (IMF), arose after the Second World War to further institutionalize the Versailles system. The hyperinflations, governmental repressions, costly social revolutions and frequent local wars during the subsequent, Cold-War period similarly failed to impress the leaders of the dominant countries of the high costs of externally imposed trade liberalization. Indeed, as before, the impositions increased only at the end of the Cold War as the IMF began insisting on more and more comprehensive free-trade policies from its numerous debtor nations. The basic small-country response to externally imposed trade liberalization Another novelty of twentieth-century international economics is the immediate post-First-World-War emergence of peacetime foreign exchange controls. (The relevant controls here are current-account rather than capitalaccount exchange controls; we nevertheless give them the simple label of ‘exchange controls’, where a dependent country persistently overvalues her currency and correspondingly rations the induced shortage of foreign exchange among her competing importers.) These costly controls were predictably introduced by the self-same central European dependents upon whom the First-World-War victors had imposed low tariffs. Subsequently, peacetime exchange controls also accompanied externally imposed tariff reductions in other dependent nations remaining within the capitalist sphere of influence. Clearly, these exchange controls were being adopted in order to avoid bearing the full brunt of the low tariffs that the dominant countries were imposing on them. Externally imposed trade liberalization and exchange controls have thus persisted in tandem to this date, except in certain post-Second-World-War countries, for which the dominant nations insisted on the avoidance of exchange controls by the dependent nations. Thus, as described above, when a small post-First-World-War dependent lowered its tariffs and thereby began suffering a continuing deficit in its balance of trade at its initial exchange rate, the dependent state, despite the almost universal disapproval of economists, worked to maintain rather than devalue its initial exchange rate by establishing a system of exchange controls to ration, among her existing importers, whatever foreign reserves were earned by her exporters. Like the small-country tariffs discussed above, these obviously costly, long-lamented, post-First-World-War exchange controls have largely remained an economic enigma.2 Yet the strangely ignored post-First-World-War

Earl A. Thompson 11

relationship between observed peacetime exchange controls and the external imposition of freer trade – exchange controls having consistently followed the external imposition of low tariffs – has a quite straightforward theoretical interpretation. A small country’s policy-neutralizing response to an externally imposed tariff reduction is simply to maintain, rather than devalue, her initial exchange rate. Since imports are then cash-constrained by exports because exports do not change while imports are in greater demand because of the imposed tariff reduction, imports must be rationed back to their initial level, assuming no change in loans from abroad. So, by employing an overvalued exchange rate and import rationing, the country immediately and efficiently achieves what it can no longer achieve with import tariffs. The neglect of this obvious historical regularity by leading academic economists is certainly not due to their inability to see the straightforward, Marshall-like, equivalence between tariffs and observed exchange controls (e.g. Bhagwati 1978). Rather, the neglect, including that of leading specialists in the field of exchange controls (e.g. Greenwood and Kimbrough 1987), is likely due to an unwillingness to view small-country trade restrictions as the result of an important economic efficiency. It is much more pleasant, and profitable, for economists to attribute these trade restrictions to some generally non-existent special interests or revenue effects, or some strangely universal, similarly indefensible, political-economic illiteracy. If something like a defence externality had been admitted into economic analysis, the small-countries’ polities would have had to be appreciated as remarkably efficient and hardly in need of the advice of policy economists. More narrowly focused economists, examining the empirical effects of externally imposed tariff reductions, have apparently been thrown off by the fact that the tariff-imposing countries – seeing effective tariff-restoration via exchange controls emerge from the imposition of lower tariffs – have often delayed the dependent country’s adoption of exchange controls by financially supporting their increase in import demand through temporary foreign exchange loan subsidies to the recalcitrant dependents. In such cases months, even years, may pass before the loan subsidies, which theoretically decrease the welfare of the subsidizers, cease and exchange controls emerge (e.g. Ellis 1941). Nevertheless, from the very beginning of these various post-Versailles programmes, exchange controls were almost immediately adopted by the victimized nations who were not given the benefit of foreign exchange loan subsidies. Such a policy response is, of course, a theoretically optimal response to an externally imposed tariff reduction. Mere coincidence does not explain the policy response because the return to high tariffs generated by the 1924 Dawes Plan induced the dependent nations to immediately dismantle their costly exchange control systems. Although the Dawes system was uniquely successful in collecting reparations debt and inducing Central European growth, the ideological unpopularity of this colonial-style scheme

12 Anatomy of a ‘Growth Miracle’

forced it to be replaced after 1927, under both US and League of Nations pressure, by a more ‘enlightened’ system, one that both reinforced the myth of national autonomy and reimposed lower tariffs. To support the post-1927 system (the so-called ‘Young Plan’) – i.e. to prevent a reintroduction of exchange controls – temporary foreign exchange loans from the promoters of the ‘enlightened’ system were extended to Central Europe. The escalating accumulation of these loans had to come to an end, which it did in the middle of 1931. After France’s highly publicized refusal of another loan increase and the immediate failure of the Austrian Credit-Anstalt banix, exchange controls were – within days (Ellis 1941) – reintroduced throughout central Europe! Economists examining the welfare effects of trade liberalization have been similarly thrown off by the related fact that the empirically measured social benefits of a loan-subsidized free-trade policy are generally quite positive in the short run. The small-country costs of a continually excessive importation of coveted consumer goods show up, as we have seen, only in the form of future military problems and political instability. Indeed, the main ostensible beneficiaries of continuing foreign exchange loan subsidies (Central Europe from 1927 to 1931 (Ellis 1941) and the Middle East, Africa, and Latin America after the early 1960s (De Vries 1987), all subsequently suffered relatively extreme military problems and political instability. Besides the nineteenth- and twentieth-century military and political evidence, and the simple financial evidence (where exchange controls or temporary foreign currency loans immediately follow the external imposition of tariff reductions), there is an additional, structural, tip-off that observed exchange control systems are nationally efficient, policy-substitution-based, small-country responses to externally imposed tariff reductions. It is that the only imported goods facing substantial import licence fees, like the only good facing substantial tariffs, are consumer durables (Bhagwati 1978). The dominant country reactions and their consequences The usual reaction of the dominant countries to the adoption of exchange controls by a dependent country is to withhold some defence benefit, typically an emergency line of credit, from the country unless it devalues her currency. This has been chiefly done by the IMF. Soon after the country devalues, its line of credit is extended. But, once this occurs, it ratchets up its money supply by an amount exceeding the original devaluation rate in order to compensate for the increased flow of imports that immediately followed the imposed devaluation, thereby overvaluing its currency by even more than the original overvaluation. Of course, the IMF soon requests another, larger-than-original, devaluation, which may be followed by another, even larger, money supply increase, etc. Hyperinflation is the inevitable consequence.

Earl A. Thompson 13

In view of this, those countries unwilling to the bear the costs of this economic war with the IMF will simply accede to the IMF’s requested devaluation, import more, increase their defence expenditures and harbour a grudge over the external policy imposition. Other countries, because of their high defence externalities, cannot afford this luxury. Their successive devaluation and inflation rates will continue to increase until the domestic resource costs of inflation are so large that the dependent country’s percentage increase in the money supply is equal to the percentage devaluation rate. At this, very high, equilibrium inflation rate, the country winds up acceding to some increase in imports (the free trade amounts that occur in between the announced devaluation and before the next jump in the price level) but not to the full free trade equilibrium (because the dependent achieves its desired import flow in between the jump in its price level and the next devaluation). The above discussion does not predict either abnormally high growth or abnormally productive foreign domestic investment. What it does instead – besides supplying us with a very large control group of normally growing countries – is enable us to understand the systematically rational extent to which small countries respond to the external impositions of low tariffs on them. Once we appreciate this, we are ready to appreciate the exceptional case that systematically generates growth miracles. An exceptional case A possible reaction of the hegemons to the anticipation of these responses to their imposed tariff reductions is to simply prohibit the dependent from adopting current-account exchange controls. This reaction arose with respect to post-Second-World-War Japan and Germany, to whom such exchange controls, normally a highly valuable complement to a state’s emergency defence efforts, were obsolete because they could not significantly defend themselves against a covetous neighbor. Similarly, while China was developing her nuclear weapon capability from 1958 to 1965, the IMF induced China’s suddenly insecure neighbours – Taiwan, South Korea, Hong Kong and Singapore – to eliminate their current-account exchange controls. Other regions that may have been just as dependent for their defence on Western powers have not been stripped of their capacity to employ exchange controls. The obvious examples are Mexico and Central America. The geographical proximity of these regions to the USA has resulted in ideologically controlled or puppet governments rather than prohibited exchange controls. Along with such governments comes freer trade and extreme political repression to prevent the revolution that would almost surely arise without it. The lacklustre economic performance of these politically unpopular dependents alone is evidence for the inadvisability of free trade policies to them. Free trade does not make a ‘growth miracle’.

14 Anatomy of a ‘Growth Miracle’

In any case, as noted above, if a country must charge inefficiently low tariffs and cannot use exchange controls to overvalue its currency, its only remaining option is to undervalue its currency. It does this by controlling the foreign exchange market and using domestic subsidies to artificially increase outflows of foreign investment to where domestic consumers must pay very high prices for foreign goods. The domestic macroeconomic effects are to create durable booms in both export- and import-competing industries that accommodate the increased savings and an increase in the labour force because of the lower real wage. Moreover, there is a continual wealth expansion without suffering the diminishing returns and real wage expansions that would quickly cool down a domestic investment boom. So the boom can continue until the country has itself become a major force in the world investment market. However, certain countries are simply unable to represent or internally defend the interests of successful investors against extortionary domestic attacks. These countries have a very poor record of wealth accumulation. Eliminating exchange controls, which we shall see induces extremely high savings in such countries, would be counterproductive because the savings would be largely spent on internal rent-seeking. The ‘growth miracle’ countries all had demonstrated the ability to represent and internally protect the interests of large concentrations of wealth. This ethically-determined ability is clearly a necessary condition for producing a ‘growth miracle’. We shall return to this when we discuss more recent attempts to create growth miracles in Section 5.

4 West Germany, Japan and the Asian ‘tigers’: ‘economic miracles’ West Germany and Japan West Germany and Japan’s post-Second-World-War voluntary currency undervaluations and corresponding import restrictions could be achieved only by governmental creation of an artificial scarcity of foreign exchange. And, indeed, an undervalued exchange rate through a continual domestic subsidy to capital-account imports, a subsidy-induced surplus in the dependent country’s balance of trade, was the explicit policy of West Germany and Japan throughout the Cold War, 1948–88 (e.g. Reuss 1963:54–65 and Minami 1986:242–4, respectively). Of course, capital-account foreign exchange controls were, of necessity, used to prevent a re-importation of foreign exchange through foreign borrowing. Governmental policies inducing capital-account imports, usually in the form of outflows of indirect foreign investment, ‘or capital flight,’ were staple policies of both Japan and Germany. Given the military insecurities and correspondingly large defence externalities within these countries, it should be clear that they wanted to avoid the consumer-durable imports that they would otherwise have suffered under the low import tariffs that were externally imposed on them.

Earl A. Thompson 15

Nevertheless, currency undervaluation – to the dependent country – is extremely welfare-inferior to the overvaluation and exchange control policy permitted to so many other countries. For one thing, currency undervaluation fails to distinguish between the targeted consumer durable imports and all other imports. It thereby inefficiently restricts the country’s imports of consumer perishables and producer goods. For another, currency undervaluation represents an unjustified subsidy to national savings. Finally, as would any subsidy-induced increase in exports, currency undervaluation amounts – again using the Bickerdike (1906) theorem – to an unambiguous terms-of-trade and corresponding welfare loss to the subsidizing country. Although corresponding benefits accrue to the rest of the world in the form of artificially low prices of imports from West Germany and Japan and artificially high supplies of savings and effort from those two countries, lump-sum transfer mechanisms (like the post-First-World-War Dawes Plan) would – under normal circumstances – alternatively generate higher utilities for all concerned. The unusual circumstances that led the immediate postSecond-World-War USA to rationally prefer the undervalued currency solution is identified later. Perhaps the most interesting feature of this predictable sequence is the tremendously high regard that economists have expressed for the economic performance of these unusually high-savings, high-growth, economies. Although the popular press may be forgiven for failing to adequately discount future consumption, it is not immediately clear why economists – many of whom are very well aware of the abnormal West German and Japanese post-1945 savings and investment subsidies – would abandon welfare economics for naive comparisons of growth rates. A quantitative welfare analysis of these savings and investment subsidies may be enlightening: First, up to the late 1980s, the various, US-induced, post-1948 German and Japanese investment subsidies, including the balance of trade surpluses and corresponding governmental subsidies to foreign investment, led these countries to save at rates that are more than twice their normal rates. (This is revealed by comparing each country’s comparative savings rates in the early 1900s with their comparative post-1948 savings rates (see, e.g. King and Fullerton 1984 and Minami 1986, respectively).) Second, again up to the late 1980s, since the financing of these various savings and investment subsidies came from income taxes (rather than fiscal deficits and national borrowing), consumer liquidity was directly sacrificed to generate the increase in savings. This means that the typical consumer discount rate, which is at least twice the investor discount rate, is the relevant rate of discount to apply to the induced investment.3 The welfare loss from the excess investment, the appropriately discounted present cost of the induced investment, is therefore at least as large as the present value of their normal quantity of aggregate investment. Thus, in welfare terms, the adult postSecond-World-War citizens of these countries were made worse off than if

16 Anatomy of a ‘Growth Miracle’

they had saved and invested at their normal rates but the total returns from these investments were completely confiscated! An important underlying advantage to the USA from vigorously promoting these artificial investment stimuli, promotions that arose immediately after the USSR displayed their highly aggressive, nuclearly supported, intentions in 1947–8, was to furnish the victorious Allies with a rich and highly locationally convenient pair of ransom payments in case the balance of power shifted to the USSR, which it never did. Nevertheless, given the insecurity of post-1948 Germany and Japan, the unusual prohibition of exchange controls imposed a substantial burden on their citizens, whose military insecurity and correspondingly high defence externality would, as pointed out above, have led them to save at subnormal rates if they had not been externally induced to do the opposite. It is this potential ransom payment that rationalizes why the USA would induce such heavy investments in regions bordering and highly coveted by their primary Cold-War enemy. With respect to distributional justice, the blameless descendent populations of these two, consumption-starved, ex-aggressor nations now stand to benefit handsomely from the cumulative realizations of these savings policies and the 1990 dissolution of the once-threatening USSR. The predictable, eventually welfare-enhancing, reductions in the domestic Japanese and German foreign investment subsidies and their corresponding reduced growth rates during the suddenly secure 1990s has been similarly mis-portrayed by economists as economically unfortunate, ‘miracle-ending’, events.4 (While it has long been clear to almost everybody that these countries should have switched to a loose money regime in order to prevent a recessionary adjustment as they were pulling back on their foreign investments in the late 1980s, their inability to do so is evidence that their policy-makers had been succeeding despite a highly incomplete understanding of ordinary macroeconomic processes.) The four Asian tigers Somewhat later than the USSR, Communist China became a Cold-War threat, to both the West and to their neighbours. Thus, while Mao was developing a nuclear arsenal to complement his militarily aggressive stance during from 1958 to 1965, the Western powers converted several of China’s smaller neighbours (Taiwan, South Korea, Hong Kong and Singapore) into Japanese and German-type centres of savings-induced wealth creation, again through a policy forcing these suddenly high-defence externality nations to avoid exchange controls and thereby rationally undervalue their exchange rates (Haggard and Pang 1994; Cumings 1997). Since China has remained somewhat of a military threat despite the break-up of the USSR, the savings and growth rates of the ‘four Asian tigers’ has remained relatively high. It might be thought that the FDI that these export booms often attract would work to perversely increase the nation’s coveted capital stock. However,

Earl A. Thompson 17

since foreign investors involve their home nations in protecting their investments abroad, there should be no presumption of increased domestic defence costs stemming from such investment. Although domestic investment also expands during these booms, such investment is cost-justified because domestic investors compensate their nations for the extra defence costs with high domestic capital and income taxes. Taiwan and South Korea, the most responsive to US policy pressure, have set the pattern for the other ‘tigers’. Thus, after the USA finally forced an end to both Taiwan and South Korea’s overvalued exchange rate policies in 1960, a new pragmatic industrial policy almost immediately arose, one which, quite appropriately, directly subsidized foreign capital-intensive export industries (Haggard and Pang 1994; Cumings 1997, respectively). The initiating jumps in the domestic prices of dollars amounted to the same sort of currency undervaluations that appeared in Japan and Germany, the implicit purpose of which was to reduce the imports of consumer durables to acceptably low levels. Predicting ‘growth miracles’ Note that Germany, Japan, and the four Asian tigers had all experienced substantial economic success prior to the Second-World-War. They had, in particular, revealed that they possessed the cultural prerequisites for high levels of economic efficiency. These prerequisites are: (1) A sensitivity of the state’s regulations to the expressed interests of its investors (2) A bureaucracy ethically dedicated to executing the rules of the state rather than some other concept of efficiency or justice (Thompson and Hickson 2001:12–50). Prior to the externally imposed exchange control eliminations that initiated their off-the-charts growth rates, these countries had established themselves as capable of generating high levels of economic efficiency and development. The foreign investment subsidy induced by the elimination of a country’s right to employ current-account exchange controls would have largely been offset by domestic rent-seeking if these countries were incapable of defending the regulations and rights incidental to high levels of economic development. It is therefore likely that the affected nations would not have continued to accept the elimination of their exchange controls unless they found themselves capable of productively responding to the demands that an undervalued currency placed on an economy. Overinvesting is far more tolerable when it generates abnormal growth than when it generates abnormal domestic rent-seeking. Perhaps the best example of a poor region that has historically shown itself to be culturally capable of extremely high levels of economic development is Mainland China.

18 Anatomy of a ‘Growth Miracle’

5 Recent ‘miracles’ China and India The failure of Communist ideology on Mainland China led to a highly pragmatic regime in 1979. FDI was encouraged, which brought in Western technology throughout the 1980s and generated a moderate export surplus and visible economic success. Then, in the early 1990s, to gain access to the markets of a developed world that was quite wary of dealing with a large, mainly Communist country, China put itself in the role of a highly dependent state. Like the above dependents, China accepted tariffs that were much lower than it wanted given the state’s high defence externality, obviously due to the continuing threat of political revolution. And, again to obtain the acceptance of the developed countries, China’s current-account exchange controls weakened in the early 1990s and, by 1994, were replaced by a substantial undervaluation of the currency. The artificially high foreign investment and savings rates after the early 1990s produced the now familiar nearly double-digit growth rates, and should continue to follow this ‘growth miracle’ path until it returns to at least the kind of equality it had with the developed nations of the West prior to the early–mid-nineteenth century arrivals of the Western hegemons. Although quantitatively somewhat less dramatic, a similar story applies to India, which similarly accelerated her foreign investment, currency undervaluation response to increased trade liberalization in the early 1990s. The induced increases in her savings and export rates stimulated a remarkably stable 5–7 per cent growth rate for over a decade now. The Indian ‘minimiracle’ shows no signs of decreasing.5 Southeast Asia and Latin America Based on the growing relative military strength of the USA, the late 1980s saw the emergence of a new IMF policy. Many discretionary IMF loans came to be conditioned upon entire fiscal and monetary packages that explicitly limited the dependent countries’ use of exchange controls. The new policy amounted to a widespread elimination of the previous freedom of IMF borrowers to employ exchange controls to neutralize unwanted tariff reductions and was partially responsible for the generally sharp reduction in exchange controls in the early 1990s (IMF 1976–94). So a large number of borrowing, high-defence externality, states were suddenly in the same boat as China, and earlier, West Germany, Japan and the four ‘Asian tigers’. While maintaining the import licence fees offered by exchange controls as much as they could without losing their loan eligibility, the borrowing, high-defence externality, states of Southeast Asia and Latin America began to use some of their export revenues to purchase investments abroad, thereby creating the beginnings of artificial savings and export booms.6

Earl A. Thompson 19

The experiences of these new potential ‘growth miracle’ countries were distinct from the earlier experiences of Japan, Germany and the four Asian tigers. For investors in the new foreign-investing countries had learned, or thought they had learned, from the experiences of the similarly foreigninvesting ‘growth miracle’ countries. Moreover, the IMF had begun to endorse foreign financial participation in the newly induced expenditures on capital imports. The result was a temporarily very high foreign demand for certain Southeast Asian and Latin American currencies to accompany the waves of supposedly informed speculative foreign investment. This temporary currency demand substantially delayed the real depreciations of these currencies. (While it is likely that the foreign investors had always expected the devaluation, for such devaluations had characterized the earlier ‘growth miracles’, it is not likely that they were aware of the cultural conditions for sustained high growth. In this sense, the investors were behaving under adaptive rather than rational expectations.) A concurrently predictable consequence of the multi-country export boom is an induced deterioration in their common terms of trade, an end to the widespread inflows of foreign direct, the inevitable devaluation and a corresponding jump in real indebtedness in a 1990s ‘debt crisis’ that modern authorities have unanimously misattributed to basic structural financial variables and an irrational ‘herd effect’ or Keynes’ ‘animal spirits’. As these counties export their way out of their massive debts and face an uncertain economic future, it is well to keep in mind that we have not seen one ‘growth miracle’ country achieve a highly developed condition that had not previously achieved such a condition. Many states, including most in Southeast Asia and Latin America, have yet to achieve a high level of economic development and should not be expect to do so without first developing the cultural conditions appropriate to such a state. In sharp contrast, China and India, which similarly benefited from the influx of FDI prior to 1997, were not hit hard by the loss of this inflow because they had only to liquidate some of their rationally heavy foreign investment positions in order to substantially offset the reduced inflow. High savings and growth works for China and India because their cultural histories have supplied them with a political ethic that is responsive to the expressed interests of their investors and an educated bureaucracy that greatly respects governmental rules.

6 Conclusion A nation’s optimal savings rate is dictated by the preferences that are registered in the political and economic institutions of that nation. Accepting these preferences, economists should not recommend that these nations work to fulfil the conditions of a modern ‘growth miracle.’ The excessive sacrifices made by these countries were artificially imposed on them by ideologized countries or Cold-War hegemons. The crude modern version of creating

20 Anatomy of a ‘Growth Miracle’

such a miracle that asks a country to sacrifice in order to attract very high inflows of FDI is a recipe for debt and certain disappointment. The much more accurate version, which asks the country to sacrifice by heavily and continually investing in foreign countries, thereby generating an export-led growth boom, is not advisable from the standpoint of welfare economics and not even advisable from a macroeconomic standpoint unless there is a sound basis for believing that the country possesses the cultural prerequisites to sustain a high level of economic development. Notes 1. Personal property taxes, general taxes on consumer-owned stocks of consumer goods, have always been prohibitively unpopular due to their corruption-inviting and privacy-invading effects. Even so, luxury consumption taxes, which would apply to all sales of consumer durables, domestic as well as foreign, would be theoretically preferable to import tariffs in a standard competitive model. This is called-for in the Conclusion of Thompson (1974). It was not until the mid-1980s, when a consistent theory of retailing (‘monopolistic competition’) was produced (Thompson et al. forthcoming), that I came to see the substantial lack of realism in the standard competitive model as regards goods produced for a local market. Such goods are rationally tailored to local tastes rather than made relatively homogeneous for sale in the wider export market. The former products require more quality refinements and retailer explanation than the latter, more homogeneous, products. The result is a much higher retail markup, or excess of price over marginal cost, for locally produced goods than for imports. With the retail markup serving as a substitute for a tax on domestically marketed consumer goods, the only justifiable consumption tax is on imports of consumer durables. 2. The usual rationale for exchange controls, that differential import license fees are a convenient way to interpersonally price discriminate between different foreign buyers (e.g. Ellis 1941 or Bhagwati 1978), does not apply to small countries. Besides, differential tariffs to different importers are at least as convenient as sales of import licences. In fact, such discriminatory tariff reductions – in preference to discriminatory import licence fees – are regularly granted to members of defence alliances, for whom the relocation of a consumer good within the alliance is of little military consequence, and therefore of little tax consequence in an efficient alliance. 3. We could arrive at the same conclusion that we are about to reach by alternatively assuming perfect capital markets and reasonable variations in the marginal costs and benefits from the consumer sacrifice. 4. The reason for the qualification with respect to the welfare benefits (that they are ‘eventual’) is that the recessionary macroeconomic effects of the reduction in exports should have been – but were not – accompanied by expansionary monetary policies. As a result, a large part of the observed reductions in Japanese and German growth rates represent real economic losses. Rational economic policy thought offers no explanation for the inability of these countries to switch to expansionary monetary policies to combat their now-quite-lengthy recessions. What does explain this policy anomaly are the special constraints on banking institutions (hyper-creditor domination) that both countries had evolved to support their undervalued exchange rates. (Short-term inflation increases import demand and reduces export supply and thereby reduces the initially optimal degree of

Earl A. Thompson 21 domestic currency undervaluation at the fixed exchange rate.) The backward-looking leaders of these essentially pragmatic countries simply see no reason to scrap the monetary institutions that served them so well for so long a time. 5. An exaggerated element of these growth rates results from the fact that an abnormal expansion in the market sector of these economics attract a substantial influx of people from subsistence agriculture and the underground economy, individuals whose incomes had not appeared in the country’s national income statistics. One reason these high growth rates should be expected to gradually decline is that the size of these sectors gradually declines. 6. The standard, textbook treatment of the Southeast Asian Boom of the 1990s is that these countries, in accepting lower tariffs and weaker exchange controls have simply chosen to accept the path of trade liberalization (e.g. Caves, Frankel and Jones 1996). Nevertheless, at least one official source reports that these booms were accompanied by such large export surpluses that total consumer imports substantially fell in the 1990–6 period (United Nations 1998).

References Bhagwati, J., The Anatomy and Consequences of Exchange Control Regimes, New York, Ballinger, 1978. Bickerdike, C.F., ‘The Theory of Incipient Taxes’, Economic Journal, 16(64), 1906, 529–35. Caves, R.E., Frankel, J.A. and Jones, R.W., World Trade and Payments, 7th edn, New York, HarperCollins, 1996, 322–8. Cumings, B., Korea’s Place in the Sun: A Modern History, New York, Norton, 1997, 308–18. De Vries, M.G., Balance of Payments Adjustment, 1945–86, Washington DC, IMF, 1987. Ellis, H.S., Exchange Controls in Eastern Europe, Cambridge, MA, Harvard University Press, 1941. Greenwood, J. and Kimbrough, K., ‘An Investigation in the Theory of Foreign Exchange Controls’, Canadian Journal of Economics, 20(2), 1987, 271–88. Haggard, S. and Pang, C.K., ‘The Transition of Export-Led Growth in Taiwan’, in J.D. Auerbach, D. Dollar and D.L. Sokoloff (eds), The Role of the State in Taiwan’s Development, New York, M.E. Sharpe, 1994, 74–83. International Monetary Fund (IMA), Annual Report on Exchange Rate Arrangements and Exchange Restrictions, Washington, DC, IMF Publication Services, 1976–94. Kim, J. and Lau, L., ‘The Sources of Economic Growth of East Asian Newly Industrialized Countries’, Journal of Japanese and International Economies, 8, 1994, 235–71. King, M.A. and Fullerton, D., The Taxation of Income from Capital, Chicago, University of Chicago Press, 1984, chapter 5. League of Nations, Report by the Economic Committee of the League of Nations, Geneva, 1936, 5–25. Lucas, R., ‘Making a Miracle’, Econometrica, 61(2) 1993, 251–72. Minami, R., The Economic Development of Japan, London, Macmillan, 1986, 203–17. Radelet, S. and Sachs, J., ‘The East Asian Financial Crisis: Diaynais Remedies Prefect’, Brookings Papers on Economic Activity, 28, 1998, 1–74. Reuss, F., Fiscal Policy for Growth without Inflation, Baltimore, MD, Gouches College, 1963. Taussig, F. W., The Tariff History of the United States, New York, Putnam, 1892. Thompson, E., ‘Taxation and National Defence’, Journal of Political Economy, 82(4), 1974, 755–82.

22 Anatomy of a ‘Growth Miracle’ Thompson, E., An Economic Basis for the ‘National Defense Argument’s for Protecting Certain Industries’, Journal of Political Economy, 87(1), 1979, 1–36. Thompson, E. and Hickson, C., Ideology and the Evolution of Vital Institutions, 2nd edn, Boston, Kluwer, 2001. Thompson, E. et. al., A Reconstruction of Economic Theory, III, forthcoming, chapter 6. UN, World Economics and Social Survey, 1998, New York, United Nations, 140–3. UN Conference, on Trade and Development, World Investment Report, 1998: Trends and Determinants, New York, United Nations, 1998, 55. Ventura, J., ‘Growth and Interdependence’, Quarterly Journal of Economics, 112(1), 1997, 57–84. Yeates, A.J., ‘Effective Tariff Protection in the United States, the European Community, and Japan’, Quarterly Review of Economics and Business, Summer 1974, 47. Young, A., ‘A Tale of Two Cities; Factor Accumulation and Technical Change in Hong Kong and Singapore’, NBER Macroeconomics Annual, Cambridge, MA, MIT Press, 1992. ———— ‘The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience’, Quarterly Journal of Economics, 110(3), 1995, 641–80.

2 Foreign Direct Investment: A Brief Overview of the Micro Issues Sumon Kumar Bhaumik

1

Introduction

During the 1960s through the 1980s, economists debated ad nauseum whether or not a country should pursue export oriented policies. Countries such as South Korea, Thailand, Malaysia and, of course, Japan were cited as examples of export-led growth, and countries such as India were urged to replace their policies of import substitution with outward orientation. This debate culminated in the General Agreement on Tariffs and Trade (GATT), with the general consensus that trade was good for economic growth. Since the 1990s, however, the emphasis has shifted from export orientation as such to the phenomenon of foreign direct investment (FDI). There is less discussion today about China’s huge trade surplus, for example, than about the fact that, depending on the estimation methodology, China attracts USD 40–60 billion per year in FDI. There is good reason for this shift in emphasis. According to the World Investment Report 2002 (UNCTAD 2002), as of 2001, there were 65,000 multinational corporations (MNCs) in the world, with about 850,000 affiliates around the world. ‘In 2001, [these] foreign affiliates accounted for 54 million employees, compared to 24 million in 1990; their sales of almost $19 trillion were more than twice as high as world exports in 2001, compared to 1990 when they were roughly equal … Foreign affiliates now account for one-tenth of world GDP and one-third of world exports’ (UNCTAD 2002:1). Indeed, FDI and the corresponding entry of MNCs into developing country markets is now viewed as the key to rapid economic growth (Basu, Chakraborty and Reagie 2003:510–16), albeit with a caveat. Specifically, FDI can be expected to promote economic growth if it is accompanied by trade liberalisation, greater competition, improvement in educational systems leading to better human capital and macroeconomic stability (Zhang 2001:175–85). Further, if the main link between FDI and growth is technology transfer, the recipient country can benefit only if it has a certain minimum threshold of human capital (Borensztein, de Gregorw and Lee 1995). 23

24 Foreign Direct Investment: Micro Issues

The caveats notwithstanding, the focus remains firmly on the quantum of FDI. For example, despite India’s rapid growth during the 1990s, and the country’s proven competitiveness in modern industries such as information technology (IT) and pharmaceuticals, there continues to be deep concern about its inability to attract FDI of the same magnitude as China.1 Given that most developing countries remain marginal recipients of FDI, there is considerable debate afoot about the nature of the policies that would enable these countries to attract investments from MNCs. The literature has identified factors like corruption (Habib and Zurawicki 2002:291–307), inept governance (Globerman and Shapiro 2002), extent of protection of intellectual property rights (IPR), availability of appropriate physical infrastructure, level of human capital (Noorabakhsh, Paloni and Youssef 2001:1593–1610), wage rate (Sethi 2003:315–26), extent of tariff protection of host country’s products (Bertrand and Madriaga 2002) and locational advantage of the host country (Bjorvatn, Kind and Nordas 2002:109–26) as important determinants of FDI inflow. Interestingly, some studies have found that corruption does not have an unambiguous impact on the quantum of FDI (Akcay 2001:27–34). Others have found that by increasing the cost of imitation strong IPR may actually reduce FDI, and eventually crowd out innovation in the North countries (Glass and Saggi 2002:387–410). Further, it has been pointed out that if a MNC already has an operation in a host country, enforcement of IPR might merely shift the rent from the local imitator to the MNC, without adding to the gains of the country in the short run (Markusen 1998). This clearly has implications for a government’s incentives to enforce IPR. One other branch of the literature has found mixed evidence about the link between FDI and human welfare in developing countries and emerging markets. It has been argued, for example, that as MNCs shift their operations to developing economies to reduce labour cost, real wage rates would decline globally on account of both North–South and South–South competition, thereby adversely affecting the welfare of labourers around the world (Mehmet and Tavakoli 2003:133–56). At the same time, empirical evidence from Korea suggests that the Gini coefficient rose with increases in both the extent of trade liberalisation and FDI inflows (Mah 2002:1007–91). However, there is also evidence to suggest that the income of the poor actually rises with increase in FDI (Jalilian and Weiss 2002:231–53). As evident from the above discussion, economists have paid a significant amount of attention to economy-wide factors affecting the quantum of FDI, and the impact of this FDI inflow on macroeconomic and quasimacroeconomic variables such as growth, poverty and inequality. Much less attention has been paid to the unit of decision making, the MNC itself. Indeed, discussions about the objectives and motives of MNCs are largely found in the strategy literature, with some discussion in the industrial organisation literature. However, unless we understand why and how a MNC invests in a

Sumon Kumar Bhaumik 25

country, any discussion about attracting FDI would be moot. This is especially true in situations where FDI is viewed as a vehicle for technology transfer and not a means to access global savings for domestic economic growth, thereby making the quality of the FDI, which is intimately related to the objectives and motives of the MNCs, more important that the quantum of FDI per se. In this chapter, therefore, we examine the motives, objectives and behaviour of MNCs that are the unit of decision making in the context of FDI. In section 2, we discuss the rationale for FDI. In section 3, we focus on the choice of the mode of entry of MNCs into host countries, the choice of the mode of entry being an important determinant of the nature and extent of spillovers. In section 4, we examine the life-cycle of joint ventures ( JVs) which is the preferred mode of entry of many developing country governments. Section 5 highlights the caveats associated with technology transfers and spillovers from FDI. Section 6 concludes.

2

Why do MNCs enter overseas markets?

A firm faces three different choices: It can produce in its home country and export the product to all other countries. Alternatively, it can enter into franchise agreements with counterparties in other countries, and enjoy a royalty or a fee-based income. Finally, it can operate production bases in many different countries, thereby becoming an MNC. The first question that one should answer, therefore, is when would a firm choose to become an MNC? The answer to this can be found in the Ownership–Location– Internationalisation (OLI) paradigm. The OLI model, which has become the centrepiece of the literature on MNCs, suggests that it is optimal for a firm to be a MNC, and thereby locate some of its production centres outside its home country if three different conditions are satisfied (Ethier 1986:805–34): ●

●

●

First, the firm has to own knowledge about products and processes that endow it with an advantage over competitors within its industry. For the sake of simplicity, we can call this intangible asset technology. Second, location in the host country should provide the firm some advantage such as elimination of tariff costs that induces the firm to locate (part of) its operations in the host country. Third, the endeavour of the firm to produce the relevant good in the host country, thereby internalising the process of catering to the demand in that country, should be more beneficial than arm’s-length transactions like licensing.

James Markusen has pointed out some salient features of the OLI model (Markusen 1995:169–89). First, he has argued that knowledge-based assets

26 Foreign Direct Investment: Micro Issues

are more likely to be associated with FDI than physical assets because the former can be easily transferred across borders, and because such assets can be used simultaneously by more than one output locations at very little extra cost. Second, if countries are similar in size, relative factor endowments and technical efficiency, FDI among these countries will gradually replace ‘trade’ in the conventional sense. This is consistent with the observation that most of the FDI flows in the world continue to be among the North countries, with China as the only Southern country accounting for a significant quantum of FDI. Third, internalisation would be considered a better option if the technology of the potential MNC involves product-specific training/ experience and reputation/brand identity. It is evident that the conjectures of the OLI model follow from neoclassical postulate of profit maximisation, and the impact of competition on profits. It does not take into consideration the obvious yet significant information problems that a firm faces when entering a new market. If the profit-related risks associated with a country are significant, a firm may not want to enter without verifying whether the potential returns which, in turn, depend on the size and growth of the host market, include the appropriate risk premium and therefore justify the associated risks. In such a case, a firm is likely to initially enter into a distribution/franchise contract with a local firm in the host market, and invest subsequently only if the size of the market and potential returns are commensurate with the risk associated with the variability in profits (Horstman and Markusen 1996:1–19). Otherwise, the firm will opt to export its product to that country even if the market potential is fairly large (Agarwal and Ramaswami 1992:1–27). The above discussion has implications for the nature of FDI across countries with different capabilities. Let us generalise that Northern countries are characterised by high technological capability, strong IPR protection, strong contract enforcement mechanisms and quasi-homogeneous rules, regulations and institutions. By the same token, Southern countries are less capable in terms of technological prowess, have weak contract enforcement mechanism and IPR protection, and high variability of rules, regulations and institutions both within countries over time and across countries at a given point in time. It can be easily seen that Northern firms, which typically own the technologies that make them competitive as MNCs, are likely to enter into horizontally integrated operations across Northern countries, and vertically integrated operations between Northern and Southern countries. For example, the decision of Japanese firms to invest in North America and Europe is driven by considerations of R&D and intangibles such as marketing networks, while their decision to invest in Southeast Asia is driven by human resource (i.e. wage) considerations and relationships among business groups (Belderbos and Sleuwaegen 1996:214–20). We have now explored in some detail the first step in a firm’s decision making process: whether or not to operate a production facility away from its

Sumon Kumar Bhaumik 27

home country. Once a firm opts for the latter, and thereby decides to become a MNC, it has to address the next issue, that of entry mode choice. An MNC has three alternatives in so far as entering a host country is concerned: ● ● ●

Greenfield entry Acquisition of an existing firm Entering into a JV with a local firm in the host country.

The drivers of the entry mode choice will be discussed in section 3.

3

Entry mode choice

As mentioned above, a MNC has the choice between greenfield entry, acquisition and JV when it enters a new country/market (see also Appendix Table A.1, p.37). There are three different ways of distinguishing between these three choices. An agency theory view of the issue suggests that agency costs would be higher for JVs than for greenfield entry and acquisition, assuming that the method of acquisition would grant the MNC controlling stakes in the acquired company.2 Agency costs would be exacerbated if it is easy for the local JV partner to imitate the technology of the MNC and emerge as a competitor at a subsequent date, or if the MNC is too dependent on the local partner’s intangible assets, thereby giving the latter enough bargaining power to corner most of the rent arising out of the technology. A transactions cost view of the issue, on the other hand, suggests that greenfield entry would be more costly than the other two modes of entry. An essential difference between an acquisition and a JV, on the one hand, and a greenfield entry, on the other, is that the former involve access to bundled local resources by way of purchase of an existing firm or a partnership with a local firm, while the latter involve purchase of individual resources from the host country market and then combining these resources to form a new production–business unit. If one makes the reasonable assumption that purchase and assembly of individual resources involve higher transactions cost, and that some intangible assets such as business relationships are not available for purchase at all, the logic underlying the transactions cost view is easily understood. Finally, if one takes into consideration the cost of negotiating and renegotiating implicit and explicit contracts with potential partners, stakeholders of acquired companies and participants in resource and product markets, it is not obvious as to which mode of entry involves a lower cost. A JV involves contract negotiation with a local partner. An acquisition, which typically involves negotiations only with shareholders, leads to renegotiation of contracts with stakeholders such as managers, labourers, lenders and distributors after acquisition of the company.3 Finally, a greenfield entry involves contract

28 Foreign Direct Investment: Micro Issues

negotiations with participants in both the factor and product markets. The relative costs of contract (re)negotiation vary with the context. Given the above discussion, we can make two broad conjectures about the influence of firm-specific and context-specific characteristics on the decision about a MNC’s entry mode choice: C1: If a firm has a high level of technology, such that potential rent associated with it, and therefore potential agency costs, are high, a MNC would be less likely to choose the JV entry mode. C2: If missing markets, host country regulations, and perverse institutional setups make purchase and assembly of individual resources into a new firm expensive, a MNC is less likely to opt for greenfield entry. The empirical literature on mode of entry has tested these two broad conjectures in many different forms, with different sets of proxies for technology and, especially, transactions cost, as well as with different sets of control variables. Broadly speaking, the literature has explored two different possibilities: greenfield entry versus JV,4 and greenfield entry versus acquisition.5 In other words, the emphasis in the literature has been on C2 (i.e. choice of a MNC between bundled and unbundled resources when bundled resources can come in the form of both a firm that can be acquired or in the form of a local partner in the host country). What measurable firm-specific and context-specific variables, therefore, determine a MNC’s choice of mode of entry into a new market? Let us first discuss the choice between greenfield entry and JV. As mentioned above, a MNC is characterised by its ownership of a technology that enables it to operate profitably – indeed, earn rents – under different business environments. One of the major concerns of a MNC, therefore, is to ensure that it does not lose control of this technology. Given the costs of writing perfect contracts and the costs associated with monitoring, the easiest way of losing control over the technology is to enter into a partnership with a partner in the host country. At the same time, partnership with a local firm in a host country enables a MNC to minimise the costs associated with an imperfect knowledge about the local policy and business environments, as well as about the product and factor markets. It follows that a MNC will desire more control – the extreme form of which is a wholly owned subsidiary (WOS) – if its product or process of R&D-intensive (Caves 1996; Smarzynska 2000), and if the MNC has made significant investment in its proprietary technology (Gleason, Lee and Mathur 2002:139–54). Correspondingly, it will desire less control if these are intensive in the resources that make a host country attractive as a location to set up operations (Teece 1986:21–45; Asiedu and Esfahani 2001:641–62). However, as we have discussed above, an MNC has to balance the agency costs associated with a tie-up with a local firm with the transactions costs

Sumon Kumar Bhaumik 29

associated with entry on its own (Gomes-Casseres 1989:1–25); transactions costs associated with acquiring resources and doing business in a country can be considerably reduced if the MNC ties up with a local firm (Hennart 1991: 483–94). Further, the MNC’s decision regarding whether or not to tie up with a local firm also depends on its risk appetite with respect to its exposure to the host country, and on its expectations about the market potential of the host country. Indeed, it has been argued that an emphasis on the agency costs associated with a JV presupposes that ‘none of Williamson’s transactional disabilities – opportunism, bounded rationality, uncertainty and small numbers condition – can be efficiently dealt with in a JV,’ but ‘this assumption need not hold in all circumstances’.6 In other words, in certain contexts, JV as a mode of entry might be the optimal choice for a MNC. Specifically, the literature argues that a MNC’s choice is determined by the following factors: ●

●

●

Risk associated with the policy and business environments of the host country, market potential of the host country (Kogut and Singh 1988a; Barbosa and Louri 2002:493–515) Cultural distance between the host country and the country of origin of the MNC7 (Expected) size of operations in the host country (Gatignon and Anderson 1988:305–36).

It also argues that that the mode of entry of a MNC to a new market or production base will depend on the experience of the MNC with respect to operating in the country concerned and/or, broadly speaking, on its experience in similar countries (Kogut and Singh 1988b:411–32; Erramilli 1991: 479–501; Cleeve 1997:31–43; Barbosa, Guimares and Woodward 1998). The literature also identifies one other determinant of the cost associated with international JV operations (Desai, Foley and Hines 2002). It follows directly from the OLI paradigm that a key motivation for a firm to operate product centres overseas is to gain from the internalisation of the advantages associated with the overseas locations. In the same vein, it can be argued that MNCs decide on the nature and extent of their global operations to internalise the profit gains that arise out of cross-country differences in tax regulations, and treatment of revenues and costs associated with different types of operations. Specifically, ‘affiliates that are embedded within a worldwide production process are not amenable to partial ownership as are other affiliates. [This implies that] the costs of coordination with local partners are much higher for those affiliates engaging in intra-firm trade. These costs could stem from anticipated disputes over the selection of suppliers, transfer pricing for inputs and sales, and whether overall production decisions should be driven by affiliate requirements or [home country] parent motivations’ (Desai, Foley and Hines 2002:22).

30 Foreign Direct Investment: Micro Issues

We now turn to the strand of the literature that examines the choice between a greenfield entry and acquisition of a local firm in the host market. To recapitulate, if a MNC opts for a greenfield entry, it has to incur the cost of putting together the resources that are required to build a company and the business networks that are required to enable this company to function profitably. On the other hand, if the MNC opts for acquisition of an existing company, it has to incur the cost of adapting the company’s production process, organisational structure, management style and business networks to suit its own requirements. In other words, in the latter case, the MNC would have to bear the cost of renegotiating contracts with the stakeholders of the acquired firm. The eventual choice between a greenfield entry and an acquisition would, in other words, be determined by the relative costs associated with the two modes of entry. Specifically, the literature argues that the following are generally true (Chatterjee 1990:780–880; Zejan 1990:349–55; Hennart and Park 1993:1054–70): ● ●

●

Acquisition is the preferred mode of entry of diversified MNCs MNCs that are strong relative to the local firms prefer greenfield entries8 Acquisitions are more likely if the growth rate of the local industry is high, if the local industry is competitive and if the size of the local affiliate is large relative to the size of the parent MNC.

The choice between greenfield entry and entry by way of acquisition would also be affected by factors determining the supply of acquirable companies. To begin with, the host country should have a secondary market for corporate–industrial assets in order for acquisition to be a viable mode of entry. For example, during the 1990s, it was easy for a MNC to enter the Central and Eastern European (CEE) countries by way of acquisition because many of the CEE countries were privatising their state owned enterprises (SOEs) through strategic sales to core investors. A MNC’s ability to enter a host country by way of acquisition would also be enhanced if the host country has a liquid secondary market for equities, and if the financial structure of the country is capital market oriented, as opposed to bank oriented. Acquisition would also require the existence of high-quality professionals such as accountants and corporate lawyers in the host country, thereby facilitating the process of due diligence that precedes all acquisitions. Finally, since entry by way of acquisition requires lesser post-entry knowledge of the local market than a greenfield entry – knowledge of product markets alone as opposed to knowledge of both product and factor markets – it is more probable when a MNC has relatively less informed about the business environment in the host country.9 In both cases – i.e. in the case of choice between JV and entering a country on one’s own, and in the case of choice between Greenfield entry and

Sumon Kumar Bhaumik 31

acquisition – an MNC’s eventual choice may ultimately be determined by regulations, especially in emerging markets.10 For example, a MNC may, in principle, want to enter a host country on its own, but the host country’s FDI regulations may require than foreign entrants to the relevant industry have a local partner. The MNC, of course, has the choice of not entering that country at all, but this may be detrimental to its long-run business plans if the potential size of the host country’s market is large and if a first-mover advantage is necessary to be profitable in the long run. In such a case, the MNC may opt to enter the host country in partnership with a local firm even if, sans constraints, it would have been optimal for it to enter on its own.11 It is easy to see how such regulations can also affect the choice between greenfield entries and acquisitions. In this section, we have explored in some detail the factors explaining choice of entry mode of MNCs into overseas markets.12 Anecdotal experience suggests that a number of MNCs initially enter a new market/country by way of a JV with a local firm, presumably to develop an understanding about the potential risk-adjusted returns associated with that market/ country. However, these JVs often do not last long, with either the local firm (or, more often than not, the MNC) buying out the JV partner. In section 4, we explore the dynamics driving the life cycle of a JV.

4

Life cycle of a JV

Governments in many developing countries believe that technological advancement of the domestic firms belonging to these countries can be achieved by encouraging FDI in the form of JVs (Blomström and Zejan 1989). In India, for example, until recently a MNC could enter only in participation with a local firm. However, empirical evidence suggests that the average life span of a JV is much lower than that of a WOS, and indeed the break-up rate of JVs is twice as high as that of WOSs.13 We have already discussed the rationale as to why a MNC might choose to enter a new market/country in JV with a local firm. To recapitulate, the MNC would choose the JV option if it feels that the transactions cost associated with acquiring on its own the tangible – and, especially, intangible resources obtainable from a potential local partner – is much higher than the potential agency costs associated with such a relationship. The decision, of course, would also be tempered by the MNC’s expectations about the size of the market and the potential growth rate of rents in the future. Implicit in this explanation as to why MNCs and local firms in host markets may want to enter into JVs is a possible explanation as to why JVs are fragile, at least relative to WOSs. As a JV partner, a MNC expects to learn about the new market and forge local business relationships, without exposing itself to the entire risk of the project, and without incurring the

32 Foreign Direct Investment: Micro Issues

associated costs to the extent that it would have had had it decided to enter the market on its own. Similarly, the local firm expects to benefit from spillovers with respect to technology and business best practices. In other words, both the JV partners expect to benefit from spillover of the other’s technology, when the technology can either be tangible and related to production processes, or be intangible and related to business best practices and business relationships (see also Appendix Table A.2, p.40). The problem associated with such expectations is that each of the two JV partners can choose to make sub-optimal contributions of its own technology if monitoring costs are high. The rationale for such an action would be that if a firm can capture the benefits from the spillovers of the other firm’s technology, while saving its own technology, it might be in a position in a future to capture much of the rent associated with the combined technologies of the JV partners. The consequent prisoners’ dilemma outcome can either make the JV unprofitable and lead to its liquidation or sale to a third party, or can lead to mistrust that can lead to the break-up of the partnership. In other words, the presence of technological spillovers and moral hazard can together lead to a speedy dissolution of a JV partnership (Wong and Leung 2001). In a similar vein, it has been argued that a JV can be unstable if there is an asymmetry between the perceptions of a MNC and the local partner about the usefulness of the MNC’s technology in providing a competitive edge. In equilibrium, the MNC might find it more profitable to get out of the JV and enter the host market on its own.14 An important aspect of this line of modelling is that, as described above, it presupposes opportunistic behaviour on the part of the MNC: ‘the instability is fully anticipated at the time of joint venture formation in the first period itself. For [a range of] parameter values, the MNC would license out the technology in the first period,l5 and in the second period, it would either enter with a subsidiary or buy out the existing business of the host firm (Sinha 2001, emphasis added).’ In sum, rapid dissolution of JVs is a consequence of several factors:

●

●

●

To begin with, the objectives of the JV partners may be very different. For example, a MNC may want have a multi-year gestation period in mind when entering a new market, whereas its local partner, especially in developing countries and hence without deep pockets, may want quick returns on their investment. Ironically, convergence of the partners’ objectives, whereby each JV partner wants to free-ride on the other’s technology, could also lead to break-up of JV relationships. Finally, in a world of rational economic agents, break-up of JVs may simply be an equilibrium outcome of a multi-period game between the JV

Sumon Kumar Bhaumik 33

partners: the JV partners associate positive and significant probability with the possibility of a break-up and the strategies and actions they consequently choose on the basis of backward induction ensures that the break-up becomes a self-fulfilling prophecy.

5

Technology transfer and spillovers

Over time, the emphasis in the literature on FDI has shifted from FDI being a way to access foreign capital to that being a platform for acquisition of best practices in the context of both production and business in general (Borensztein, de Gregorio and Lee 1995; Finolay 1978:1–16). This is largely a tribute to the development of international capital markets that permit both sovereign states and private enterprises to borrow from capital markets in other countries using a variety of financial covenants and instruments. It is also a tribute to the evolution of financial engineering that allows both borrowers and creditors/investors to hedge their currency and interest rate risks. Finally, international capital markets owe their evolution to the growth of the credit rating industry which reduces the monitoring cost of the lenders. To begin with, we must note that it is often in the interest of MNCs to transfer technology to their affiliates in the host countries in which they operate. As we noted earlier, a MNC can indulge in rent seeking on the basis of its ownership of a technology. In other words, transfer of the technology to the host country affiliate is necessary for rent-seeking in the overseas market. The problem with such a transfer is that the transfer of technology is often associated with spillovers that might eventually reduce the technological gap between the MNC and the local firms in a host country, thereby reducing the MNC’s capability for rent-seeking. However, this opportunity cost of forgone rent has to be balanced against the benefits associated with technology spillovers: ●

●

First, consumers in the overseas markets may be more inclined to buy a MNC’s product if local firms are able to provide after-sales service, thereby offering the consumers greater choice and better guarantee of quick service subsequent to a sale. Second, if local firms adapt to the MNC’s technology, some of them can become a low-cost supplier of inputs to the MNC over time, thereby enabling the MNC to reduce its cost of production.16

However, transfer of technology from MNCs to host countries is associated with some caveats. To begin with, expansion of production base into overseas markets may be market-seeking in nature, and aimed specifically at

34 Foreign Direct Investment: Micro Issues

delaying the demise of a product whose development involved significant cost, but which may be heading for obsolescence in the MNC’s home market. This is likely to be especially true in the context of entry of MNCs from developed countries into developing country markets. Indeed, there is evidence to suggest that technology transferred to developing countries by developed country MNCs may be as much as ten years old (Mansfield and Romeo 1980:737–50), the corresponding lag in the technology transferred to developed countries being four years.17 Further, the average time taken for spillover of the transferred technology from the MNCs’ affiliates to local firms in the host country is often as much as four years. In other words, even in the event of spillover, a local firm in a developing country may obtain a technology that is about fourteen years old in the developed world. This lag may well reflect the capability of host country firms to adapt to global technological standards, and hence may be optimal (Tihanyi and Roath 2002:188–98). Indeed, it has been argued that coexistence of skilled labour and MNCs in developing countries can lead to rapid technological growth of the local firms over time (Patibandla and Petersen 2002:1561–77). However, the above empirical evidence suggests that, in general, the following are likely to be true: (1) Technology transfer would not necessarily bridge the technological gap between developed and developing countries (2) Quasi-developing countries that have both skilled labour force and ability to purchase technology off the shelf might be better off pursuing that avenue in order to technologically catch up with the developed countries. Indeed, there is evidence to suggest both that post-liberalisation firms in developing countries prefer import of technology rather than invest in R&D (Vishwasrao and Bosshardt 2001:367–87), and that importing technology does add to the productivity of local firms in developing countries (Hasan 2002:23–49). Finally, there is evidence to suggest that an MNC is more likely to transfer technology to a WOS than to an affiliate with any other type of contractual relationship with the MNC (Mansfield and Romeo 1980:664–70). This is entirely consistent with the aforementioned argument that MNCs are wary about the agency costs associated with partnerships with local firms in host countries, as well as with the literature on the life-cycle of JVs. To what extent, therefore, can we argue in favour of positive spillovers associated with entry of MNCs into developing country markets? There is evidence to suggest that while ‘increases in foreign equity participation are correlated with increases in productivity for [small] recipient plants … suggesting that these plants benefit from the productive advantages of

Sumon Kumar Bhaumik 35

the foreign owners, … increasing foreign ownership negatively affect the productivity of wholly domestically owned firms in the same industry … On balance, [the] evidence suggests that the net effect of foreign ownership on the economy is quite small.’18 When taken together with the observation that MNC affiliates are reluctant to adopt new technology in competitive markets even after economic liberalization (Bhaumik and Dimova 2004), and all the caveats governing transfer of technology by MNCs to their affiliates in host countries, it is not obvious that the gains from technology transfer and spillovers, in general, that are associated with FDI would accrue to developing countries across the board.

6

Concluding remarks

Growth by way of technological spillovers associated with FDI has become the mantra of the policy makers since the early 1990s. However, while there seems to be macro-level evidence between positive correlation between the growth and quantum of FDI, micro-level evidence of the motives and objectives of MNCs and spillovers suggests that the relationship between FDI and growth may be overhyped. For example, there is evidence to suggest that MNC investment in the Indian software industry has aided the rapid growth of the local industry. But such a study does not tell us whether, in the first place, MNCs invested in the Indian software sector because conditions were conducive for growth of the sector. In other words, neither sector-specific nor country-specific studies tell us whether or not the Indian software experience or the Chinese chip-making experience is replicable in other countries, and under other combinations of resources, institutions, regulations and market structures. On the other hand, there is some evidence, albeit limited, to suggest that the net gains from FDI accruing to a developing country may be limited. In other words, while FDI may be a factor aiding growth and technological improvement in a developing country, the ultimate gains from FDI are likely to depend on the local economic environment, and therefore domestic economic reforms – as opposed to FDI – should perhaps be at the forefront of a developing country’s economic agenda. Liberalisation and consequent competition (and, ideally, Schumpeterian dynamics) may be sufficient to induce productivity growth and competitiveness of local firms,63 the forerunners of growth, such that FDI would eventually play its ideal role as the proverbial ‘icing on the cake’.

36

Appendix Table A2.1 Choice of entry mode Study

Data

Key conclusions

Barbosa and Louri (2002)

469 cases of FDI in Portugal and 363 cases of FDI in Greece

MNCs prefer full ownership in Portugal, but only partial ownership in Greece Their choices are affected more by firm-specific considerations in the Portugese context, but by characteristics of the domestic market in the Greek context

Bertrand and Madariaga (2002)

US FDI to Canada, Mexico, Argentina and Brazil during 1989–98

US FDI to Latin America involves greenfield entries that take advantage of the low labour costs in the host countries.

Desai, Foley and Hines (2002)

About 18,000 cases of US FDI overseas between 1982 and 1991

WOS is preferred when the production process is integrated across locations Complete ownership of affiliates leads to greater transfer of technology and greater tax benefit for MNCs

Gleason, Lee and Mathur (2002)

302 cases of expansion by US firms into China

The most profitable modes of entry are JVs and by way of contracts; other modes of entry do not yield significant excess returns

Lin and Png (2002)

148 cases of Taiwanese FDI to China during 1987–91

The probability of entering by way of JV increases with the distance between the host and home countries, largely because monitoring costs increase with distance

Anand and Delios (2001)

2,175 cases of entry by Japanese, German and British firms into the USA

Entry mode choice for downstream projects is determined by the absolute level of capabilities in the host country’s industry

37 Table A2.1 Continued Study

Data

Key conclusions The choice for upstream projects, on the other hand, depends on the capability of the MNCs relative to that of the host country firms

Brouthers and Brouthers (2001)

231 cases of Dutch, British, German and US FDI in Hungary, Poland, Czech Republic, Russia and Romania

Cooperative modes of entry are more likely when the risk associated with investment in the host country is low, and WOSs are more likely when this risk is high

Luo (2001)

174 cases of FDI in China

JVs are more likely if the extent of government intervention and the level of uncertainty in general is high WOSs are more likely if the MNC seeks long-term profitability, has adequate knowledge of the local market, competes with a growing number of local firms and has a knowledgeintensive product

Smarzynska (2000)

1,405 cases of FDI in transition CEE economies of and the former Soviet Union (FSU)

MNCs that operate in high or medium-technology industries, and are leaders in technology or operational aspects of business such as marketing are more likely to opt for WOSs There is no clear pattern for low-technology industries

Leung (1997)

98 cased of FDI in the USA and 116 cases of US FDI overseas

Since the main benefit of JVs is to gain information from local partners, JVs have shorter time spans than WOSs

38 Table A2.1 Continued Study

Data

Key conclusions JVs in developing countries have longer time spans than JVs in developed countries because MNCs are more willing to tolerate under performance of affiliates in developing countries

Belderbos and Sleuwaegen (1996)

All cases of Japanese FDI up to June 1989

Firms investing in Western economies have siginificant firm-specific intangible assets, while FDI to South East Asia was driven by other factors such as resources and prior experience with these countries

Hennart and Park (1993)

270 Japanese affiliates operating in the USA during the 1980s

Greenfield entry is more likely if the US affiliate is small, if the product sold in the USA is already produced in Japan and if the product is technologyintensive Acquisition is more likely when the local market experiences rapid growth MNCs entering as followers do not have any specific preference for either entry mode

Agarwal and Ramaswami (1992)

285 cases of entry into three countries, involving 119 US MNCs

Small MNCs with limited overseas experience are more likely to enter a new market with JVs Exports and licensing are preferred if contractual or other risks associated with the country of choice are high

Chatterjee (1990)

47 Fortune 500 firms with at least five four-digit product lines, accounting for 144 individual diversification moves during 1961–6

Acquisitions are more likely if the market is highly concentrated or if stock prices are high, while greenfield entry is more likely if the MNC has significant internal funds or has access to low-risk debt

39

Table A2.1 Continued Study

Data

Key conclusions

Zejan (1990)

1978 data for 77 Swedish MNCs and their 250 affiliates in 30 countries in which the MNCs had majority ownership

Diversified firms are more likely opt for acquisition, as opposed to greenfield entry Acquistions are also more likely if the host country has high per capita GDP, but less likely if the its market experiences rapid growth

Blomström and Zejan (1989)

1974 data for all Swedish MNCs operating across 50 countries

Minority ownership in affiliates are more likely if a MNC has limited overseas experience and is highly diversified, and if the MNC and the affiliate produce different products at the two-digit level

Table A2.2 Spillovers from FDI Study

Data

Key conclusions

Patibandla and Petersen (2002)

Panel data for 20 large Indian software firms for the 1990–9 period.

MNCs make significant contributions to the emergence of competition, and the resultant growth of productivity

Kokko, Zejan and Tansini (2001)

1,243 cases of FDI in Uruguay, spread across 74 four–digit manufacturing industries

MNCs transfer better technology to affiliates that compete with local firms in protected markets If the host country has an outward oriented policy, MNCs compete more with marketing tools, etc. than with technology

Vishwasrao and Bosshardt (2001)

Panel data for 1989–93 for 1,400 Indian manufacturing firms

Foreign-owned firms are more likely to adopt new technology Competition can induce

40 Table A2.2 Continued Study

Data

Key conclusions domestic firms to adopt such technology, but can also deter adoption of technology by reducing rents accruing from new technology FDI does not have a significant impact on the export performance of the Indian economy

Sharma (2000)

Annual Indian macro economic data for 1970–98

Aitken and Harrison (1999)

Unbalanced panel of 6,044 Venezuelan firms for the period 1978–82

Productivity increases with extent of foreign ownership for small firms But increased foreign ownership has adverse impact on productivity of domestic firms

Blomström and Sjoholm (1999)

1991 data for 13,663 Indonesian firms

Labour productivity is higher for firms with foreign ownership FDIrelated spillovers accrued only to firms who did not already face global competition

Branstetter (2000)

2,093 cases of Japanese FDI in the USA

FDI enhances flow of knowledge in both directions: from Japanese to US firms, and vice versa

Kokko (1994)

1971 industry level data for 216 four-digit Mexican industries

Spillover of technology is brought about by a combination of differences in the levels of both the technological complexity and productivity between domestic and foreign firms

Ramachandran (1993)

All cases of technology transfer from MNCs to Indian firms during 1964–70, 1970–73 and 1977–81.

Subsidiaries of MNCs clearly receive more resources for technology transfer than domestic firms, but the distinction between WOS and subsidiaries with partial ownership is less clear

Sumon Kumar Bhaumik 41

Notes 1. According to recent estimates, India’s net FDI in flow per year is of the order of $4 billion, which is less than a tenth of net FDI into China. 2. Note that the conventional wisdom that ownership of 51 per cent of equity would give someone a controlling stake in a company may not be true under all circumstances. In India, for example, a minority shareholder with 26 per cent of the equity can block resolutions at the board level. Hence, when we refer to a ‘controlling stake’ in this chapter, we imply the ownership of the required majority or supermajority stake that would enable a shareholder to make decisions without constraint. 3. Specifically, a MNC may decide that acquisition is the easiest way to enter a market, especially because it does not increase production capacity in the industry and hence does not threat the local incumbents, and upon entry the MNC might completely restructure the operations of the acquired company. The cost of restructuring of this scale can be quite high. See, for example, Meyer and Estrin (2001). 4. For example, Luo (2001). 5. For example, Gorg (2001). 6. See Beamish and Banks (1987). 7. It is easy to see why, for example, a Russian oil company would be able to adapt to the local business environments in Kazakhstan than a British or an American company. There is consensus in the literature that the factor influencing the ability of MNC to quickly adapt to local conditions in a host country, however, has little to do with geographical distance per se and more with the extent of similarity between the legal and institutional frameworks of the host country and the country of the MNC’s origin. See, for example, Kim and Hwang (1992:29–53). However, it has sometimes been argued that if monitoring costs increase with geographical distance, MNCs operating far away from their home bases would prefer to enter the far-off markets in a JV with local firms. See, for example, Lin and Png (2002). 8. This is consistent with the finding that the extent of a MNC’s home country’s industry-level comparative advantage vis à vis the host country is positively correlated with the probability of greenfield entry, but that the correlation is statistically insignificant for acquisitions. See, for example, Feliciano and Lipsey (2002). 9. In a slightly different vein, Gorg (2001) argues that greenfield might be a better option for a MNC if the cost of gaining knowledge of the local market is lower than the cost of adapting the product to suit the local market conditions. 10. For a theoretical exposition explaining the rationale for divergence between the objectives of a host country government and a MNC which, in turn, leads to imposition of restrictions on certain modes of entry, see Mattoo, Olarreaga and Saggi (undated). 11. The Indian insurance market, which restricts foreign equity ownership in insurance companies operating in India at 26 per cent, has witnessed a significant number of Jvs between Indian firms and multinational insurers who operate on their own in most (or all) other countries. 12. For a schematic presentation of the discussion see Hill, Hwang and Kim (1991). 13. For a discussion of the literature, see Wong and Leung (2001). 14. Sinha (2001). Sinha’s paper also provides an exhaustive review of the industrial organisation literature addressing the issue of JV fragility.

42 Foreign Direct Investment: Micro Issues 15. Note that while licensing agreements and JVs are fundamentally different in terms of the mechanics of the contractual agreements between the partners, it can be shown that the profit-sharing outcomes of licensing agreements and JVs are essentially the same. See, for example, Svejnar and Smith (1984:149–67). 16. A good example highlighting the beneficial aspects of technology spillovers, from a MNC’s perspective, is the auto industry in India. The entry of a wide range of multinational car producers in India’s auto sector has given rise to a strong and internationally competitive auto components sector. This reduces the risk and quantum of servicing costs associated with purchase of a car manufactured by a MNC’s production facility in India. At the same time, companies like Sundaram Fastners have emerged as integral components of supply chains of multinational car companies. 17. The smaller lag in the context of technology transfer among developed countries possibly manifests greater homogeneity of consumer preferences and purchasing capabilities among developed countries than between developed and developing countries. It may also reflect the possibility of greater competition among developed-country MNCs in Northern markets than in Southern markets, with possible exception of large Southern countries such as Brazil, China and India. 18. See Aitken and Harrison (1999:617–18).

References Agarwal, S. and Ramaswami, S.N., ‘Choice of Foreign Market Entry Mode: Impact of Ownership, Location and Internalisation Factors’, Journal of International Business Studies, 23(1), (1992), 1–27. Aitken, B.J. and Harrison, A.E., ‘Do Domestic Firms Benefit from Direct Foreign Investment? Evidence from Venezuela’, American Economic Review, 89(3), (1999), 605–18. Akcay, S. ‘Is Corruption an Obstacle for Foreign Investors in Developing Countries? A Cross-Country Evidence’, Yapi Kredi Economic Review, 12(2), (2001), 27–34. Asiedu, E. and Esfahani, H.S., ‘Ownership Structure in Foreign Direct Investment Projects’, Review of Economics and Statistics, 83(4), (2001), 647–62. Barbosa, N. and Louri, H., ‘On the Determinants of Multinationals’ Ownership Preferences: Evidence from Greece and Portugal’, International Journal of Industrial Organisation, 20, (2002), 493–515. Barbosa, N., Guimaraes, P. and Woodward, D., ‘Foreign Firm Entry in Portugal: An Application of Event Count Models’, Paper presented at the 25th Annual EARIE Conference, Copenhagen. Basu, P., Chakraborty, C. and Reagle D., ‘Liberalisation, FDI, and Growth in Developing Countries: A Panel Cointegration Approach’, Economic Inquiry, 41(3), 2003, 510–16. Beamish, P.W. and Banks, J.C., ‘Equity Joint Ventures and the Theory of the Multinational Enterprise’, Journal of International Business Studies, 18(2), (1987), 1–16. Beata K. Smarzynska, ‘Technological Leadership and the Choice of Entry Mode by Foreign Investors’, Washington, DC, World Bank, 2000, mimeo. Belderbos, R. and Sleuwaegen, L., ‘Japanese Firms and the Decision to Invest Abroad: Business Groups and Regional Core Networks’, Review of Economics and Statistics, 78(2), (1996), 214–20. Bertrand, O. and Madariaga, N., ‘Firm Location Choices, Modes of Entry and Economic Integration: A Macroeconomic Study Applied to the US FDI in the NAFTA and the MERCOSUR’, University of Paris and Sorbonne, (2002), mimeo.

Sumon Kumar Bhaumik 43 Bhaumik, S.K. and Dimova, R., ‘How Important is Ownership in a Market with a Level Playing Field? The Indian Banking Sector Revisited’, Journal of Comparative Economics, 32(1), (2004), 165–80. Bjorvatn, K., Kind, H.J., and Nordas, H.K., ‘The Role of FDI in Economic Development’, Nordic Journal of Political Economy, 28(2), (2002), 109–26. Blomstrom, M. and Sjoholm, F. ‘Technology Transfer and Spillovers: Does Local Participation with the Multinationals Matter?’, European Economic Review, 43, (1999), 915–23. Blomström, M. and Zejan, M., ‘Why do Multinationals Seek out Joint Ventures?’, Working Paper, 2987, National Bureau of Economic Research, Cambridge, MA, 1989. Borensztein, E., Jose de Gregorio and Jong-Wha Lee, ‘How Does Foreign Direct Investment Affect Economic Growth’, Working Paper 5057, National Bureau of Economic Research, Cambridge, MA, 1995. Branstetter, L., ‘Is Foreign Direct Investment a Channel of Knowledge Spillovers? Evidence from Japan’s FDI in the United States’, Working Paper No. 8015, National Bureau of Economic Research, Cambridge, Massachusetts, 2000. Brouthers, K.D. and Brouthers, L.E., ‘Explaining the National Cultural Distance Paradox’, Journal of International Business Studies, 32(1), (2001), 177–89. Caves, R.E., Multinational Enterprise and Economic Analysis, 2nd edn, Cambridge, Cambridge University Press. Chatterjee, S., ‘Excess Resources, Utilisation Costs, and Mode of Entry’, Academy of Management Journal, 33(4), (1990), 780–800. Cleeve, E., ‘The Motives for Joint Ventures: A Transactions Cost Analysis of Japanese MNEs in the UK’, Scottish Journal of Political Economy, 44, (1997), 31–43. Deepak Sethi, ‘Trends in Foreign Direct Investment Flows: A Theoretical and Empirical Analysis’, Journal of International Business Studies, 34(4), (2003), 315–26. Desai, M., Foley, C.F. and Hines Jr., J.R., ‘International Joint Ventures and the Boundaries of the Firm’, Working Paper, 9115, National Bureau of Economic Research, Cambridge, MA, 2002. Erramilli, K.M., ‘The Experience Factor in Foreign Market Entry Behavior of a Service Firm’, Journal of International Business Studies, 22, (1991), 479–501. Ethier, W.J., ‘The Multinational Firm’, Quarterly Journal of Economics, 101(4), (1986), 805–34. Feliciano, Z. and Lipsey, R.E., ‘Foreign Entry into US Manufacturing by Takeovers and the Creation of New Firms’, Working Paper, 9122, National Bureau of Economic Research, Cambridge, MA, 2002. Findlay, R., ‘Relative Backwardness, Direct Foreign Investment, and the Transfer of Technology: A Simple Dynamic Model’, Quarterly Journal of Economics, 92(1), (1978), 1–16. Gatignon, H. and Anderson, E., ‘The Multinational Corporation’s Degree of Control Over Foreign Subsidiaries: An Empirical Test of Transactions Cost Explanation’, Journal of Law Economics and Organization, 4(2), (1988), 305–36. Glass, A.J. and Saggi, K., ‘Intellectual Property Rights and Foreign Direct Investment’, Journal of International Economics, 56(2), (2002), 387–410. Gleason, K.C., Lee, C.I. and Mathur, I., ‘Dimensions of International Expansions by US Firms to China: Wealth Effects, Mode Selection, and Firm-Specific Factors’, International Review of Economics and Finance, 11, (2002), 139–54. Globerman, S. and Shapiro, D., ‘Global Foreign Direct Investment Flows: The Role of Governance Infrastructure’, World Development, 30(11), (2002), 1899–1919.

44 Foreign Direct Investment: Micro Issues Gomes-Casseres, B., ‘Ownership Structures of Foreign Subsidiaries’, Journal of Economic Behaviour and Organisation, 11, (1989), 1–25. Gorg, H., ‘Analysing Foreign Market Entry: The Choice Between Greenfield Investment and Acquisitions’, Journal of Economic Studies, 27(3), (2001), 165–81. Habib, M. and Zurawicki, L., ‘Corruption and Foreign Direct Investment’, Journal of International Business Studies, 32(2), (2002), 291–307. Hasan, R., ‘The Impact of Imported and Domestic Technologies on the Productivity of Firms: Panel Data Evidence from Indian Manufacturing Firms’, Journal of Development Economics, 69, (2002), 23–49. Hennart, J.F., ‘The Transactions Costs Theory of Joint Ventures: An Empirical Study of Japanese Subsidiaries in the United States’, Management Science, 37(4), (1991), 483–97. Hennart, J.F. and Young-Ryeol Park, ‘Greenfield vs. Acquisition: The Strategy of Japanese Investors in the United States’, Management Science, 39(9), (1993), 1054–70. Hill, C.W., Hwang, P. and Kim, W.C., ‘An Eclectic Theory of International Entry Mode’, Strategic Management Journal, 11, (1990), 117–28. Horstman I.J. and Markusen, J.R., ‘Exploring New Markets: Direct Investment, Contractual Relations and the Multinational Enterprise’, International Economic Review, 37(1), (1996), 1–19. Jalilian, H. and Weiss, J., ‘Foreign Direct Investment and Poverty in the ASEAN Region’, ASEAN Economic Bulletin, 19(3), (2002), 231–53. Kim, W.C. and Hwang, P., ‘Global Strategy and Multinationals’ Entry Mode Choice’, Journal of International Business Studies, 23(1), (1992), 29–53. Kogut, B. and Singh, H., ‘Entering the United States by Joint Venture: Competitive Rivalry and Industry Structure’, in F. Contractor and P. Lorange (eds), Cooperative Strategies in Business, Lexington, MA, Lexington Books, 1998a. Kokko A., ‘Technology, Market Characteristics, and Spillovers’, Journal of Development Economics, 45, (1994), 279–93. Kokko, A., Zejan, M. and Tansini, R., ‘Trade Regimes and Spillover Effects of FDI: Evidence from Uruguay’, Weltwirtschaftliches Archiv, 137(1), (2001), 124–39. Leung, W.-F. ‘The Duration of International Joint Ventures and Foreign WhollyOwned Subsidiaries’, Applied Economics, 29, (1997), 1255–69. Lin, C.C. and Png, I., ‘Monitoring Costs and the Mode of International Investment’, National Chengchi University, Taiwan, 2002, mimeo. Luo, Y., ‘Determinants of Entry in an Emerging Economy: A Multilevel Approach’, Journal of Management Studies, 38(3), (2001), 443–72. Mah, J.S., ‘The Impact of Globalisation on Income Distribution: The Korean Experience’, Applied Economic Letters, 9(15), (2002), 1007–9. Mansfield, E. and Romeo, A., ‘Technology Transfer to Overseas Subsidiaries by USBased Firms’, Quarterly Journal of Economics, 95(4), (1980), 737–50. Markusen, J.R., ‘The Boundaries of Multinational Enterprises and the Theory of International Trade’, Journal of Economic Perspectives, 9(2), (1995), 169–89. ———— ‘Contracts, Intellectual Property Rights, and Multinational Investment in Developing Countries’, Working paper 6448, National Bureau of Economic Research, Cambridge, MA, 1998. Mattoo, A., Olarreaga, M. and Saggi, K., ‘Mode of Foreign Entry, Technology Transfer, and FDI Policy’, World Bank, Washington DC, undated, mimeo. Mehmet, O. and Tavakoli, A. ‘Does Foreign Direct Investment Cause and Race to the Bottom? Evidence from Four Asian Economies’, Journal of the Asia Pacific Economy’, 8(2), (2003), 133–56. Meyer, K. and Estrin, S., ‘Brownfield Entry in Emerging Markets’, Journal of International Business Studies, 32(3), (2001), 575–84.

Sumon Kumar Bhaumik 45 Noorbakhsh, F., Paloni, A., and Youssef, A. ‘Human Capital and FDI Inflows to Developing Countries: New Empirical Analysis’, World Development, 29(9), (2001), 1593–1610. Patibandla, M. and Petersen, B., ‘Role of Transnational Corporations in the Evolution of a High-Tech Industry: The Case of India’s Software Industry’, World Development, 30(9), (2002) 1561–77. Ramachandran, V., ‘Technology Transfer, Firm Ownership, and Investment in Human Capital’, Review of Economics and Statistics, 75(4), (1993), 664–70. Sharma, K. ‘Export growth in India: has FDI Played a Role?’, Discussion Paper No. 816, Economic Growth Centre, Yale University, New Haven, CN, 2000. Sinha, U., ‘International Joint Ventures, Licensing and Buy-Out Under Asymmetric Information’, Journal of Development Economics, 66, (2001), 127–51. Svejnar, J. and Smith, S.C., ‘The Economics of Joint Ventures in Less Developed Countries’, Quarterly Journal of Economics, 99(1), (1984), 149–67. Teece, David, ‘Transactions Cost Economics and the Multinational Enterprise: An Assessment’, Journal of Economic Behaviour and Organization, 7, (1986), 21–45. ‘The Effect of National Culture on the Choice of Entry Mode’, Journal of International Business Studies, 19, (1988b), 411–32. Tihanyi, L. and Roath, A.S., ‘Technology Transfer and Institutional Development in Central and Eastern Europe’, Journal of World Business, 37, (2002), 188–98. United Nations Conference on Trade and Development, World Investment Report: Transnational Corporations and Export Competitiveness, Overview, New York and Geneva, United Nations, 2002. Vishwasrao, S. and Bosshardt, W., ‘Foreign Ownership and Technology Spillover: Evidence from Indian Firms’, Journal of Development Economics, 65, (2001), 367–87. Wong, K.-Y. and Leung, W.-F., ‘International Joint Ventures. Moral Hazards, and Technological Spillovers’, University of Washington, 2001, mimeo. Zejan, M.C., ‘New Ventures or Acquisitions. The Choice of Swedish Multinational Enterprises’, Journal of Industrial Economics, 38(3), (1990), 349–55. Zhang K.H., ‘Does Foreign Direct Investment Promote Economic Growth? Evidence from East Asia and Latin America’, Contemporary Economic Policy, 19(2), (2001), 175–85.

3 China’s Experience with Foreign Direct Investment: Lessons for Developing Economies Leonard K. Cheng*

1

Introduction

Since 1993 China has become the largest recipient country of FDI among all developing countries, and in six consecutive years from 1993 to 1998 it was the second largest recipient country in the world, after only the USA. In 2002 it displaced the US as the top recipient of FDI in the world.1 Its total FDI inflow in 2003 was $53.5 billion. By June 2003 the total number of foreign projects approved was over 443,000, the cumulative amount of contracted FDI was US$879 billion and the cumulative amount of actual or realized FDI was US$478 billion. By September 2001, about 180,000 foreign invested firms (hereafter ‘foreign firms’) employed 21 million Chinese workers, nearly 10 per cent of the labour force in China’s urban areas. The roles played by foreign firms in the Chinese economy from 1991 to 2000 are illustrated in Table 3.1.2 Realized FDI as a fraction of China’s total investment in fixed assets rose from a little over 4 per cent in 1991 to 17.1 per cent in 1994, when China adopted tight fiscal and monetary policies, but fell back in subsequent years and was 11.2 per cent in 1999. The ratio of investment in fixed assets by foreign firms to total investment in fixed assets rose from 5.3 per cent in 1992 to 10.5 per cent in 1998. Workers employed by foreign firms rose from fewer than 3 million in 1991 to 10 million in 1993, 16 million in 1995 and remained close to 18 million in 1996–8, accounting for about 11 per cent of total urban employment in China. Industrial output produced by foreign firms amounted to 5.3 per cent of China’s total industrial output in 1991, and rose quickly to over 27 per cent * An earlier version of this chapter was presented at the ‘Conference on Foreign Direct Investment: Opportunities and Challenges for Cambodia, Laos and Vietnam’ in Hanoi, on 16–17 August 2002. I would like to thank Professor Shujiro Urata of Waseda University and an anonymous referee for their helpful comments and suggestions. 46

Table 3.1 Roles of foreign firms in China’s economy, 1991–2000

FDI/Total investment in fixed assets (%) Foreign investment in fixed assets/ Total investment in fixed assets (%)1 Workers employed by foreign firms (million)2 Share of non-agricultural labour force (%) Share of foreign firms’ industrial output (%)3 Share of foreign firms’ value added of the industrial sector (%)4 Share of foreign firms’ exports and imports (%)5 Share of foreign firms’ tax payment (%)6

1991

1992

1993

1994

1995

1996

1997

1998

1999

4.15

7.51

12.13

17.08

15.65

15.10

14.79

13.23

11.17

2.90

5.30 4.90

6.9 10.0

9.50 12.60

10.20 16.00

5.29

7.09

11.26

14.31

18.00 11.00 15.14

18.00 11.00 18.57

10.50 18.00 11.00 24.00

27.75

27.11

50.78 15.99

49.91 17.55

9.15

16.85 21.34

26.43 4.25

34.27 5.71

37.04 8.51

39.10 10.96

2000

20.9 47.29 11.87

46.95 13.16

48.68 14.38

Notes 1 The figures for 1991–5 are based on data provided in Zhang (1999, Table 2.6) and the 1998 figure is from Guo (2000 a,b). 2 The figures for 1991–5 are obtained from Zhang (1999, Table 2.5) and those for 1996–8 are from Huang (2000). 3 The 2000 figure is obtained from the Almanac of China’s Foreign Economic Relations and Trade 2001, Ministry of Foreign Trade and Economic Cooperation. 4 The 1995 figure is obtained from Zhang (1999, Table 2.11) and the 1998 figure is obtained from Guo (2000 a,b). 5 The 2000 figure is obtained from the Almanac of China’s Foreign Economic Relations and Trade 2001, Ministry of Foreign Trade and Economic Cooperation. 6 The 2000 figure is obtained from the Almanac of China’s Foreign Economic Relations and Trade 2001, Ministry of Foreign Trade and Economic Cooperation. Sources: Cheng and Qiu (2003). Unless stated otherwise, all data were obtained from the MOFTEC website.

47

48 China’s Experience with FDI

in 1999–2000. From data provided by Zhang (1999), the foreign firms’ share in industrial value added was close to 17 per cent in 1995 and according to Jiang (2001) it was about 20 per cent in 1996–9. The foreign firms’ contribution to China’s exports and imports was very substantial. In 1991 they accounted for over 21 per cent of China’s total trade (exports  imports). The ratio continued to climb in subsequent years and by 1999 and 2000 it was about 50 per cent. Obviously, foreign firms in China were very much export oriented, and export processing was a core activity for some of them. As a reflection of their success in production and sales, foreign firms became a significant source of tax revenue. Their contribution was less than 5 per cent of the government’s total tax revenue in 1992, but rose to 16 per cent in 1999 and 17.5 per cent in 2000. In Section 2, I shall briefly describe China’s experience in attracting FDI over the period 1979–2000. The evolution of China’s FDI policy will be reviewed in Section 3, to be followed by an analysis of the sectoral and regional distribution of FDI in Section 4. Section 5 addresses several issues related to the economic benefits and harmful effects of FDI in the Chinese context. Key observations about, and implications of, China’s experience with FDI are highlighted as ‘lessons’. A brief comparison of China’s experience with those of ASEAN and India is presented in Section 6, and Section 7 offers some conclusions.

2

FDI in China 1979–2000

China’s ‘open door’ policy began in 1979 with the passage of its first joint venture law, to be followed shortly with the approval of the establishment of four Special economic zones (SEZs) in Guangdong and Fujian Provinces. The success of the SEZs led to the gradual addition of various kinds of zones and special designations. As China opened itself to FDI, it also reformed its foreign trade system by decentralizing the right to import and export. Foreign firms were given the right to import the equipment and materials required for their operation in China and to export their own products. At least up to the early 1990s, foreign firms had limited access to China’s domestic market. Foreign trade and FDI thus went hand in hand. Even today, many foreign firms continue to produce for export, making a very significant contribution to China’s total exports. In the early years of China’s opening to FDI, the dominant mode was ‘Joint exploration’ ( JE) ventures, to be followed by ‘Contractual joint ventures’ (CJVs), ‘Equity Joint Ventures’ (EJVs), and ‘Wholly foreign owned enterprises’ (WFOEs). JE ventures were set up predominantly between a corporation or ministry under China’s State Council and one or more foreign partners for the purpose of exploring and developing natural resources such as coal, oil and natural gas. An EJV is a legal entity in which JV partners share profits, losses and any other risks in accordance with the partners’ respective shares of the

Leonard K. Cheng 49

venture. Unlike an EJV, a CJV spells out what each partner will bring to and get from the venture. It is not unusual for one party to assume much of the risks associated with the venture, and by definition a WFOE is owned entirely by foreign investors. In recent years, foreign investors have invested in existing companies via the acquisition of their stocks. The share of this new mode of FDI, known as ‘stockholding companies,’ however, remains negligible. The share of JEs in total FDI decreased from 40.6 per cent in 1983 to less than 8 per cent in 1987 and was below 1 per cent by 1996. The share of CJVs stood at 31.6 per cent in 1983 and grew to 42.3 per cent at its peak in 1986, two years before the long-awaited ‘Law on Cooperative Ventures’ was passed. It fell to the 20 per cent range in the rest of the 1980s and remained stable at about 20 per cent during the 1990s. In 2000 the share fell further to 16.2 per cent. The share of EJVs increased from 10.2 per cent in 1983 to a peak of 64.2 per cent in 1987, fell to about 40 per cent in 1998 and fell further to 35.2 per cent in 2000. WFOEs accounted for close to 6 per cent of total FDI in 1983, and hovered around 1 per cent from 1984 to 1987. After implementation of the ‘Law on Enterprises Operated Exclusively with Foreign Capital’ in 1988 the share shot up to 7.1 per cent. It continued to rise over the years, exceeding 20 per cent by 1991 and 30 per cent by 1996. In 2000 it reached 47 per cent! To summarize, after two decades of experimentation and development, JEs have not only lost their dominance but also become negligible. In contrast, from a humble beginning WFOEs have become the most prevalent mode, to be followed by EJVs and CJVs. Hong Kong was clearly the largest source of China’s FDI. Its share varied between 48.9 per cent and 68.6 per cent from 1984 to 1991, but dropped to 38.1 per cent in 2000. Depending on the period, the second largest investor was either the USA, Japan, or Taiwan. In 1997–2000, the USA became the second largest investor, accounting for about 9–11 per cent of China’s total inward FDI. Investors from Asian economies other than Japan focused on export oriented labour-intensive products and were located mainly in the coastal provinces in the south. In contrast, investors from the USA, Europe and Japan included many major MNCs. Some of them were in technologyintensive and capital-intensive industries and tended to focus on China’s domestic markets. As a result, they gravitated toward major cities such as Beijing, Shanghai and Tianjin. Lesson no. 1: The kind of FDI China could successfully attract depends on both the willingness of foreign investors and China’s comparative advantage and market potential. Export oriented FDI exploited China’s comparative advantage, and was more sensitive to preferential fiscal incentives. In contrast, market oriented FDI was driven by China’s economic and legal environment. A healthy and steadily growing national economy was conducive to FDI by MNCs.

50 China’s Experience with FDI

3

Evolution of China’s FDI policy

The initial phase (1979–85) was one of experimentation with FDI and FDI policy. Based on the successful experience of four SEZs established in 1980–1, ‘open coastal cities,’ ‘economic and technological development zones’, and ‘open coastal economic areas/zones’ were added in 1984–5. Nevertheless, foreign investors already in China faced many operating difficulties. At the root of these was the lack of a transparent legal framework for foreign investors, especially those that wanted to run wholly owned firms. Owing to the deficiency of the legal system, opportunistic local authorities breached contracts to maximize their short-term gains at the expense of foreign firms. The operation of foreign firms was also seriously hampered by restrictions imposed by the central government, including limited access to the domestic market, balancing of foreign exchange receipts and payments, restrictions on the national identity of the senior administrators of JVs, the requirement of JVs to revert to Chinese partners after a given period of time, expensive but outdated communications and transportation systems, restrictive labour practices and substandard intermediate inputs. Lesson no. 2: Granting tax and import duty exemptions was not enough to attract FDI, not even for foreign firms that engaged only in production for exports. The Chinese government had to create a business-friendly environment that was conducive to viable operation by foreign investors. Contracted FDI fell substantially in 1986. The second phase (1986–91) was characterized by the introduction of measures to address the difficulties faced by foreign investors and to improve the general business environment. For example, a foreign currency ‘swap market’ was opened in 1985 to supplement a foreign exchange ‘retention system’. The ‘Provisions of the State Council on the Encouragement of Foreign Investment’ were passed in October 1986 and later followed by implementation measures at various levels of government. These and other measures clarified the autonomy of JVs in making decisions about salaries, bonuses and senior administrators. They also gave foreign firms priority access to water, electricity, transportation, land and bank loans. The preferential policy toward FDI continued to spread geographically. New areas included the Liaodong Peninsula and Shandong Peninsula in the north in 1987 and Hainan Island (the fifth SEZ), in the south in 1988. However, the most important development was the establishment in 1990 of the Pudong New Zone in Shanghai at the mouth of the Yangtze River. Foreign investors responded favourably to the improved business environment and the extension of preferential policy to new areas. The amount of realized FDI continued to rise, and the amount of contracted FDI gradually recovered. Unfortunately, as FDI picked up, China’s economy

Leonard K. Cheng 51

experienced serious macroeconomic imbalance and double-digit inflation in the late 1980s. In the aftermath of the Tiananmen Square incident in 1989 and the uncertainty that followed, investors from the Western countries slowed down or retreated from their investment plans. However, both contracted and realized FDI continued to rise further between 1989 and 1991 because investors from Asia more than made up for the difference.

Lesson no. 3: It may not be wise to have excessive dependence on a small set of source economies. Given China’s substantial foreign reserves and proven capability in exporting manufactured goods, China may be a valuable source of FDI for developing economies.

The government’s preoccupation with its own political survival cast doubts on whether China would continue to pursue its ‘open door’ policy. The third phase began in 1992 with Deng Xiaoping’s tour of South China to reaffirm China’s economic reform. Subsequently the goal of building a ‘socialist market economy’ was officially adopted. These developments lifted the cloud that had been hanging over foreign investors since 1989. In addition, thirty-seven cities in the interior and western regions were designated as ‘open cities,’ along with the designation of new ‘border economic cooperation areas’ and ‘national tourist and resort areas’. From this point onward, the encouragement (or lack of discouragement) of FDI was to be for the entire country, not just in the coastal areas. Realized FDI in 1992 more than doubled the 1991 level to reached US$11 billion, and then more than doubled again in 1993 to reach US$27.5 billion. The phenomenal growth in these two years catapulted China from the thirteenth host country to FDI in the world in 1991 to third place in 1992, and then to second place in 1993, after only the USA. Realized FDI continued to grow and by 1997 exceeded US$45 billion. The share of investment from advanced countries rose gradually during this and the following phases. A real estate bubble quickly developed after Deng’s tour. The government stepped on the brakes in 1993 by applying restrictive fiscal and monetary policies and took measures to cool off the real estate fever. It succeeded in creating a ‘soft landing’ for the national economy as the growth rate in real GDP declined gradually from 13.5 per cent in 1993 to 8.8 per cent in 1997. The fourth phase (1998–2000) started not long after the devastating Asian Financial Crisis began in the second half of 1997. As a result, investment from the East Asian economies slowed down. In addition, weakness in global demand and drastic devaluation of East Asian currencies combined to put pressure on demand for Chinese exports. In the light of the reversal of macroeconomic conditions, China decided to shift gear, relying on an active

52 China’s Experience with FDI

fiscal policy (and to a less extent a liberal monetary policy) to stimulate domestic demand to fight deflation and to continue its effort to attract FDI. The Asian Financial Crisis took its toll on China’s FDI: realized FDI in 1998 remained basically at the 1997 level, and that of 1999 fell by more than 10 per cent.3 From 1997 to 1999 contracted FDI was on a declining trend. By 2000, however, contracted FDI increased by over 50 per cent from the 1999 level and realized FDI experienced a slight increase, partly in anticipation of China’s imminent entry into the World Trade Organization (WTO) in 2001. A desire to upgrade the technologies of its industries necessarily implied a greater focus on FDI originating from the advanced economies, especially investment by leading MNCs. Recognising that the Asian newly industrializing economies (NIEs) and developing economies were unable to sustain their investment in China, the Chinese government decided in late 1998 to place particular emphasis on FDI by MNCs from the advanced economies (Hu 1999). Lesson no. 4: In the early years of China’s ‘open door’ policy, FDI from the Asian NIEs was key to China’s rapid development of export oriented labour-intensive industries. However, as China’s economy continued to grow and as the need to upgrade its industrial structure and technology became clear, China modified its FDI policy to attract major MNCs.

4

Sectoral and regional distribution of FDI

The sectoral distribution of FDI in China from 1985 to 2000 is given in Table 3.2. The data are grouped into four periods as discussed in Section 2 (but data on sectoral distribution before 1985 are not available). As shown, the primary sector had a negligible annual share that varied between 1.5 per cent and 2.7 per cent over the period 1985–2000. Lesson no. 5: In many policy pronouncements, China emphasized the importance of the agriculture sector as a key area for attracting FDI, but without much success. What is regarded as a strategically or politically important sector by the host government may mean little to foreign investors unless it is profitable. Profitable sectors are those involving the host country’s comparative advantage. The secondary sector’s share jumped from 39.7 per cent in 1985 to 75.1 per cent in the second phase, fell to 61.1 per cent in the third phase and recovered to 70 per cent in the fourth phase. Thus, except for the first phase, the secondary sector had a dominant share of China’s FDI. Like the agriculture sector, China has always given priority to new and high-technology

Leonard K. Cheng 53 Table 3.2 Sectoral shares of contracted FDI, 1985–2000, per cent Year Primary Agriculture, forestry, husbandry and fishing Secondary Industry Construction Tertiary Reconnasissance survey and geological prospecting Transportation, posts and telecommunications Commerce and catering Real estate and social services Hygiene, sports and social welfare service Education, arts and videocast Scientific research and technical services Finance and insurance Other Total

1985

1986–91

1992–7

1998–2000

1.99

2.39

1.45

2.67

1.99 39.74 37.65 2.09 58.27

2.39 75.10 73.41 1.69 22.51

1.45 61.08 57.84 3.24 37.47

2.67 69.95 67.59 2.36 27.38

5.72

0.01

0.19

1.12

1.67 8.31 35.85

0.90 1.50 16.93

2.35 3.76 26.78

3.10 2.54 16.92

0.81 0.07

0.47 0.47

0.89 0.37

0.23 0.11

0.10 1.00 4.73

0.17 0.03 2.02

0.32 0.12 2.67

0.35 0.07 2.92

100

100

100

100

industries. However, at least until recently, it has had limited success. Comparative advantage, market access and protection of IPRs are important considerations for FDI in technology-intensive industries. The tertiary sector’s share in 1985 was 58.3 per cent. It fell drastically to 22.5 per cent during the second phase, rose to 37.5 per cent during the third phase, but fell further to 27.4 per cent during the fourth phase. The tertiary sector’s share was primarily driven by the share of ‘real estates and social services’ and to a lesser extent by the share of ‘commerce and catering’, the latter category including wholesale, retail and hotels.

Lesson no. 6: FDI in China’s key services sectors such as banking and telecommunications accounted for a small fraction of all FDI. It was mainly a result of the government’s unwillingness to open these sectors to foreign investment. Opening them could cause major disruptions to national firms (often national monopolies and oligopolies), but without substantial opening the sectors would remain backward and uncompetitive.

54 China’s Experience with FDI Table 3.3 Shares of realized FDI, leading provinces and municipalities, 1979–2000,1 per cent Year

Beijing Tianjin Hebei Shandong Liaoning Guangdong Jiangsu Shanghai Zhejiang Fujian

1979–85 1986–91 1992–7 1998– 2000

0.00 8.47 3.36

1.38 2.06 3.91

0.00 0.78 1.75

0.13 2.94 6.63

0.48 5.00 4.35

38.17 36.09 27.42

0.25 3.21 12.15

2.28 7.17 8.73

0.44 1.41 3.40

3.98 7.13 10.32

4.61

3.99

2.24

5.88

4.19

27.64

15.13

7.59

3.29

9.22

Note 1

FDI of Ministries and affiliated corporations are included in total FDI.

Table 3.3 provides information on the shares of the leading provinces and municipalities in attracting FDI during the four phases, where the FDI of ministries and affiliated corporations under the central government are included in the national total. Among all provinces, Guangdong had the biggest share of FDI in China. The other major recipients of FDI were Beijing, Fujian (a favourite destination of Taiwanese investors), Tianjin, Liaoning (a favourite destination of Japanese investors), Shandong (a favourite destination of South Korean investors), Shanghai and Jiangsu. During the fourth phase the bulk of China’s FDI gravitated toward three urban clusters. Guangdong’s share was 27.6 per cent, and much of its FDI concentrated in the province’s Pearl River Delta. The second largest cluster was the Yangtze River Delta (Jiangsu, Shanghai and Zhejiang) that had 26 per cent of the country’s total FDI. The third major cluster, with a 21 per cent share, was the Bohai area (Beijing, Tianjin, Hebei, Shandong and Liaoning).

5

Economic benefits and harmful effects of FDI

FDI provides additional funds for investment. However, nowadays this is not regarded as the most important contribution, especially given China’s very high savings rate. Advanced technology, superior managerial skills and linkages to international marketing networks are regarded as more important. FDI from advanced countries is a source of technological progress (broadly defined to include management skills) because MNCs from advanced economies are widely regarded as the repository of advanced technologies and global market information. Technology transfer, industrial and export upgrading With a tradition of central economic planning under the guidance of orthodox Marxist ideology, there was never a shortage of domestic sceptics and critics concerning China’s ‘open door’ policy, in particular its FDI policy. Researchers at the National Planning Commission (1997; 1999) raised concerns about foreign firms in China. One was that foreign firms decided to transfer only low and old technology to China for the purpose of

Leonard K. Cheng 55

maintaining their own monopoly. In addition, they argued that since foreign firms took greater risks in direct investment than in pure lending, they would demand a higher rate of return, thus hurting China’s economic interests. They concluded that FDI should be substituted with the purchase of technology and know-how financed by foreign borrowing. In fact, the assumption that what foreign firms gained by taking risks was at the expense of their host economies had no logical validity and ran counter to the policies of many host economies aggressively courting FDI. In addition, there were known problems in China with technology transfer financed by foreign loans, including poor management of the imported technology, low returns on technology and high risk in repayment of loans. South Korea had a policy of protecting national firms whose excessively ambitious investment was financed by international borrowing. The huge equity loss of the national conglomerates after the Asian Financial Crisis as a result of investment failures should serve as a reminder of the pitfalls of a nationalistic policy that keeps out FDI. Jiang (1999) provides an excellent summary of the evidence on the transfer of advanced technology to China via FDI, in particular by MNCs from advanced economies. According to her study, many MNCs invested in China after 1992, bringing with them advanced technology. They also engaged in collaborative R&D with Chinese research institutes, set up technology development centres and trained Chinese employees. In 1997 the shares of sales in electronics, transportation equipment, electrical machinery and food processing accounted for 66.9 per cent of the total sales of the 500 biggest foreign firms in China and there was evidence that FDI played an increasingly important role in improving technical progress and industrial upgrading. By 2000, foreign firms accounted for more than half of leading enterprises in electronics, telecommunications equipment, chemicals, engineering equipment, automobile and pharmaceutical industries. Jiang (1999), citing prior work, provides evidence on the role of FDI in upgrading China’s industrial products and industrial structure. Many of the biggest MNCs in Germany and Japan with investment in China were concentrated in electronics, automobile, electrical appliances, telecommunications equipment, machinery and electrical and chemical sectors. The evidence corroborates Zheng, Du and Ba’s (1998) finding that foreign firms in these industries led in market shares. Jiang (1999, 2001) also provides evidence on the role played by foreign firms in upgrading exports. Jiang (1999, Table 4) shows that the shares of manufacture exports in total exports by foreign firms was higher than that of all firms, but the difference was most apparent in the export of electrical products. Moreover, the lion’s share of exports by foreign firms was accounted by major MNCs. Jiang (2001, Table 4) shows further that the share of exports of machinery and electrical/electronics products in total exports by foreign firms rose from 43.7 per cent in 1996 to 52.4 per cent in 1999,

56 China’s Experience with FDI

compared with a share for all firms at 31.9 per cent in 1996 and 39.5 per cent in 1999, respectively. The leading exports of foreign firms were automatic data processing equipment, integrated circuits, microelectronics components and phonics equipment. Guo (2000a, 2000b) argues that FDI has contributed to China’s technology-intensive industries. Relative to state owned enterprises (SOEs) and collective enterprises, foreign firms were relatively more prominent in electronics, telecommunications equipment and transportation equipment industries. In 1995 electronics and telecommunications equipment accounted for 1.9 per cent of the total value added of SOEs and collectively owned industrial firms, but 14.4 per cent of foreign industrial firms. In transportation equipment, the shares of value added of SOEs and collectively owned industrial firms were 5.1 per cent and 4.4 per cent, respectively, but the foreign industrial firms’ share was 7.3 per cent.

Lesson no. 7: FDI policy should be guided by facts and international norms, not by ideological biases that are neither logical nor supported by empirical evidence. There was evidence that relatively superior technology possessed by MNCs from advanced economies was transferred to China, and that FDI contributed to upgrading Chinese industries and exports.

Efficiency of foreign firms and spillover to national firms Jiang (1999, Table 3) shows that the foreign firms’ ratio of output–assets was higher than the average of all industrial firms, and in particular that of SOEs. Within the electronics industry, foreign firms outperformed SOEs in terms of the ratio of profits to sales, the ratio of profit tax to capital, return on capital (ROCE) and return on total assets. Moreover, among foreign firms, WFOEs’ performance was the best. Based on the 1995 data of 189 branches of the ‘industry’ subsector, Sun (1998:95) finds that ‘foreign invested enterprises lead state owned enterprises in both average product and marginal product of capital and labour.’ Zheng, Du and Ba (1998) regard the success of domestic firms (e.g. Changhong, Qindao Haier and Haier in TV, air conditioners, and refrigerators) to be a result of the introduction of relevant technologies to China by MNCs in the 1990s. These national firms were not only domestic market leaders but also started to export to overseas markets. Other industries that were positively stimulated by FDI included electronics and telecommunications equipment, electrical wires and cables, medical equipment, etc. Lesson no. 8: There was evidence that foreign firms not only were operated with greater efficiency than national firms, but also contributed to the emergence of efficient national firms.

Leonard K. Cheng 57

Macroeconomic growth There are many studies on the relationship between China’s FDI and its macroeconomic growth (i.e. growth of real GDP or industrial output), but few statistical analyses have gone beyond postulating intuitively plausible reduced form estimation equations to be implemented by simple regression analyses.4 Berthelémy and Demurger (2000), Demurger (2000, 2001) and Demurger et al. (2002) represent some of the exceptions. In these analyses, a growth model is developed in which FDI not only contributes to, but is also influenced by, the growth rate of real income and FDI. This simultaneous-equation framework is unique among analyses of Chinese statistics, in contrast with most other studies that typically assume a uni-directional relationship from FDI to economic growth. Using provincial data from 1985 to 1996 and simultaneous-equation estimation techniques, Demurger and her co-authors have found a positive two-way relationship between FDI and economic growth, with the beneficial effect of FDI being aided by human capital.5 Wei (1996) uses data from 434 cities over the period 1988–90 to test the effect of FDI on the cities’ industrial growth rates. The explanatory variables include the growth rate of labour, the sum of domestic and foreign owned capital stock and human capital, as well as dummy variables of preferential policy and the importance of initial FDI at the beginning of the period.6 Among others, Wei’s results indicate ‘statistically significant evidence that FDI was positively associated with cross-city differences in growth rates’. Lesson no. 11: There is statistical evidence consistently showing that FDI was an important factor in explaining the differential growth rates of Chinese regions and cities.

6 A comparison of China’s experience with those of ASEAN and India In this section I compare China’s experience with FDI against the experiences of India and ASEAN, which is made up of six senior members and four new members.7 Here I focus primarily on the ‘ASEAN-5’ that is made up of Singapore (an NIE and a pioneer in using FDI as a key strategy for economic development), Malaysia and Thailand (two new ‘Asian tigers’ with very substantial FDI), and Indonesia and the Philippines (two other members that have tried to catch up in the FDI race).8 Both China and the ASEAN-5 except Singapore began to take serious measures to attract FDI in the mid-1980s. Promotion of export oriented FDI was their common strategy of economic development, and their effort resulted in rapid economic growth through the export of labour-intensive manufactures. In terms of total FDI flows, China attracted less FDI than

58 China’s Experience with FDI

ASEAN-5 until 1992.9 In the next several years China’s FDI experienced quantum jumps, even though ASEAN’s FDI flows also experienced rapid growth. After 1992 China’s inward FDI flow remained significantly above that of ASEAN, in particular after the Asian Financial Crisis. Nevertheless, the FDI–GDP ratios of all members of ASEAN-5 except Indonesia were above that of China.10 Moreover, part of China’s inward FDI represented investment by Chinese firms via overseas subsidiaries set up in Hong Kong and other tax havens. The large amount of FDI in China was thus mainly a reflection of its economic size. China and ASEAN were different in several aspects. First, while ASEAN relied primarily on investment from the OECD countries, the lion’s share of China’s FDI originated from Hong Kong and other Asian NIEs. The investors in China were thus mostly small and medium sized firms (SMEs) whereas those in ASEAN tended to be big MNCs. Second, given China’s population and the prospect that it will grow to become the world’s biggest economy by 2015, its market potential is much bigger than ASEAN’s. Thus, China is in a stronger position to leverage its market size to obtain more favourable terms from major multinational firms. Third, being a big country also gives China a stronger sense of economic security vis à vis big MNCs, and thus a greater willingness to open its domestic market to foreign investors. While both ASEAN and China restricted FDI to certain industries and imposed requirements on local content, exports, equity shares and technology transfer, China clearly had a more liberal attitude toward the mode of foreign investment. By 2000 wholly foreign owned firms accounted for 47 per cent of FDI in China, and surpassed all other modes. In comparison with China or the ASEAN-5, India’s policies toward FDI were more restrictive. Reform of India’s FDI regime since 1991 resulted in a dramatic increase in foreign investment and by 1997 it had attracted 2.2 per cent of the world’s total FDI. Nevertheless, its cumulative FDI of about US$10 billion during 1990–7 paled into insignificance against China’s US$200 billion over the same period (Thomsen 1999, Table 1). In addition to the significant variation in the total amount of FDI, there were also other differences. First, while the most dynamic element of China’s inward FDI was in export oriented manufacturing by investors from Asia’s NIEs, foreign investors in India were primarily attracted by its domestic market. It was only after they discovered that India’s domestic market was smaller than anticipated that they began to look into the possibility of exporting. This sequence of focusing first on the domestic market was diametrically opposite to that in China, where many foreign manufacturing firms were not allowed to sell in the domestic market at all before the early 1990s. Second, much FDI in India took the form of merger and acquisition (M.A), whereas in China FDI was predominantly greenfield investment. Perhaps this difference can be explained by the fact that China’s SOEs were saddled with numerous problems, making them unattractive targets for acquisition by foreign investors.

Leonard K. Cheng 59

Third, while FDI is generally regarded as the most important factor behind China’s rapid economic growth, India’s experience with FDI was not very positive. Nagaraj (2003) summed it up as follows: While the entry of foreign firms has increased competition and improved variety and quality of consumer goods, there are some disturbing signals. Foreign investment in infrastructure is a failure. Gradual loss of managerial control in many industrial firms, decline in competition in some industries, extinction of some leading domestic brand names and limited improvement in domestic production capability seem to be signs of concern. While the last two concerns have been raised in China, there is strong evidence that the benefits of FDI has outweighed its costs. Perhaps the differences between their experiences could be attributed to the failure of India’s FDI to exploit its abundant labour supply through the export of labour-intensive manufactures, whereas that was one of the greatest successes of China’s FDI. Exports of labour-intensive products also increased the purchasing power of local consumers, thus enlarging the size of China’s domestic market, which in turn made it more attractive to foreign investors.

7

Conclusions

Let me now draw some conclusions from the Chinese experience that might be relevant to developing countries. The process of globalization is driven by continual technological progress, which has made increasingly deeper division of intensive production on a global scale both possible and profitable. There is not only the traditional, horizontal division of labour rules which countries specialize in different products, but also the new, vertical division of labour rule which countries intensive specialize in production processes that use required to produce certain final products. Of course, globalization is made possible by members of the international economy via trade and investment negotiations. The value chain of each product includes basic and applied R&D, design of products, prototype production, design of mass production processes, sourcing of raw materials, production of parts of components, assembly, testing, packaging and shipping, sales and after-sale services. To achieve global efficiency, different parts of the value chains are located in different countries (see Cheng and Kierzkowski 2002). It is hard to mimic this by any single country in isolation, not even by the leading economic powers. Moreover, FDI by multinational firms is a very important feature of today’s global economy because FDI is the most important organization form under which globalized production is implemented.11 Countries that refuse FDI will be left behind in production capability and national income. The architect of China’s economic reform, Deng Xiaoping, decided in the late 1970s that

60 China’s Experience with FDI

China should integrate into the world economy to reap the benefits of division of labour. Since then China’s policies toward FDI have been devised with this broad strategic objective in mind. Certainly, embracing FDI was one of the most important factors behind China’s recent economic success. Furthermore, the finding that FDI was an important factor in explaining the differential economic performance of Chinese regions and cities is particularly revealing because the different Chinese regions and cities were subject to the same set of macroeconomic policies and operated under the same legal system. On the one hand, given the multiple benefits that FDI brings to the host countries, a hostile attitude toward FDI is obviously wrong from an economic perspective. On the other hand, it would be equally wrong to have a romantic view about FDI because the primary objective of foreign investors is profit, not assisting in the host countries’ economic development. They will contribute to economic development only if it is compatible with their profit incentive. It is therefore crucial for policy analysts and policy makers in developing economies to find ways for foreign investors to make profits while at the same time contributing to economic development. Overall, China has taken a pragmatic view of FDI, and has thus responded quite well to the needs of both its own economy and those of the foreign investors. Labour-intensive industries were clearly part of China’s comparative advantage, and thus profitable. Not surprisingly, they were where China had the greatest success with FDI, exports and employment. In contrast, when China deviated from pragmatism and tried to promote those industries that were regarded as crucial to China (the agricultural sector and hightech industries) but were against the country’s comparative advantage, little was accomplished. It would be unrealistic for a developing country with poor or no human capital to look down on labour-intensive industries and to dream about high value added and technology-intensive industries. Given China’s substantial foreign reserves and proven export capability in labour-intensive products, China may be a valuable source of FDI for developing economies. A salient feature of China’s pragmatic ‘open door’ policy was experimentation and adaptation. It was found through such experimentation that when foreign firms were given the freedom to set up WFOEs, many chose this mode over other modes that involved local partners. It was also discovered early on that granting tax and import duty exemptions was not enough to attract FDI, not even for foreign firms that engaged only in production for export. The Chinese government realized that it had to create a business-friendly environment for FDI to have a chance of success. And when the business environment improved foreign investors responded favourably. While the experience of India seemed to be negative, there was evidence that FDI contributed to upgrading of Chinese industries, exports, and technology; technology transfer in ASEAN occurred through relations between

Leonard K. Cheng 61

foreign companies and local suppliers.12 It should be emphasized that FDI is not a panacea, and FDI in labour-intensive manufactures can be rather footloose. Domestic policies such as investment in education and human capital and the development of appropriate physical and legal infrastructures are thus essential in sustaining the contribution of foreign investment to national economic development. Notes 1. According to World Investment Report 2003, the inward FDI of China rose from $46.8 billion in 2001 to $52.7 in 2002. In contrast, the inward FDI of the USA decreased from $144 billion in 2001 to $30 billion in 2002. 2. This table is taken from Cheng and Qiu (2003, Table 1.1). 3. In addition to the slower growth of the Chinese economy, Hu (1999) believes that the decline in FDI during this period was also due to the success of domestic firms in challenging foreign firms and government support provided to domestic firms through administrative means. 4. See Cheng and Qiu (2003) for a review. 5. Since FDI depends on economic growth and economic growth depends on FDI, there is a self-reflecting effect of FDI on itself, reflecing Cheng and Kwan’s (2000) finding that past FDI was a significantly positive determinant of current FDI. The finding of a positive dependence of FDI on infrastructure and ‘openness’ by Demurger and her associates is also similar to findings by Cheng and Kwan. 6. Wei’s treatment of foreign owned capital stock was similar to that of He and Xu (1999) – namely, foreign owned capital stock was added to domestically owned capital stock to get the total capital stock, but foreign capital stock was allowed to play an additional role through a separate variable. 7. The senior members include the ‘ASEAN-5’ and Brunei; the new members are Vietnam, Laos, Cambodia and Myanmar. 8. The new members of ASEAN were newcomers in using FDI as a major tool for economic development. 9. See, for examples, Wu et al. (2002, Exhibit 1). 10. See Wu et al. (2002, Exhibit 2), who compared each country’s FDI Performance Index (i.e. the FDI–GDP ratio of each host country divided by the same ratio for the entire world, a common denominator for all countrie. 11. See Cheng, Qiu and Tan (2001) for an analysis. 12. See Thomsen (1999:28) and Mirza et al. (undated:70–3).

References Berthelemy, J.-C. and Demurger, S. ‘Foreign Direct Investment and Economic Growth: Theory and Application to China’, Review of Development Economics, 4 (2), 2000, 140–55. Cheng, L.K. and Kierzkowski, H. (eds), Global Production and Trade in East Asia, Boston, Kluwer Academic Publishers, 2002. Cheng, L.K. and Kwan, T.K. ‘What are the Determinants of the Location of Foreign Direct Investment? The Chinese Experience’, Journal of International Economics, 51 (2), 2000, 379–400. Cheng, L.K. and Qiu, L.D. ‘China’s Foreign Trade, Foreign Direct Investment, and Their Contributions to Economic Growth’, Working Paper, Department of Economics, Hong Kong University of Science and Technology, Hong Kong, 2003.

62 China’s Experience with FDI Cheng, L.K., Qiu, L.D.W. and Tan, G., ‘Foreign Direct Investment and International Fragmentation of Production,’ in Arndt, S.W. and H. Kierzkowski (eds), Fragmentation: New Production Patterns in the World Economy, Oxford, Oxford University Press, 2001, 165–86. Demurger, S., Economic Opening and Growth in China, Development Centre Studies, Organisation for Economic Co-operation and Development, Paris, 2000. ———— ‘Infrastructure Development and Economic Growth: An Explanation for Regional Disparities in China?’, Journal of Comparative Economics, 29, 2001, 95–117. Demurger, S, Sachs, J.D., Woo, W.T., Bao, S., Chang, G. and Mellinger A., ‘Geography, Economic Policy and Regional Development in China’, Asian Economic Papers, 1, 2002. Guo, K., ‘Waishang zhijie touzi dui wo guo chanyie jiegou de yingxiang yianjiu’ (A Study of the Effects of Foreign Direct Investment on Our Country’s Industrial Structure), Guanli Shijie (The World of Management), 2, 2000a, 34–45, 63. ———— ‘Jiaru WTO hou waishang touzi jiegou de biandong qushi ji xiaoying fenxi’ (A Study of the Trends and Effects of Changes in the Structure of Foreign Investment after Entry into the WTO), Kaifang Daobao (The Openness Herald), Shenzhen, 3 February, 3, 2000b, 11–13. He, J. and Xu, L. ‘Zhongguo gongyie bumen yinjin waiguo zhijie touzi waiyi xiaoying de shizheng yianjiu’ (An Empirical Study of the Spillover Effects of Foreign Direct Investment on China’s Industrial Sector), Shijie Jingji Wunhui (Essays on the World Economy), 2, 1999, 16–21. Hu, A., ‘Jiji xiyin kuaguo gongsi zhijie touzi’ (Actively Attract Direct Investment by Multinational corporations), Hongguan Jingji Gaige (Macroeconomic Reform), 5, 1999, 36–42, 64. Huang, H., ‘Waishang zhijie touzi yu woguo shizhi jingji guanxi de shizheng fenxi’ (An Empirical Study of the Relationship between Foreign Direct Investment and our Country’s Real Economy), Nankai Economic Studies, 5, 2000, 46–51. Jiang, X., ‘Liyong waizi yu jingji zengzhang fangshi de zhuan bian’ (Changes in the Utilization of Foreign Investment and the Mode of Economic Growth), Guanli Shijie (World of Management), 2, 1999, 7–15. ———— ‘Shiwu qijian waishang dui hua touzi chushi fenxi’ (An Analysis of the Trend of Foreign Investment in China during the Tenth Five-Year Plan), Chaimou Jingji (The Economics of Finance and Trade), 2, 2001, 55–9. Mirza, H., Giroud, A. and Koster, K., ‘Recent Flows in Foreign Direct Investment and Technology Transfer to ASEAN Economies’, Working Paper, University of Bradford School of Management, undated. Nagaraj, R., ‘Foreign Direct Investment in India in the 1990s: Trends and Issues,’ Economic and Political Weekly, 26, April 2003. National Planning Commission (Economic Research Institute Study Team on Utilization of Foreign Investment), ‘Woguo zhong chang qi liyong waizi de zhanlue xuanze’ (Our Country’s Strategic Choices over the Utilization of Foreign Investment in the Medium- and Long-Run), Zhanlue yu Guanli (Strategy and Management), 2, 1997, 63–72. National Planning Commission (Macroeconomics Society Study Team), ‘Wuguo kua shiji jingji fazhan jincheng zhong de guoji tou rong zi zhanlue wenti yianjiu’ (Research on Issues Related to Our Country’s International Investment and Fund Raising in the Process of Economic Development into the Next Century), Guanli Shijie (World of Management), 1, 1999, 65–79, 89.

Leonard K. Cheng 63 Sun, H., Foreign Investment and Economic Development in China: 1979–1996. Aldershot, Ashgate, 1998. Thomsen, S., Southeast Asia: The Role of Foreign Direct Investment Policies in Development, Working Papers on International Investment, Directorate for Financial, Fiscal and Enterprise Affairs, Organisation for Economic Co-operation and Development, Paris, 1999. Wei, S.-J., ‘Foreign Direct Investment in China: Sources and Consequences,’ in T. Ito and A. Krueger (eds), Financial Deregulation and Integration in East Asia, Chicago, University of Chicago Press, 1996, 77–101. Wu, F., Poa T. S., Yeo, H.S., and Puah, K.K., ‘Foreign Direct Investments’ to China and Southeast Asia: Has ASEAN been Losing Out’, Economic Survey of Singapore, Third Quarter, 2002, 96–115. Zhang, X., ‘Foreign Investment Policy, Contribution and Performance’, in Y. Wu (ed.), Foreign Direct Investment and Economic Growth in China, Cheltenham, Edward Elgar, 1999, 1–41. Zheng, J., Du, Y. and Ba, W., ‘Woguo liyong waizi xianzhuang de dinliang fenxi he chubu yianjiu’ (A quantitative Analysis and Preliminary Investigation of Our Country’s Present Utilization of Foreign Investment) Guanli Shijie (World of Management), 1, 1998, 80–6, 99.

4 A Normative Model to Evaluate China’s FDI Regime Ramin Cooper Maysami and Wayne Lim

1 The Chinese economy and the path to FDI: a historical perspective The reform of the Chinese economy began after Mao Zedong’s death in 1976. Led by Deng Xiaoping, the Chinese government started slowly, allowing impoverished localities to experiment with household farming. Chairman Deng’s reforms quickly led to the ‘open door’ policy of foreign trade in 1979. In the same year, ‘The Equity Joint Venture Law’ allowed the legal entry of FDI into the Mainland and thus provided the statutory basis for the establishment of joint ventures (JVs) in China. Shortly after, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) was established to develop China’s foreign economic relations and trade. The central government followed the reforms by allowing industrial firms to retain a modest share of their profits as an incentive to enliven state assets. In the 1980s, Special economic zones (SEZs) were set up in its coastal cities such as Shenzhen, Zhuhai, Shan Tou and Guangdong provinces to attract foreign investors. Two important regulatory events in the 1980s were the passage of the ‘Law on Enterprises Operated Exclusively with Foreign Capital’ in 1986 and the ‘Law on Cooperative Ventures’ in 1988. With the passage of these laws, China developed a legal infrastructure to govern the three main forms of foreign-invested enterprises–Sino-foreign joint ventures (SFJVs), Sino–foreign cooperative ventures (SFCVs) and Wholly foreign owned enterprise (WFOEs)1. In the 1990s, China’s economy achieved an astounding average yearon-year GDP growth of more than 8 per cent (Table 4.1). Since then, China has continuously impressed the world as it has joined the list of countries experiencing the ‘East Asian Miracle’ and has also become a hotbed of foreign investment. In September 2001, China officially became a member of the World Trade Organization (WTO), and this is expected to provide a further boost to its economic development as well as the acceleration of its economic integration with the global economy. 64

Ramin Cooper Maysami and Wayne Lim 65 Table 4.1 China’s annual GDP growth, 1991–2001, year-on-year Year GDP growth (%)

1991 1992

9.2

14.2

1993

1994 1995

13.5

12.6

10.5

1996 1997 1998 1999

9.6

8.8

7.8

7.1

2000 2001

8.0

7.3

Source: China Statistical Yearbook (various years).

2

Foreign direct investments in China

There has indeed been a significant influx of foreign capital into the Chinese market since the time that these changes took place. FDI in China can be broadly categorized into three forms: SFJVs, SFCVs and WFOEs. SFJVs are the most common form of business setup. It is governed by the ‘Law of the People’s Republic of China on Chinese Joint Ventures,’ a comprehensive set of regulation to control business ventures, organization structure, fund movements and employment of workers. A JV is to be registered and is considered a Chinese legal entity and must abide by all Chinese laws. Shareholdings in a JV are usually non-negotiable and cannot be transferred without approval from the Chinese government. Registered capital is restricted from withdrawal during the life of the JV contract. A minimum investment of 25 per cent by the foreign partner is required. The permissible debt-equity ratio of a JV is regulated, depending on its size.2 SFCVs are contractual JV structures, where in addition to capital funds investors implement foreign expertise and technology into their companies in China. A key feature of the SFCV is that there is no minimum contribution required. In addition, the parties involved may operate as separate legal entities and bear liabilities independently rather than as a single entity. The greater flexibility of the SFCV structure is a clear advantage over investments under SFJV. WFOEs enjoy exclusive management control over their management activities. They are the least preferred form of business setup, mainly because of extensive regulation, but these regulations are expected to ease following China’s entry into the WTO. In addition, the independence offered to the foreign investor is often outweighed by the lack of direct links to the domestic economy. This shortcoming is admitted by Deloitte (2003), who comment that it is important to invest the time needed to build and maintain the proper relationships to be successful in China. Often such relationships are established through a set of informal ‘exchange practices’ or Guanxi. As all three forms of FDI are likely to be a Chinese legal entity, they are also governed by all Chinese laws and international agreements.

66 A Normative Model for China’s FDI Regime

3

Trend of FDI into China

The flow of FDI began slowly in 1979 with the injection of capital by small and medium-sized enterprises (SMEs) in Hong Kong, and was highly concentrated in the neighbouring Guangdong Province. The inflow accelerated in 1992 when the utilization of FDI nearly tripled, from approximately US$4,300 million to US$11,000 million. Although the increase in fund inflows started with Deng Xiaoping’s much-publicized tour of the southern provinces in early 1992, inflation was finally brought under control in that year. Reform policies previously suspended due to inflation were re-implemented (Sun 2002). This phenomenal growth continued in 1993 through another staggering increase of about 1.5 times to approximately US$27,500 million. FDI in the 1994–9 grew by an average of 10 per cent, with the level of FDI actually utilized in 1998 amounting to US$45,400 million (see Figure 4.1). With the exception of a fall in the actual utilization of FDI in 1999 by around 11 per cent, China has managed to register further growth of FDI inflow. Its cumulative actual investment reached US$444,500 million by the end of 2001. Trend of investment by country Almost from the beginning, China’s foreign investment policy was biased in favor of the southeast coastal region, possibly to take advantage of the locational benefits to attract investments from Hong Kong and Macau. It is therefore, not surprising to find Hong Kong as the leading source country for FDI. Tuan and Ng (2003) studied the impacts of agglomerations on FDI flows in Guangdong and found that Hong Kong undeniably served as a city

700 US$100 million

600 500 400 300 200 100 0 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002* Total capital inflow

Total FDI inflow

Figure 4.1 Realized capital and actual FDI inflows, 1984–2000 Source: China Statistical Yearbook (various years).

Ramin Cooper Maysami and Wayne Lim 67

core to facilitate FDI in Guangdong and in particular, in the peripheral region of the Pearl River Delta. Another reason cited for the high investment from Hong Kong is ‘round-tripping’ investment. Such investment emanates from China itself that is routed via Hong Kong to take advantages of incentive measures such as ‘tax holidays’. Huang (1998) estimates the ‘round-tripping’ capital at 15 per cent of total Hong Kong investment in China in the Chinese official statistics. Multinational companies (MNCs) from industrialized nations, meanwhile, began investing heavily in China from 1992. Table 4.2 shows the sudden shift in the source of FDI starting in 1992. Although Hong Kong’s investment in China has increased in absolute terms, its percentage share has declined steadily. Other countries – Japan, Taiwan, the USA, for example, as well as the tiny island-nation of Singapore – have been quick to fill in the gap. Investment trends by sectors The sectoral distribution of FDI in China has been highly uneven (Table 4.3). Throughout the 1990s, the industry and manufacturing and the real estate and public utilities were the two largest sector recipients. In the real estate sector, FDI grew by 213.2 per cent, from US$5,813 million in 1999 to US$7,165 million in 2001. During the same period, FDI in the manufacturing sector grew from US$25,654 million to US$49,491 million. These two sectors accounted for 81.87 per cent of the total FDI inflow in 2001, as compared to 76.3 per cent in 1999. Regional distribution of FDI The highly geographic pattern of FDI in China has basically remained unchanged (Figure 4.2). The major recipient provinces and cities of FDI are

Table 4.2 Chinese FDI inflow by country of origin, 1992–2001, selected countries and years Country

1992 %

1997 %

1998 %

1999 %

2000 %

2001 %

Hong Kong Japan Singapore Taiwan Virgin Islands USA Republic of Korea

68.2 6.6 1.1 9.3

45.6 9.6 5.8 7.3

40.7 7.5 7.5 6.4

40.6 7.4 6.6 6.4

38.1 7.2 5.3 5.6

35.7 9.3 4.6 6.4

0.0 4.6

3.8 7.2

8.9 8.6

6.6 10.5

9.4 10.8

10.8 9.5

1.1

4.7

4.0

3.2

3.7

4.6

Source: China Statistical Yearbook (various years).

68 A Normative Model for China’s FDI Regime Table 4.3 Sectoral share of total FDI through agreements and contracts, 1995–2001 Sector

1995 %

1996 %

1997 %

1998 %

1999 %

2000 %

1.90

1.55

2.09

2.31

3.57

2.38

2.55

Industry and Manufacturing

67.54

68.90

54.47

60.80

62.23

71.76

71.52

Electric Power, Gas and Water Production and Supply, Real Estate

Farming, Forestry, Animal Husbandry and Fishery and Water Conservancy

2001 %

19.54

17.54

19.37

16.54

14.10

10.35

10.35

Construction

2.10

2.73

6.12

3.36

2.66

1.33

2.63

Transport, Storage, Post and Telecommunication Services

1.86

2.18

5.14

4.42

2.70

2.27

1.28

Wholesale and Retail Trade and Catering Services

3.75

3.20

3.61

2.52

2.92

2.30

2.02

Scientific Research and Polytechnic Services

0.30

0.24

5.23

5.78

7.32

6.82

6.20

Health Care, Sports and Social Welfare

0.92

0.48

0.28

0.27

0.16

0.25

0.19

Education, Culture and Arts, Radio, Film and Television

0.38

0.23

0.14

0.04

0.18

0.13

0.10

Other Sectors

1.71

2.94

3.56

3.96

4.16

2.41

3.15

Source: China Statistical Yearbook (various years).

located in the coastal regions. One of the reasons that the government policy on FDI is biased to these regions is the proximity in culture and location to Hong Kong, Macau and Taiwan. A common reason cited for inward FDI in China is the vast potential market and labour abundance (Lim 2001; MIGA 2003). It is therefore, not surprising that the bulk of the FDI is concentrated in the coastal regions, which have a high population density. In terms of the share in the total national cumulative actual investment, the five biggest provinces and cities are Guangdong, Jiangsu, Fujian, Shanghai and Shandong. The actual investment in these five provinces and cities accounted for 65.2 per cent of the total national FDI in 2001, a slight decrease from 71.6 per cent in 1992. This is a result of the governmental effort to attract FDI into the Western and Central Regions.

Ramin Cooper Maysami and Wayne Lim 69

% 100 90 80 70 60 50 40 30 20 10 0 1 Coastal

Western

Central

Figure 4.2 Distribution of actual FDI, by region Source: China Statistical Yearbook (various years).

4

Review of relevant literature

Velde (2001) has established two broad categories of policies which are likely to affect the level and impact of FDI on the host economy: economic policies that are largely under direct domestic control and those policies and factors are not controllable by the host economy. The former encompasses both industrial and macroeconomics policies. Relevant industrial policies expected to affect inward FDI include promotion, targeting and image-building, financial and fiscal incentives, efficient administrative procedures and rules on ownership, encouraging development in key sectors, taxation, developing export platforms, training of employees, encouragement of R&D, performance requirements and interaction with research institutions and other firms. The macroeconomics policies affecting FDI inflow are labour market policies, development of financial markets, sound macroeconomic performance and prospects, trade policies and export promotion, competition policies, the availability of infrastructure and privatization opportunities. In addition, global economic integration and transportation costs, international, regional and bilateral treaties, insurance and political risk taking, the absence of corruption, geographical advantage, availability of resources as well as social and cultural issues are factors contributing to FDI movement. Dunning (2002) recognizes two points of view that multinational enterprises (MNEs) may adopt when choosing their ideal host country. The first

70 A Normative Model for China’s FDI Regime

is based on an MNE’s motivation in relocating its activities as a result of the new global economic environment. There are four such motives – marketseeking, resource-seeking, efficiency-seeking and asset-seeking – with each motive placing emphasis on different economic determinants in the host country. Generally, the economic determinants of this perspective include market size and growth, accessibility to regional and global markets, country-specific consumer preference, building costs and rentals, the cost of raw material and labour, infrastructure, presence of regional integration agreement to promote efficiency, the macroeconomic environment and entrepreneurial education capacity. The second perspective is based on the economic and business environment of the host country and the FDI-related policies pursued by host governments. Investors are concerned about the economic, political and social stability of the host nation, as well as the policies that the government has implemented within the economy. A stable business environment is also important in facilitating the growth and functioning of investments. Good infrastructure and support services are vital to provide bureaucratic efficiency, connectivity and an integrated network of business units. Other factors include ‘hassle’ costs due to corruption, lack of social amenities and weak economic morality (see Appendix 1, p. 89). Dunning’s study also suggests new determinants of FDI in view of increased globalization. These determinants include the increased emergence of Internet and business-to-business (B2B) electronic commerce and a trend shown by MNEs to take advantage of the subnational and spatial agglomeration of the countries through diversifying and expanding their operations. Houde and Lee (2000) classify FDI into market oriented FDI and export oriented FDI. The most important factor to attracted import oriented FDI is the size and growth of the host country. On the other hand, export oriented FDI is mainly attracted by cost competitiveness. Notwithstanding these differences, the study suggests some key determining factors for attracting FDI. First, the size, growth and prospects of the economy are important factors to attract FDI into the host nation. Second, the economy should have and make available a large pool of natural and human resources supported by a physical, financial and technological infrastructure. Thirdly, its openness to international trade and access to international markets would further enhance its attractiveness to foreign investments. These include bilateral trade agreements and preferential governmental policies. In addition, the host government can also offer attractive incentives to encourage investments and reinvestments. Finally, the existence of a regulatory framework and coherent economic policies are also important determinants in attracting FDI. These factors are necessary to protect the interest of foreign entities.

Ramin Cooper Maysami and Wayne Lim 71

Singh and Jun (1995) postulate that the level of exports, social and political risks and conditions for business operation help determine the level of FDI in a developing country. Supported by standard regression analysis and by Granger causality tests, they imply that the strongest variable in explaining a country’s ability to attract FDI is the level of exports, especially manufacturing exports. The level of social and political risk was found to be a significant determinant of FDI in countries that have historically attracted high FDI inflows while socio-political instability was found to have attributed to low FDI flows in other countries. Finally, conditions for business operation were discovered to be important determinants of FDI in countries that received high investment flows and the amount of taxes on international transactions also had a positive relation with the amount of FDI. MIGA (2003) conducted a benchmarking study on the operating costs and conditions in six Asian countries for the electronics and shared services industries, which are regionally strong in attracting FDI. The six Asian countries included China, Indonesia, Malaysia, the Philippines, Thailand and Vietnam. The investors in Shanghai and Beijing were interviewed and the following factors were the most highly rated: utility availability and costs, political–social stability, market access globally and domestically, incentives and labour costs and skills. The factors identified in the literature review are summarized in Table 4.4 and can be broadly grouped into nine categories: (1) Factors of production, (2) Support facilities and infrastructure to facilitate business, (3) Domestic market, (4) Global markets, (5) Investment-promoting policies, (6) Laws and government policies, (7) Quality of government administration, (8) Political and social stability and (9) Exchange rate regime.

5

A normative model to evaluate FDI inflow

The chapter continues with the construction of a normative model that encompasses the nine categories of FDI contributory factors listed above. These factors are then amalgamated with relevant features of several agreements from two international economic bodies – the Multilateral Agreement on Investment (MAI) of the Organization for Economic Cooperation and Development (OECD),3 and the General Agreement on Trade in Services (GATS), the Agreement on Trade-Related Investment Measures (TRIMs), the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs), and the ‘Dispute Settlement Understanding’ (DSU) of the WTO. The model will evaluate China’s FDI regime through an examination of whether China has pursued the factors prescribed by the framework, and by investigating the existence of effective enforcement and application of the FDI regime.

72

Table 4.4 Summary of FDI determinants highlighted in the literature

Category

Velde(2001)

Dunning (2002)

1

Production factors

(1) Raw materials (2) Low cost unskilled labour and skilled labour

2

Support facilities and infrastructure

3

Domestic market

4

Global markets

(1) Availability of skilled labour and good labour relations (2) Availability of natural resources (1) Availability of infrastructure (2) Developing key sectors (agglomeration and clustering) (3) Development of financial market and debt position (1) Sound macroeconomic performance and prospects (2) Location near large and wealthy markets (1) Developing export platforms (2) No impediments to trade of goods and services

MIGA (2003)

Singh and Jun (1995)

Houde and Lee (2000)

(1) Utility availability and costs (2) Labour skills

(1) Wage costs (2) Labour relations

(1) Large pool of human resource (2) Large pool of natural resource

(1) Infrastructure

(1) Supported by physical, financial and technological infrastructure

(1) Land and building costs/rents and rates, components, parts (2) Good infrastructure and support services (1) Economic stability (2) Market size, growth

(1) Market access domestically

(1) Market size (2) Economic growth

(1) Size and growth of the host country (2) Economic policy

(1) Trade policy and coherence of FDI and trade policies (2) International agreements on FDI

(1) Market access globally

(1) Export orientation (2) Tax on trade

(1) Openness to international trade and access to international markets

5

Investing promoting policies

6

Laws and government policies

7

Quality of administration

8

Political and social stability Exchange rate regime

9

(3) International, regional and bilateral treaties (1) Financial and fiscal incentives and bargaining (2) Promotion, targeting and image-building (1) Rules on ownership

(1) Absence of corruption (2) Efficient administrative procedures

(3) Access to regional and global markets (1) Investment promotion schemes (2) Investment incentives

(1) Rules regarding entry on operations (2) Policies on functioning and structure of markets (3) Industrial / regional policy (1) Reduce ‘hassle’ costs related to corruption (2) Bureaucratic inefficiency (1) Political and social stability

(2) Bilateral agreements and preferential policies by the government (1) Attractive incentives to encourage investments and reinvestments

(1) Incentives

(1) Enforceability of contracts

(1) Political and social stability

(1) Development of regulatory framework

(1) Political continuity (1) Stability (2) Convertibility

73

74 A Normative Model for China’s FDI Regime

6

Factors affecting FDI inflow

Production factors Successful FDI inflow depends on the host economy’s comparative advantage in factors of production, including its labour force, land and natural resources. The country is required to provide a large workforce pool and resources at a competitive cost to foreign investors (Dunning 2002). The country should also have basic education and compulsory training for the improvement of the workforce’s quality (Velde 2001). Support facilities and infrastructure A country interested in attracting FDI should provide an adequate physical, financial and technological infrastructure (Houde and Lee 2000) since good infrastructure and support facilities are vital to provide bureaucratic efficiency, connectivity and an integrated network of the business units (Dunning 2002). Other than developing a sound physical infrastructure – such as roads, ports and gas pipelines – the host country’s banking system and its capital markets should be developed to facilitate fund-raising by foreign investors (Velde 2001). The host economy should also establish and implement effective supervision and regulation to ensure smooth operation of the financial markets. Financial services including banking, insurance and other related services should be provided to foreign owned enterprises. The government needs to promote investments in key sectors by creating clusters of firms which lead to agglomeration economies, resulting in access to common learning facilities, information, infrastructure, factor and product markets, which will attract foreign investors. Domestic market Lim (2001) surveyed the literature on determinants of FDI in China and concluded that ‘the most robust determinant is market size’. Any policy or events affecting the size, growth and access to the domestic market will therefore have an impact on FDI flows (Singh and Jun 1995; MIGA 2003). Other than sound macroeconomic policies, the host economy should also treat both foreign and local investors equally with respect to the establishment, acquisition, expansion, operation, management, maintenance, use, enjoyment and sale or other disposition of investments. This includes taxation, rule-setting, administrative procedures and access to courts. If the host economy has offered special treatment or has in the past favoured investors from a particular country, it must now extend such privileges to other countries. Investors should not be denied market access or treated differently on the basis of their nationality, as prescribed by the MAI and GATS.

Ramin Cooper Maysami and Wayne Lim 75

Global markets Foreign investors are more likely to manufacture and export their products from the host economy than sell to the domestic markets (Singh and Jun 1995). Successful attraction of FDI thus requires an export oriented policy in the host economy by removing trade barriers such as administrative enforcement, export tariffs, local content requirement and export proportion requirements. The existence of international, regional and bilateral agreements by the host economy is important in attracting FDI, according (Velde 2001; Dunning 2002). Imposition of international agreements such as TRIMs, National and Most favoured nation (MFN) treatment and the conclusion of regional and bilateral agreements will encourage FDI, as these limit the power of the host country to impose performance requirements on foreign investors. Foreign investors then enjoy more freedom over business and investing decisions. Investment promoting policies Dunning (2002) shows that the host economy should establish investment promotion schemes to target and attract foreign investors. This can be done by providing general information, advertising, undertaking ‘match-making’ activities, organizing site visits and supporting feasibility studies and project proposals. Investment incentives could also be introduced to encourage inward FDI (MIGA 2003). ‘Investment incentives’ are a host government’s policies designed to promote FDI, and generally fall into three categories: (1) Tax incentives such as tax holidays, export tax reductions, and exemptions from import duties; (2) Other financial incentives such as grants for investment and loan guarantees; (3) Non-financial incentives such as provision of infrastructure, pre-built factory premises and business services (MAI). The provision of such incentives will result in an increase in FDI inflows (see Appendix 4, p. 96). Laws and government policies Singh and Jun (1995), Houde and Lee (2000), Velde (2001), and Dunning (2002) maintain that the legal framework and policies on functioning of businesses will have an impact on the host country’s attractiveness to FDI. The host economy should make available publicly its laws, regulations, procedures, administrative rulings and judicial decisions of general application as well as international agreements which may affect the operation of foreign investors. When changes or new policies are established, the host economy should promptly publish or make them publicly available (MAI, GATS). It should also set out specific courses of action that may be taken in cases of disputes with foreign countries or foreign investors. In a state–state dispute settlement, the countries involved should be allowed to initiate

76 A Normative Model for China’s FDI Regime

consultations and/or seek recourse with an independent authority for mediation, reconciliation, or arbitration to resolve the dispute. In the event of disputes between a host economy and a foreign investor, the foreign investor should be allowed to seek arbitration for any disputes concerning obligations which the host country has entered into with regard to a specific venture of the investor. This rule enables private investors and corporations to sue national governments, and seek monetary compensation if warranted, in the event that a law, practice or policy violates their rights (MAI, DSU). In addition, the host economy should provide high level of IPR protection and enforcement for copyrights, trademarks, geographical indications, industrial designs, patents, layout designs of integrated circuits and trade secrets. The scope and degree of such protection should conform to international practices. The host economy should also have in place an effective judicial body to deal with violations such as piracy and copyright infringement. Relevant legislation should be constantly revised to ensure all areas are protected (MAI, TRIPs). Temporary entry, stay and authorization to work should be granted to foreign investors or key personnel in order to attract FDI. The host economy should also be encouraged to grant a similar temporary entry and stay and provide any necessary confirming documentation to the spouse and minor children of foreign investors who have been granted temporary entry, stay and authorization to work (MAI). Finally, the host economy should ensure that all legitimate payments relating to an investment in its territory may be freely transferred into or expatriated out of the territory. These transfers include initial capital and additional amounts to maintain or increase an investment, returns, payments made under a contract, proceeds from the sale or liquidation of an investment, compensation, earnings and other remuneration of personnel engaged from abroad in connection with investments (MAI). In summary, the development of business-friendly policies and a strong legal framework are vital to enhance the host country’s attractiveness for FDI. Quality of administration The quality and integrity of the public administration affect a country’s ability to attract FDI (Velde 2001). Administrative procedures relating to FDI include general investment approval, approval of incentives, tax registrations, company formation, granting of work permits and business licenses, among others. As cumbersome procedures have been known to hinder and deter FDI inflow, the host economy should focus on the quality and speed of its administrative procedures (Dunning 2002) (see also Appendix 5, p.97). Besides efficiency, the integrity of public administration is important. Corruption leads to economic loss and will contribute to social and political

Ramin Cooper Maysami and Wayne Lim 77

instability (Velde 2001). These, in turn, lead to a decrease in confidence of foreign investors in the host economy’s regulatory and administrative credibility, hence reducing investment inflows. The host economy should therefore increase the transparency of government activities by encouraging citizen participation, freedom of the media and an independent judiciary. The government should be questioned and, if necessary, held responsible for mistakes or wrongdoing. Furthermore, government officials should be forbidden from interference and participation in business enterprises. Finally, legislation against corruption should be enacted and such laws strictly enforced (Hu 2001). Political and social stability Political and social stability is essential to attracting FDI as it provides an conducive environment for investors and investments (MIGA 2003). The host economy should have credible political and legal institutions and stabilizing monetary and fiscal policies. Good foreign political and economic relationships should also be maintained. Exchange rate regime The host economy should implement a credible exchange rate policy to ensure that its currency is not subject to excessive volatility as this would impede both trade and FDI flows (Kerr and Monsingh 2001). The host country’s currency should also be convertible to facilitate fund transfers (Singh and Jun 1995).

7

Evaluation of China’s FDI regime

Equipped with the framework thus developed, the current study proceeds by evaluating China’s status with respect to each of the factors mentioned above. Production factors China’s potential lies in the availability of large amount of natural and human resources. Located in an excellent geographic location in Eastern Asia, China is the world’s fourth largest country with a land area of 9,596,960 km2. It has an abundance of natural resources such as coal, iron ore, petroleum, natural gas, mercury, tin, tungsten, uranium, aluminum, lead and zinc. In addition to natural endowments, China has a large pool of untapped labour, with its population of 1,284 million and a labour force of 706 million. MIGA (2003) has ranked the cost of the Chinese workforce as lowest when compared to Indonesia, Malaysia, the Philippines, Thailand and Vietnam. The average monthly wage in China is US$120, compared to US$197 in Thailand and much lower than those of the USA ($2,800) and Singapore ($1,770), for example.4 Kerr and Monsingh (2001), having recognized the surge and importance of FDI in China, examined the determinants

78 A Normative Model for China’s FDI Regime

of FDI flows into China over the period 1980–98. Their findings reveal that wages are indeed negatively related to FDI inflow – lower wages in the host country encourages FDI. Low wages in China have contributed considerably to China’s success in attracting FDI. Other than low wages, the quality of the Chinese workforce has contributed to its success in attracting FDI. MIGA (2003) noted that in the electronics manufacturing industry China’s workforce is considered very productive, and there is an almost inexhaustible supply of new college and technical school graduates. China’s literacy rate, of children aged 15 and above, is 81.5 per cent. Sun, Tong and Yu (2002) analysed the spatial and temporal variation in FDI among China’s 30 provinces from 1986 to 1998, and found labour quality to be an important determinant of FDI in China. In conclusion, these natural and human endowments gave China a comparative advantage in attracting FDI. However, China faces several challenges. Despite the country’s large oil reserves, it has remained a net importer of petroleum since 1993 owing to its own high consumption.5 Its economy therefore remains exposed to the fluctuations of oil supply and prices. China has also faced the risk of rising labour costs in the major coastal cities. Sun, Tong and Yu (2002) found that wages had a positive relationship with FDI before 1991 but had a negative relationship since then. They argued that in Guangdong and Fujian intensive competition for quality workers have drove up labour costs. Although Chinese labour is competitive in manufacturing industries, it is not as competitive in other industries, such as the shared support services industry. MIGA (2003) showed that salaries in the shared services industry in China were among the highest of those surveyed. In addition, MIGA (2003) noted that the Chinese workforce in this industry lacked management talent and language skills qualifications. Concern over Chinese labour has been reiterated by OECD (2000). They commented that: the factor cost advantages have been experiencing some erosion. With the globalization of the world economy and the liberalization of international trade and the giant strides in technological innovation, the advantage of a cheap labor force has become less important for foreign investors. China’s disadvantages in terms of technology gap and lack of labor qualification in some areas will also take some time to improve.

Support facilities and infrastructure China has increased it attractiveness by upgrading its infrastructure to accommodate an expected influx of investors. Existing ports were upgraded and newer ports constructed along the coastal regions. Roads and railways were built to link these ports to the SEZs. China’s transportation system

Ramin Cooper Maysami and Wayne Lim 79

includes railways (67,524 km), highways (1.4 million km), waterways (110,000 km), pipelines for crude oil (9070 km), ports and harbours (20) and airports (489).6 Sun, Tong and Yu (2002) found evidence that infrastructure was an important determinant in attracting FDI. An econometric examination of American and Japanese direct investment in China from 1990 to 2001 by Fung, Iizaka and Tong (2003) found that the number of Economic and technological development zones (ETDZs) was helpful in attracting Japanese and US investment. In addition, they found that infrastructure, including railways and roads, was positively related to US and Japanese direct investment flows. Transportation therefore matters to the manufacturing operations of US and Japanese multinationals in China. Development of supporting industries has also contributed to China’s attractiveness for FDI. In the assessment of China’s electronics manufacturing industry, MIGA (2003) concluded that China had a well-developed electronic supply base. The presence of supporting industries contributed to manufacturing industry having a majority share of the total FDI. The Chinese banking system also underwent significant improvements in the 1990s. ‘Regulations of the Bank of China on Providing Loans to Enterprises with Foreign Investment’ are issued with a view to supporting the production and operation of foreign-invested enterprises (FIEs), expanding international economic and technical cooperation as well as promoting the development of China’s economy. Currently, FIEs can obtain additional financing through loans from both domestic and financial institutions and by issuing equity stock, either domestically or overseas, with the approval of the appropriate authorities. However, the government remains largely in control of the banking sectors and directs lending to state-favoured projects, businesses and individuals. OECD (2000) asserts that the slow development of the service sector has been mainly due to China’s relative closure to foreign participation and the monopoly of state enterprises. The study mentions that although there have been a substantial number of foreign bank offices, operations in most cases have been restricted to foreign currency business and circumscribed in their geographic scope. However, with China’s accession to the WTO, the financial sector should become more liberalized as China has explicitly committed itself to opening its services sector to foreign firms. McKibben and Wilcoxen (1998), who explored the impact of China’s WTO accession using a dynamic intertemporal general equilibrium model, affirmed that under a financial liberalization scenario, financial flows into China increased very quickly. Domestic market China’s large population presents a vast potential for consumption. Since the 1980s, China’s economic reconstruction saw GNP per capita grow an average of 6.7 per cent from 1965 to 1996.7 In 2002, GNP per capita was approximately RMB7876 (USD951).8 The rapid growth of the economy meant

80 A Normative Model for China’s FDI Regime

the strengthening of the people’s purchasing power. This, in turn, attracted market-oriented FDI aiming to set up enterprises to supply goods and services to the local market. Lim (2001) surveyed the empirical literature and concluded that market size was one of the determinants that attracted FDI into China. He cited an empirical work by Fung, Iizaka and Tong (2003) that studied the factors that explained direct investment from the USA and Japan into China and concluded that market size was one such factor. OECD (2000) contends that it is quite possible for China to keep economic growth at a rate of 6–7 per cent until 2015. If this is the case, China will remain a fast-expanding huge market and continue to attract marketoriented FDI. In addition, China’s accession to WTO should have a positive impact on its GDP growth (McKibben and Wilcoxen 1998; Walmsley and Hertel 2000; Goldman Sachs 1999). Global markets China adopted an ‘export promotion development strategy’ and attempted to promote trade by concluding several bilateral trade arrangements as well taking some unilateral actions. Before accession to the WTO in 2001, China signed economic agreements with the ten APEC member nations (Australia, Chile, Indonesia, Japan, Malaysia, New Zealand, the Philippines, the Republic of Korea, Singapore and Thailand). Between 1984 and 1997, the nominal value of exports grew 16 per cent annually while manufactured exports grew 21 per cent. While China accounted for only 0.75 per cent of world exports in 1978, the share rose to 3.3 per cent in 1997. The share of foreign affiliates’ exports in China’s total exports increased from negligible in the early 1980s (0.27 per cent in 1984) to 20 per cent in 1992, and then 41 per cent in 1997. In 1998, the value of exports by foreign affiliates was USD81 billion, constituting 44 per cent of China’s total exports, with even higher shares in manufactured exports (Zhang and Song 2000). It is evident that foreign companies investing in China are manufacturing products to be exported and distributed worldwide. China’s orientation towards promoting exports is thus not only important for its economic well-being, but also vital to its ability to attract FDI. Kerr and Monsingh (2001) found that an open economy encouraged inward FDI in China. Investment-promoting policies Investment agencies at both national and municipal levels were established with the primary objective of promoting China’s trade and economic relations with the rest of the world. At the national level, agencies included the ‘China Council for the Promotion of International Trade (CCPIT)’ and the ‘China Chamber of International Commerce (CCOIC)’. At the municipal level, most provinces set up investment commissions or development boards to encourage and promote FDI into their provinces. Investment promotion fairs were continuously organized to attract foreign investors as well

Ramin Cooper Maysami and Wayne Lim 81

as to introduce them to the new sectors and regions. The Ministry of Foreign Trade and Economic Cooperation (MOFTEC) sponsored the annual China International Fair for Investment & Trade (CIFIT). The 2nd China Western Region Foreign Investment Promotion Fair (2003) was been similarly organized specifically to promote foreign investments into the less developed Western regions. The aggressive investment–promotion efforts of the Chinese government provided more avenues for foreign investors to obtain timely information relating to the available investment opportunities. Investment agencies also provided information regarding the laws, procedures and requirements related to investing in China. This helped to reduce the information asymmetry traditionally experienced by foreign investors. In addition to active promotions, investment incentives were offered by China at both national and subnational levels. For example, tax incentives offered at the national level included tax reduction and exemption for FIEs. Special concessions and exceptions to general restrictions were also permitted for investments in favoured regions or sectors. For example, ‘Provisions of the State Council on the Encouragement of Foreign Investment’ provided for preferential taxes for investment in the high-technology sectors, export oriented investments and investments in the Western Regions. At the state level, the scope and extent of incentives varied across provinces. Examples of such incentives included the waiver of local taxes and the preferential provision of important land, resources and utilities at local rates. Kerr and Monsingh (2001), in their examination of the determinants of FDI flows into China over the period 1980–98 found that tax incentives promoted FDI inflow. Laws and government policies Since joining the WTO, China has tried to fulfil the Organization’s transparency obligations (see Appendix 3, p.93). Basic laws and regulations guiding foreign investments are now available to the public through various media. MOFTEC, the provincial and municipal commissions of foreign trade and economic relations, as well as investment agencies, have also been established and contact details made publicly available. China has also noticeably streamlined its legal system concerning FDI, amending a series of laws, regulations and provisions such as the Equity Joint-Venture Law and Contract Law (OECD 2000). Especially noteworthy in this area are matters concerning dispute settlement, expropriation and compensation, immigration system and IPR. Dispute settlement There are two approaches to resolving disputes in China – the formal and the informal mechanism. There are, in turn, three avenues for foreign investors who seek conciliation in China through the formal apparatus: (1) Court Conciliation, (2) Settlement by the International Conciliation Centre

82 A Normative Model for China’s FDI Regime

through the Beijing Conciliation Centre (BCC) and (3) Appeasement by International Arbitration Commissions through the China International Economic and Trade Arbitration Commission (CIETAC). ‘The Arbitration Law of the PRC’ stipulates provisions for all mediation of disputes arising from foreign economic, transportation, trade, or maritime matters. There are two international arbitration commissions in China to handle international commercial and maritime disputes – CIETAC and the China Maritime Arbitration Commission (CMAC). A ‘Convention on the Settlement of Investment Disputes between States and Nationals of Other States’ was signed and approved by the Chinese government to allow investors to bring disputes to the International Centre for the Settlement of Investment Disputes. Many foreign investors, however, deem the formal mechanism to be time-consuming and unreliable, and generally employ this mechanism of dispute settlement only when necessary. In practice, a strong emphasis is placed on informal conciliation and consultation methods. In order to convince foreign investors of the integrity of the dispute resolution system, so as to encourage full use of the system, the government should keep a clear record of regular enforcement of arbitral awards. One problem with China’s current dispute settlement enforcement is that its arbitration commissions have been unduly slow. Another problem that may arise is that even when a foreign company wins in arbitration, the People’s Intermediate Court in the locality where the foreign venture is situated may choose not to enforce the decision. Expropriation and compensation ‘The Law of the PRC on Chinese–Foreign Equity Joint Ventures,’ ‘The Law of the PRC on Chinese Foreign Cooperative Joint Ventures,’ and ‘The Law of the PRC on Wholly-Owned Enterprises,’ stipulate that the state will not nationalize and expropriate any FIE. Under special circumstances, however, and in the social and public interest, the FIE may be expropriated in accordance with legal procedures, and appropriate compensation provided. China has signed bilateral investment protection agreements with more than seventy countries. All such agreements have provisions against expropriation and nationalization of foreign investments by the contracting parties, except for cases of public interest and under legal procedures. In reality and to the credit of the Chinese government, there have been no cases of expropriation of foreign investment since China opened up to the outside world in 1979. Most cases have been resolved through negotiation or mediation, but the local authorities are sometimes also influential (OECD 2002). Immigration system Since the 1980s, China’s immigration system has become less stringent and more transparent. The specific procedures and requirements for entry and exit

Ramin Cooper Maysami and Wayne Lim 83

are now legislated. ‘Administrative Law of the PRC on Foreigner’s Entry & Departure’ spells out the procedures for all foreigners’ entry, transit and residence in China. The ‘Administrative Provisions on Foreigner’s Employment in China’ describe the application requirements for the approval of employment of foreign employees. The ‘Employment Approval Credentials of Foreigners’ provides the procedures for approving and handling of professional visas, and issuing ‘Employment Certificates for Foreigners’ and ‘Residence Certificates for Foreigners Staying and Working in China’. The Chinese government has further streamlined the procedure in the case of foreign investors who frequently enter and leave the country by issuing special immigration permits. Multi-entry visitor permits are now valid for two–five years rather than for only a year. Relaxation of the immigration regulations on foreigners entering China on business-related visits has enhanced its attractiveness as a FDI hub. The arrival of foreign investors and key personnel has helped bring in capital, knowledge and expertise to the Chinese economy. However, China continues to impose certain restrictions (e.g. the requirement for certain qualifications and the inquiry into the nature and purpose of the visit) on foreigners entering the country. This may be viewed as a form of protectionist policy to guard local talent from being cannibalized by foreign competitors. Intellectual property rights As a WTO member, China is required to maintain certain minimum levels of protection for IPR. The country has made substantial progress in IPR protection, along with progress in economic reform and market opening. It has formulated and refined various laws and regulations on IPR protection in order to increase its scope. ‘The PRC Trademark Law’ and ‘Implementing Rules of the PRC Trademark Law’ provide detailed rules for the application, examination, registration and protection of trademarks. The ‘PRC Patent Law’ and ‘Implementing Rules of the PRC Patent Law’ provide for the protection of patents. Amendments to raise the standards of patent protection to meet the requirement of TRIPs have also been made. The ‘PRC Regulations on Protection of Computer Software’ were enacted to protect the rights and interests of the creators of computer software, and the ‘PRC Regulations on Customs Protection of Intellectual Property Rights (IPR)’ was ratified to protect IPR of imported and exported goods. Other relevant laws include the ‘PRC Copyright Law’ and the ‘Implementing Regulations of the PRC Copyright Law.’ In addition to formulating and refining various laws and regulations on IPR protection, the central government initiated anti-piracy and anticounterfeiting campaigns. Although the awareness of the importance of IPR protection has improved, enforcement problems for such protection remain. Despite active actions by the Chinese court and police systems to combat

84 A Normative Model for China’s FDI Regime

piracy, there are still widespread IPR violations. MIGA (2003) observed that IPR is not respected, and pirating is still rampant in the domestic market and spreading among exports. The main problems are that penalties for IPR infringements are too low to deter violation, high evidentiary thresholds have to be met before one may be charged in court and coordination among the state and provincial ministries and agencies is weak. Corruption, lack of training and inconsistent application of rules by most judges have resulted in unfair enforcement of the law. Unless Chinese Courts take more referrals of IPR violations from the private sector, the long-term effectiveness of China’s IPR enforcement efforts remains doubtful. Generally, China has taken steps to ensure that laws and regulations adopted by all levels of government are harmonized and consistent with the country’s basic laws and regulations. It has also agreed to the establishment of a mechanism for reviewing its compliance efforts with WTO commitments for eight years after its accession. However, as noted by MIGA (2003), the local legal system is still developing and the concept of the ‘rule of law’ is not well understood throughout the economy. Quality of administration Generally, we can assess the quality of administration in terms of efficiency and integrity. Efficiency of administrative procedures Potential foreign investment projects usually go through a multi-tiered screening process in China. Depending on the value of a particular foreigninvested project, the approval rights are delegated to varying levels of authorities or local governments. MOFTEC’s reviewing officers are, nevertheless, authorized to review all project proposals regardless of size to insure that they fulfil the relevant regulations and policy requirements. There are four basic steps that foreign investors need to take in seeking approval for their projects: (1) submission of the project proposal; (2) submission of a feasibility study or research reports; (3) submission of the contract and charter of incorporation and (4) application for a business licence upon receiving the certificate of approval. This procedure, on average, takes about fifty-five days.9 Since recent reforms, all such administrative routines and procedures may be cancelled by The State Council-Affiliated Office of the Administrative Approval & Examination System Reform if they prove to be redundant and bureaucratic in nature. On 16 October 2002, the Chinese government deleted no fewer than 789 items from its administrative procedural list in order to demarcate the government’s function and to improve administrative efficiency. There are more than 3,000 administrative approval procedures

Ramin Cooper Maysami and Wayne Lim 85

which are currently under the scrutiny of the central government, quite a large number of these are expected to be deleted in the near future. Most provincial governments are also currently looking into and tidying up the administrative approval items under their respective jurisdiction, while some are actually prepared to initiate a second or third round of reform, such reforms will eventually expand to the grass-roots authorities at the prefecture and county levels.10 Studying the cross-country data on bilateral stock of FDI from the seventeen most important source countries, Wei (2000) found evidence that China’s relatively high regulatory burden had significantly discouraged FDI. Although the administrative procedure is still cumbersome, steps are being taken to expedite the process. Integrity of public office Corruption is widely perceived as a problem. Wei (2000) found evidence that China’s relatively high corruption burden significantly discouraged FDI. China’s corruption index was rated 3.8 by the World Bank on a scale of 0 to 10 in 1998 – a low rating as compared to Singapore (9), Hong Kong (7.8) and even Malaysia (5.3) and Korea (4.2). The Central Communist Party (CCP) has taken steps to intervene in the corrupt behaviour of some high-ranking officials, a clear indication that the CCP intends to monitor and control the anti-corruption campaign so that it will progress without threatening the Party’s survival. The ‘Criminal Law of the PRC’ was revised to include penalties for corruption. The two relevant chapters are related to the crime of graft and bribery and the crime of dereliction. The Administrative Control Act was promulgated to provide a legal basis for supervisory bodies to perform the function of control and inspection. Rules and regulations with regards to ethics and governance were also made public, and systems for financial disclosure, gift registration and power separation established. A Code of Conduct for leading officials was enacted so that these officials could check their own behaviour and ensure compliance with provisions and standards. Inspections were intensified after the implementation of state laws, regulations and administrative decisions, and corrupt officials were severely sanctioned. In summary, China’s relatively high corruption and regulatory burden have discouraged FDI. Wei (2000) showed that the level of FDI would increase by 218 per cent if red tape and corruption were reduced to the Singapore level. Steps have been taken to eradicate the problem, although there is still a long road ahead. Political and social stability China has concerted efforts to project itself as a stable socialist country ruled by a communist party, stating their traditional emphasis on political stability

86 A Normative Model for China’s FDI Regime

at the United Nation’s Millennium Summit 2000 the 8th Informal APEC Summit, the 3rd Asia-Europe Meeting, the 55th UN General Assembly, the UN Committee on Disarmament and International Security and at the UN Commission on Human Rights. Changes to the Constitution were announced in the 16th National Congress Party and the government has since then used a hybrid of communism and capitalist ideologies to implement economic and social reforms. A stable Chinese government undoubtedly attracts foreign investments. MIGA (2003), for instance, identified China’s stable government and society as advantages for FDI in shared services. Sun, Tong and Yu (2002) found that China’s increased political stability helped in attracting foreign investments. International conflicts have had a direct impact on China’s political stability. The conflict between China and Taiwan is still active as China regards Taiwan as part of its sovereign territory and insists on unification under ‘one country, two systems.’ There have been frequent military exercises aimed at intimidating Taiwan. In addition, international disputes over territorial issues such as the Spratly Islands located in the South China Sea and the Senakaku Islands (DiaoYu Tai) have kept the relationship with its neighbors on a knife edge. The rising tension in East Asia caused by the North Korea nuclear crisis has been another source of concern. Foreign exchange regime China’s exchange rate system prior to 1994 was based on a dual exchange rate regime. A single exchange rate, in effect pegged to the US dollar, was then adopted and has been supported by comprehensive direct capital account controls. The China Foreign Exchange Trading Centre (CFETC) is the nation-wide interbank foreign exchange market, with the state exercising centralized control over the management of foreign exchange. The Renminbi (RMB) is freely convertible to foreign currency on current account but is still subject to very tight control by the State Administration of Foreign Exchange (SAFE). The ‘Regulations on Exchange Control of the PRC’ stipulate that purchase of foreign exchange for current account transactions by institutions in China shall be done only with the designated foreign exchange banks, in accordance with the regulations issued by the State Council on selling and purchasing foreign exchange and upon presentation of valid documents. The problems with China’s exchange rate regime is that only financial institution headquarters hold CFETC memberships and the market is dominated by the People’s Bank of China and the Bank of China. The existing capital control regulations suppress both supply and demand and China’s centralised trading system has high costs and restrictions. Basically, there are only three foreign currencies (USD, HKD and JPY) in the exchange market, and no futures and options contracts have been introduced. There exists an urgent need for a more flexible exchange rate system and the liberalization of

Ramin Cooper Maysami and Wayne Lim 87

the capital account seems inevitable. The authorities should develop an early warning system to monitor the balance of international payments so as to improve the working efficiency of the foreign exchange market, as well as cracking down on illegal and fraudulent activities. Monetary reforms implemented by China in 1996 removed the inconvertibility of the RMB. This was a welcome move as it facilitated the repatriation of funds and profits for foreign investors.

8

Discussion and conclusions

Table 4.5 summarizes the extent to which China’s FDI regime adheres to the normative framework developed in the current study. It is apparent that China, to a great extent, has pursued the factors proposed by the FDI literature and world trade organizations. It has expanded considerable effort to review its laws, regulatory framework and policies at both central and local levels – mostly, it seems, as part of its effort to comply with WTO requirements. Although the study concludes that, in its current form, China’s legislative and regulatory structure for foreign investment are along the same lines as the proposed framework, there are still areas which need improvement. These main deficiencies relate to issues of transparency, foreign exchange regime, national MFN and treatment, performance requirements, efficiency of administrative procedures, development of financial markets, IPR and dispute settlement. The lack of uniform application and effective enforcement of the regulatory and legislative framework, as well as inadequate coordination among government ministries, are the main issues hindering the implementation of its economic reform in these areas. In addition, the study notes the inadequate emphasis placed by China on the environmental impacts of FDI. In its bid to accelerate economic growth through the utilization of foreign capital, the sustained influx of FDI into China may have had adverse implications on its environmental well-being. Industries such as chemicals, petrochemicals, leather, printing and dyeing, electroplating, pesticides, mining and metallurgy and rubber and plastic have been extensively established since the 1980s. Referred to as ‘Pollutionintensive industries (PII)’ because of their high emission intensities of pollutants, they have been perceived as one of the major sources of environmental pollution (Fabry and Zeghni 2000). Certain foreign investors have also been able to transfer production facilities and technical processes that do not meet environmental standards in other countries to China through direct investments (Zhan 1994). This may further escalate levels of pollution, thus endangering China’s ecological well-being. Along with the increase in pollution level, rapid economic growth along with rising population has amplified the amount of primary energy consumed. This will ultimately lead to the depletion of China’s limited natural resources.

88 A Normative Model for China’s FDI Regime Table 4.5 Assessment of China’s FDI regimea Factors affecting FDI flows into a country

Production factors and infrastructure Economic integration Export orientation Investment promotion Political stability Corruption Level of development of financial markets and availability of financial services Foreign exchange regime National treatment and MFN Transparency Temporary entry, stay and work of investors and key personnel Performance requirement Market policies Investment incentives Efficiency of administrative procedures IPR Expropriation and compensation Transfer of fund Dispute settlement Taxation

Does China’s regime heed the factors prescribed by the FDI promotion framework?

Assessment of the effectiveness, enforcement and application of the framework

Yes Yes Yes Yes Yes Yes

Sufficient Sufficient Sufficient Sufficient Lacking Lacking

Yes Yes

Lacking Lacking

Yes Yes

Lacking Lacking

Yes Yes Yes Yes

Sufficient Lacking Sufficient Sufficient

Yes Yes

Lacking Lacking

Yes Yes Yes Yes

Sufficient Sufficient Lacking Sufficient

Notes: a This evaluation is based on (1) the consensus of the literature, (2) according to compliance with relevant features of several agreements from the OECD and the WTO and (3) an assessment based on the normative model developed as part of the current chapter.

In order to achieve sustainable FDI and economic growth while preserving its ecological well-being, China should further revise and enforce the relevant laws and regulations. More resources should be dedicated to the improvement of its infrastructure, training and education of its human resources, as well as restructuring of government ministries and agencies with the role of promote FDI. Environmental laws and an effective nation-wide environmental monitoring and supervision system should also be in place to compliment China’s FDI regime.

Ramin Cooper Maysami and Wayne Lim 89

Appendix 1: the role of guanxi Although seldom addressed formally, the unique business culture of China necessitates an introduction to the concept of guanxi. It has had a significant influence in how business is conducted in China, and FDI investments are not excluded from the influence of this cultural phenomenon. Guanxi may be defined as a set of informal ‘exchange practices’ and a system of ‘social accounting in China,’ which includes exchange of gifts and money in the process of business negotiation/conduct. Not viewed as bribery, it has been regarded as one of the major dynamic forces in the Chinese business environment and has been credited for certain corporate success stories in China. Foreign firms are often placed at an apparent disadvantage because of their ‘outsider’ position in the guanxi network. They usually experience difficulties in guanxi practices in the Chinese market since they may not be equipped with Chinese language skills and an in-depth understanding of the Chinese culture. Their direct contacts with the local business communities may therefore have been somewhat hampered. Foreign investors operating in the Chinese market are well advised to place high priority on informal business practices, language and culture so as to understand and manage local guanxi activities. They also need to fully understand the obligations as well as the benefits attached when they set up guanxi with their Chinese counterparts. If they neglect the former, they will be kept out of the guanxi circle and remain excluded from future benefit flows. Attention should also be placed to establishing guanxi with government officials and influential business partners so as to set up a network of protection from which they might seek help in case of unexpected threats, without carrying the practice to inappropriate levels.

90 A Normative Model for China’s FDI Regime

Appendix 2: the outline of the Multilateral Agreement on Investment (MAI) The aim of the MAI is to: (1) (2) (3) (4)

Strengthen the legal framework Introduce new disciplines Design a state-of-the-art chapter on investment protection Add legally binding procedures for the settlement of investment disputes through recourse to international arbitration so as to reach an agreement among OECD member states and to create a more favourable investment environment to further encourage investment flows (see Table 4A2.1).

Table 4.A2.1 The MAI Agreement I

GENERAL PROVISIONS

●

Preamble

II ● ● ●

III ● ● ● ●

● ● ● ● ● ● ● ● ● ● ● ● ●

SCOPE AND APPLICATION Definitions Geographical Scope of Application Application to Overseas Territories TREATMENT OF INVESTORS AND INVESTMENTS National Treatment and Most Favored Nation Treatment Transparency Temporary Entry, Stay and Work of Investors and Key Personnel Nationality Requirements for Executives, Managers and Members of Boards of Directors Employment Requirements Performance Requirements Privatization Monopolies/State Enterprises/Concessions Entities with Delegated Governmental Authority Investment Incentives Recognition Arrangements Authorization Procedures Membership of Self-Regulatory Bodies Intellectual Property Public Debt Corporate Practices Technology R&D

Ramin Cooper Maysami and Wayne Lim 91 Table 4.A2.1 Continued ● ●

Not Lowering Standards Additional Clause on Labor and Environment

IV ● ● ● ● ● ● ●

INVESTMENT PROTECTION General Treatment Expropriation and Compensation Protection from Strife Transfers Information Transfer and Data Processing Subrogation Protecting Existing Investments

V

DISPUTE SETTLEMENT

●

State–State Procedures Investor–State Procedures

●

VI ● ● ●

EXCEPTIONS AND SAFEGUARDS General Exceptions Transactions in Pursuit of Monetary and Exchange Rate Policies Temporary Safeguard

VII ● ● ● ● ● ● ● ● ●

FINANCIAL SERVICES

Prudential Measures Recognition Arrangements Authorization Procedures Transparency Information Transfer and Data Processing Membership of Self-Regulatory Bodies and Associations Payments and Clearing Systems/Lender of Last Resort Dispute Settlement Definition of Financial Services

VIII IX ●

X ● ●

XI ● ●

TAXATION COUNTRY SPECIFIC EXCEPTIONS

Lodging of Country Specific Exceptions RELATIONSHIP TO OTHER INTERNATIONAL AGREEMENTS Obligations under the Articles of Agreement of the International Monetary Fund The OECD Guidelines for Multinational Enterprises IMPLEMENTATION AND OPERATION The Preparatory Group The Parties Group

92 A Normative Model for China’s FDI Regime Table 4.A2.1 Continued XII ● ● ● ● ● ● ● ● ● ● ● ●

FINAL PROVISIONS

Signature Acceptance and Entry Into Force Accession Non-Applicability Review Amendment Revisions to the OECD Guidelines for Multinational Enterprises Withdrawal Depositary Status of Annexes Authentic Texts Denial of Benefits

Source: OECD, ‘The Multilateral Agreement on Investment (MAI) Negotiating Text (as of 24 April 1998)’, 1998.

Ramin Cooper Maysami and Wayne Lim 93

Appendix 3: WTO investment rules Foreign investment issues are dealt with in several WTO Agreements. The General Agreement on Trade in Services (GATS), the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs) set the provisions relating to the entry and treatment of foreign enterprises and the protection of certain property rights. The Agreement on Trade-Related Investment Measures (TRIMs) circumscribes the ability of WTO members to apply certain kinds of measures to attract investment or influence the operations of foreign investors. The Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU) contains clearly defined rules for addressing conflicts that arise under all of these agreements (Table 4A3.1).

Table 4.A3.1 WTO investment rules Relevant WTO Agreement

Investment-related issues

GATS

GATS provides general obligations (contained in Parts I and II of the agreement) such as Most Favoured Nation (MFN) treatment and transparency1; national schedules of commitments on market access and national treatment in specific service sectors or subsectors2; and annexes addressing sectoral and horizontal specificities. Article I stipulates that the GATS applies to measures by members affecting trade in services, defined as including any service in any sector delivered via any of the four modes, with the exception of those supplied in the exercise of government functions. Article II codifies the unconditional MFN treatment principle, making it one of the agreement’s core general obligations Under the MFN rule, members of the GATS are committed to treating services and service providers from one member in the same way as services and service providers from any other member. The basic obligation of national treatment is stated in terms very similar to those of the national treatment rule in GATT’s Article III, but in the case of GATS, it is limited to services sectors where commitments have been undertaken in the schedule of the Member concerned.

TRIMs

This agreement recognizes that certain investment measures restrict and distort trade. It provides that no WTO member shall apply any

94 A Normative Model for China’s FDI Regime Table 4.A3.1 Continued Relevant WTO Agreement

Investment-related issues

TRIM inconsistent with Articles III (national treatment) and XI (prohibition of quantitative restrictions) of the GATT Measure deemed to be inconsistent with national treatment: a. Local content requirement;3 b. Import Balancing;4 Measure deemed to be inconsistent with prohibition of quantitative restrictions: a. Import Limitation;5 b. Foreign Exchange Limitation;6 c. Export Limits.7 TRIPs

The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs) builds upon the existing framework of intellectual property conventions (i.e. the Berne Convention, 1971; the Paris Convention, 1967 the Washington Treaty on Intellectual Property in Respect of Integrated Circuits, 1989, among others). The aim is to generate positive investment protection externalities by addressing five core issues: (a) Applicability of GATT principles such as national treatment, MFN and those of relevant international intellectual property agreements;8 (b) Provision of intellectual property rights (IPR) for copyright, trademarks and service marks, geographical indications, industrial designs, patents, layout designs for integrated circuits, trade secrets as well as consultations between government concerning anti-competitive practices concerning contractual licence;9 (c) Procedures and remedies under the domestic laws of members to ensure that IPR can be effectively enforced by foreign and national rights holders;10 (d) Provisions for multilateral dispute settlement under the WTO’s integrated consultation and arbitration mechanism;11 (e) Transitional arrangements to phase in the TRIPs Agreement in accordance with Members’ levels of economic development.12

DSU

A provision that is generic in nature and applied to all areas covered by WTO rules, including all investment related matters subject to Final Act disciplines. Provisions include: (a) Automation adoption of panel reports;13 (b) Possibility of requesting the review of a panel report by an Appellate Review Body;14 (c) Possibility of cross-sectoral retaliation;15

Ramin Cooper Maysami and Wayne Lim 95 Table 4.A3.1 Continued Relevant WTO Agreement

Investment-related issues

(d) The requirement for Members to establish what the ‘reasonable time for implementation’ will be, which should result in the proper implementation of panel recommendations.16 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

GATS, PART II. GATS, PART III. TRIMS Agreement, Annex TRIMS Agreement, Annex TRIMS Agreement, Annex TRIMS Agreement, Annex TRIMS Agreement, Annex TRIPs Agreement, Part I. TRIPs Agreement, Part II. TRIPs Agreement, Part III. TRIPs Agreement, Part IV. TRIPs Agreement, Part II. DSU, Article 16. DSU, Article 17. DSU, Article 22. DSU, Article 21.

1(a). 1(b). 2(a). 2(b). 2(b).

96 A Normative Model for China’s FDI Regime

Appendix 4: corporate tax rates Table 4.A4.1 Extract from corporate tax rate survey, January 2002 Country

Argentina Australia Austria Belgium Bolivia Brazil Canada China Colombia Denmark Dominican Republic Fiji France Germany Hong Kong India Indonesia Japan Luxembourg Malaysia New Zealand Philippines Republic of Korea Singapore South Africa Taiwan Thailand Turkey UK USA Vietnam

Tax rate 1 Jan. 2001 (%)

Tax rate 1 Jan. 2002 (%)

35.00 34.00 34.00 40.17 25.00 34.00 42.1 33.00 35.00 30.00 25.00 34.00 35.00 38.36 16.00 39.55 30.00 42.00 37.45 28.00 33.00 32.00 30.8 25.5 37.8 25.00 30.00 33.00 30.00 40.00 25.00

35.00 30.00 34.00 40.17 25.00 34.00 38.6 33.00 35.00 30.00 25.00 32.00 34.33 38.36 16.00 35.7 30.00 42.00 30.38 28.00 33.00 32.00 29.7 24.5 37.8 25.00 30.00 33.00 30.00 40.00 25.00

Source: KPMG’s Corporate Tax Rate Survey ( January 2002, extract).

Ramin Cooper Maysami and Wayne Lim 97

Appendix 5: administrative efficiency Table 4.A5.1 Comparison of administrative efficiency selected countries (extract)

Economy Australia Canada China Denmark Egypt, Arab Rep. France Germany Hong Kong, China India Indonesia Japan Korea, Rep. Malaysia Mongolia New Zealand Philippines Singapore Sri Lanka Taiwan, China Thailand Turkey UK USA Vietnam

Number of procedures 2 2 12 3 13 10 9 5 10 11 11 13 7 8 2 14 7 8 8 8 13 5 5 10

Duration (days) 6 2 55 3 52 53 45 20 88 168 30 36 56 31 2 62 8 73 43 45 53 4 4 68

Notes: a Refers to all costs necessary for the startup of a business. GNI: Gross national income. Source: Djankov et al. (2002: 1–37).

Cost (% of GNI per capita)a 1.8 0.6 13.2 0.0 76.3 2.7 5.8 3.2 51.1 15.3 11.5 18.9 26.6 13.6 0.2 14.5 6.1 15.7 6.3 6.7 43.2 1.1 0.6 36.2

98 A Normative Model for China’s FDI Regime

Notes 1. Later sections of this chapter will identify some characteristics of different enterprises shaped by these laws. More detailed information regarding laws governing FDI in China may be found at The authoritative site on foreign direct investment of China (www.chinafdi.com.cn) and Invest in China (www.fdi.gov.cn). 2. Interested readers should refer to The authoritative site on Foreign Direct Investment of China (www.chinafdi.org.cn) and Invest in China (www.fdi.gov.cn) for more information on the laws governing FDI. 3. See Appendix (p.00) 2. 4. ILO LABORSTA. 5. Analysis of the trend of oil import of China is made by the Study Group of the Economic Research Centre of the State Economic and Trade Commission (2000). They noted acute contradictions in demand and supply and a bigger gap in crude oil supply. The fundamental reason given is that oil production in the country can hardly meet consumption, hence the need to increase import. The output of oil in China has increased at an annual rate of 1.7 per cent since the Eighth Five-Year Plan period, but in the meantime consumption has increased at an annual rate of 4.9 per cent, far exceeding the rate of output increase. 6. Figures were extracted from CIA The World Factbook 2002. 7. Data extracted from the World Bank. 8. Data extracted from the Asian Development Bank. 9. Djankov et al. 2002, Appendix 1.61. 10. ‘China Vows to Cut Short Red-tape’, People’s Daily, 10 January 2003.

References Books and articles American Chamber of Commerce, People’s Republic of China, ‘WTO Implementation Report, Fall 2002’, 2002. http://www.amcham-china.org.cn/publications/wto/. Asia-Pacific Economic Cooperation Committee on Trade and Investment, ‘Guide to Investment Regimes of the APEC member People’s Republic of China’, http://www. apecsec.org.sg/GuideBook/China.html#People’s_Republic_of_China. Central Intelligence Agency, The World Factbook 2002, http://www.odci.gov/cia/ publications/factbook/geos/ch.html#Issues. China Bureau of Statistics, China Statistical Yearbook, various years. Deloitte, ‘Navigating China: Learning the Ropes and Establishing Guan Xi’, China Today, 03–01 (30 June 2003). Djankov, S., La Porta, R., Lopez-De-Silanes if and Shleifer, A., ‘The Regulations of Entry’, Quarterly Journal of Economics, 117(1), 2002, 1–37. Dunning, J.H., ‘Determinants of Foreign Direct Investment: Globalization Induced Changes and the Role of FDI Policies’, World Investment Prospects 2002, London, Economist Intelligence Unit, 2002, 1–13; http://wbln0018.worldbank.org/eurvp/ web.nsf/Pages/PaperbyDunning/$File/DUNNING1.pdf. Fabry, N. and Zeghni, S., ‘FDI and the Environment: Is China a Pollutant Haven?’, Working Paper 2000–2, Université de Marne-la-Vallée, September 2000, 2–22; http://www.univ-mlv.fr/recherche/labo/geopolitique/wp2000_2.pdf. Fung, K.C., Iizaka, H. and Tong, S., ‘Foreign Direct Investment in China: Policy, Trend and Impact’, Paper prepared for an international conference on ‘China’s Economy in the 21st Century, 24–25 June 2003.

Ramin Cooper Maysami and Wayne Lim 99 Goldman Sachs, ‘Global Economics’, Paper 14 (Fred Hu), 26 April 1999. Houde, M.F. and Hak-Loh, L., ‘Main Determinants and Impacts of Foreign Direct Investment on China’s Economy’, Working Papers on International Investment 2000/4, paris, OECD, December 2000, 1–17; http://www.oecd.org/pdf/M000015000/ M00015431.pdf. Hu, A., ‘Corruption and Anti-Corruption Strategies in China’, 2001; http://www.ceip. org/files/events/AngangHuEvent.asp?EventID  284. Huang, Y., ‘Foreign Direct Investment in China’, Singapore, National University of Singapore Press, 1998. International Labour Organization (ILO), LABORSTA, http://laborsta.ilo.org/. Kerr, I.A. and Monsingh, V.P., ‘The Determinants of Foreign Direct Investment in China’, Paper for the 30th Annual Conference of Economists, September 2001, 1–4. KPMG, KPMG’s Corporate Tax Rate Survey, January 2002; http://www.kpmg.bg. Lai, C.C., ‘Recent Developments in Foreign Direct Investment in China’, Chinese Economies Research Centre Working Paper, 96/3, Adelaide, University of Adelaide, January 1996, 1–45. Lim, E.-G., ‘Determinants of, and the Relation between, Foreign Direct Investment and Growth: A Summary of Recent Literature’, IMF Working Paper, WP/01/175, November 2001. McKibben, W.J. and Wilcoxen, P., ‘The Global Impacts of Trade and Financial Reform in China’, Asia Pacific School of Economics and Management, Working Paper, 98–3, 1998. Multilateral Investment Guarantee Agency (MIGA), ‘Benchmarking FDI Competitiveness in Asia’, 2003. Organization for Economic Cooperation and Development (OECD), ‘The Multilateral Agreement on Investment (MAI) Negotiating Text (as of 24 April 1998)’ 1998; http://www.oecd.org/pdf/M00003000/M00003291.pdf. ———— ‘China in the World Economy – The Domestic Policy Challenges’, pans, 2002, 323–58. ———— ‘Main Determinants and Impacts of Foreign Direct Investment on China’s Economy’, Working Paper on International Investment, 2000/04, (Paris, December 2000). People’s Daily, ‘China Vows to Cut Short Red-Tape’, 10 January 2003; http://english. peopledaily.com.cn/200301/10/eng20030110_109907.shtml. Pingyao, L., ‘Foreign Direct Investment in China: Recent Trends and Patterns’, China & World Economy, 2, 2002, 25–32. Singapore Department of Statistics, Singapore Yearbook of Statistics, various years. Singh, H. and Jun, K.W., ‘Some New Evidence on Determinants of Foreign Direct Investment in Developing Countries’, Policy Research Working Paper, 1531, Washington, DC, World Bank, International Finance Division, International Economics Department, November 1995, 1–9. Study Group of the Economic Research Centre of the State Economic and Trade Commission, ‘An Analysis of the Trend of Oil Import of China’, Investment in China (Monthly Report), 8, 2000; http://www.ahk-china.org/china-economy/berichteanalysen-oil-import.htm. Sun, Q. Tong, W. and Yu, Q., ‘Determinants of Foreign Direct Investment Across China’, Journal of International Money and Finance, 21, 2002, 79–113. Tuan, C. and Ng, L., ‘FDI Facilitated by Agglomeration Economies: Evidence from Manufacturing and Services Joint Venture in China’, Journal of Asia Economics, 13, 2003, 749–65.

100 A Normative Model for China’s FDI Regime United States Trade Representative (USTR), ‘2002 Report to Congress on China’s WTO Compliance’, December 2002, 3–39; http://www.ustr.gov/regions/china-hk-mongoliataiwan/2002-12-11-China_WTO_compliance_report.pdf. Velde, D.W. te, ‘Policies towards Foreign Direct Investment in Developing Countries: Emerging Best-Practices and Outstanding Issues’, London, Overseas Development Institute, March 2001, 1–34; http://www.odi.org.uk. Walmsley, T. and Hertel, T. ‘China’s Accession to the WTO: Timing is Everything’, GTAP Working Papers, 403, Centre for Global Trade Analysis, Purdue University, 2000. Wei, G. ‘Multilateral Investment Agreement and China’s Foreign Direct Investment Policies’, Master of Strategy and Global Management Thesis, School of Public Policy and Management, Korean Development Institute, 2000, 1–59; http://www. kdischool.ac.kr/library/data/t99016.PDF. Wei, S.-J., ‘Can China and India Double Their Inward Foreign Direct Investment?’ NBER Working Paper, 2000. World Trade Organization (WTO), ‘The Results of the Uruguay Round of Multilateral Trade Negotiations – The Legal Texts, Geneva, World Trade Organization’, 1995, http://www.wto.org. Wu, L., ‘Guanxi: A Cross-cultural Comparison of New Zealand and Chinese Business People’, Master of Commerce Thesis, University of Auckland, 1999, 139–8; http://www.lilywu.com/guanxi_thesis.htm. Zhan X.J., Guoming, X., Cheng, Z., Yangui, Z. and Shunqi, G., ‘The Interface between Foreign Direct Investment and the Environment: The Case of China’, Occasional Paper, 3, Copenhagen Business School, April 1999, 17–29; http://www. unctad-10.org/pdfs/preux_fdipaper3.en.pdf. Zhang, K.H. and Song, S., ‘Promoting Exports: The Role of Inward FDI in China’, China Economic Review II, 2000, 385–96.

Web resources Asian Development Bank http://www.adb.org. China Council for the Promotion of International Trade http://www.ccpit.org. China FDI http://www. fdi.gov.cn. Invest in China, www.fdi.gov.cn. Ministry of Foreign Trade and Economic Cooperation, http://www.moftec.gov.cn. The authoritative site on foreign direct investment of China: http://www.chinafdi. com.cn. The World Bank, http://www.worldbank.org.

5 China’s Development: Foreign Direct Investment, Accession to the WTO and Future Perspectives Jurgis Samulevicius and Tong Xiaoshuang

1

Introduction

The target and objective of this chapter is to analyse the development of China’s economy from the overview of FDI, accession to WTO and the IT and digital revolution of China, and then to forecast the future perspectives of China’s economy. China has a population of 1.2 billion and a history of over 5,000 years. Since 1978, the reforms and opening-up have injected new vitality into China’s development and brought about unprecedented economic and social progress. For two decades, China’s average annual growth rate was 9.8 per cent, as compared to an average world growth rate of 3.3 per cent. Its GDP totalled 7,477 billion RMB (US$ 900 billion) in 1997, seventh place in the world in terms of economic aggregates. China held tenth place in world trading in 1998, the value of imports and exports reaching US$ 324 billion. Its foreign exchange reserves amounted to US$ 145 billion in 1998, the second in the world. China’s economic growth accelerated, and its comprehensive strength was enhanced by 2000. GDP for the year was US$ 1,079.7 billion, representing an 8 per cent growth in real terms; growth in 2000 was 0.9 per cent higher than in 1999. China’s economy performed better than expected in 2002, boosted by strong growth in exports and foreign investment, strong consumer demand and yet another year of governmentstimulated spending. GDP hit 10.2 trillion RMB (US$ 1.23 trillion), up 8 per cent from 2001. China’s forecasters expected similar growth in 2003, with most estimates ranging from 7.9 to 8.2 per cent, but international observers expected slightly slower growth. Why is China’s economy booming? One of the most important reasons is that China has changed its economic style from a centrally planned economy (CPE) to a more market oriented economy. When Deng Xiaoping 101

102 China: FDI, WTO Accession, Future Perspectives

created the ‘open door’ policy, China began to adopt foreign investment to stimulate the development of the economy. The main form of foreign investment is foreign direct investment (FDI), an issue of strategic national and international importance. FDI in China is growing very fast: it was almost zero in 1978, but in the first months of 2003 China had approved the establishment of 427,545 foreign-funded enterprises with a contracted FDI of US$ 837.3 billion and actual FDI of US$ 451.6 billion. China’s entry to the WTO should increase FDI in China as it adapts its laws and regulations to conform to the WTO’s fundamental rules, improves and develops its socialist market economy and creates suitable conditions for fair competition between domestic and foreign enterprises. The invest environment has also greatly improved. China’s entry into the WTO will stimulate the developing of the IT industry and digitization, which will help China’s economy grow even faster.

2

FDI influences on China’s economy

China’s ‘open door’ policy Beginning in 1978, Deng Xiaoping created the ‘open door’ policy, and China began to open to the outside world. Tourism was allowed, students began to go overseas, Special economic zones (SEZs) were established, and joint ventures ( JVs) with foreign firms were encouraged to bring in foreign technology, investment, managerial know-how and market access. The policy attracted foreign investment; the depth and breadth of such investments in China was dramatically boosted after 1992 in the wake of the country’s opening up to the outside world and a marked improvement in its investment climate. In June 1995, the State Council approved and released the ‘Interim Regulation on Foreign Investment Orientation’ and ‘Guide of Industries for Foreign Investments’. Further recommendations were also made by the Party Central Committee in 1998 regarding further opening up and raising the efficiency of overseas capital utilization. Under the guidance of these documents and recommendations, foreign investments began to come from an increasing number of countries and regions as well as Western transnational corporations (TNCs). A growing amount of these funds has been invested in large capital- and technology-intensive industries or infrastructure projects, and the average scale of the investments has risen steadily. Foreign investments have also grown considerably in the Central and Western regions of China, along with accelerated capital inflows into the coastal provinces. China has become the second-largest host country of foreign investment after the USA. During the Ninth Five-Year Plan (1996–2000), China utilized foreign investment of US$ 289.4 billion, an 80 per cent increase over the Eighth Five-Year Plan period. At the same time, the quality and structure of foreign investment were greatly improved.

Jurgis Samulevicius and Tong Xiaoshuang 103

Foreign investment attracted to China is generally in the form of FDI. The form of FDI most often adopted in China is for Sino-foreign joint ventures (SFJVs), Sino-foreign cooperative ventures (SFCVs), Wholly foreign-owned ventures (WFOVs) and cooperative exploitation. By September 2001, China had approved a cumulative total of 357,455 foreign-investment enterprises (FIEs). These represented US$ 652 billion in contracted investment and US$ 334 billion in actual investment. Approximately 400 of the Global 500 firms have already invested in China.1 The role of FDI in China The role of FDI in China is, as we have seen, an issue of strategic national and international importance. Although China’s growth since the 1980s was not primarily driven by foreign investment and exports, but by domestic savings and domestic consumer and investment demand, FDI has nonetheless been critical for China’s modernization and development. China is, by far, the largest recipient of FDI among developing countries (more than $ 40 billion in l997), followed by Mexico, Brazil, and Indonesia (until the onset of the Asian Financial Crisis).2 The amount of actual FDI in China has increased every year since l990. Measured as a share of GDP, the largest recipient of FDI is Vietnam, followed by Angola, Trinidad and Tobago and Bolivia. China is seventh in this ranking. The most rapid increase of FDI flows in recent years has been to Brazil. Since the early l990s, China has also become an important source of FDI, mainly in Hong Kong, the USA, Australia, New Zealand and Peru. Since the initiation of reform and opening policies in China in 1979, the utilization of foreign funds has included borrowing money from foreign countries, FDI, and other forms of investment. FDI mainly takes the form of establishing FIEs or Chinese–foreign cooperative development of resources. Cumulative FDI, negligible before 1978, reached nearly US$ 100 billion in 1994 and annual inflows increased from then onward. Between 1979 and 1997 China used US$ 220.18 billion in FDI. In 1997, China approved 20,780 FDI with a contracted value of US$ 48.7 billion, of which US$ 45.3 billion has been utilized, an increase of 8.8 per cent over 1996.3 Table 5.1 shows the total FDI of China in 1979–97. Main legal forms for FDI in China The legal and institutional framework for FDI has been progressively elaborated and has been part of the building up of modern economic legislation in China. Three main legal regimes exist for FDI: (1) The equity joint venture (EJV) was the first form of FIE to be authorized by the Joint venture Law ( July 1979), which stipulates that foreign capital must account at least for 25 per cent of the total capital of a JV.

104 China: FDI, WTO Accession, Future Perspectives Table 5.1 China’s total FDI, 1979–97 1979–89

1991

No. of contracts 21,776 12,978 Amount contracted (US$ million) 32,360 11,980 Amount utilized (US$ million)a 18,468 4,366

1992

1993

1994

48,764

83,437

47,549

37,011 24,556 21,046 283,365

58,122 111,436

82,680

91,282 73,276 51,780 519,512

11,008

33,767

37,521 41,726 45,280 223,061

27,515

1995

1996

1997

Total 1979–97

Note: a Includes utilized investment in material processing, compensation trade and leasing arrangements. The total number of contracts and total amount contracted exclude these projects. Sources: MOFTEC Year Book (1995–6 and 1996–7); State Statistical Bureau (SSB) of China for 1997 data.

(2) A cooperative joint venture is a FIE in which the distribution of profits does not depend on the partners’ shares in equity capital but is determined by agreement between the partners in the contract. Cooperative joint ventures have been widely used, especially by Hong Kong firms, even before they received a legal status, as the law on Cooperative Joint Ventures was passed only in April 1988. (3) Enterprises with 100 per cent foreign capital were authorized in 1986 by a law which imposed two conditions – the WFOE should export at least 50 per cent of their production or produce technologically advanced goods. In the early 1990s, EJVs accounted for the largest amount of FDI but they have since lost ground. From 1993 to 1999, their share dropped from 50 per cent to 32 per cent of the total contracted amount of FDI, and in 2002 was just 30 per cent. Foreign firms preferred to invest in WFOEs, which represented more than 60 per cent of the contract value of FDI in 2002, as against 25 per cent in 1994. The constraints imposed in principle on this type of enterprise have been compensated by the advantages perceived by foreign investors in terms of management autonomy. Cooperative joint ventures have retained their relative importance (around one-fifth of FDI). For foreign investors, this latter category has the advantage of flexible rules and practice. WFOEs concern larger projects on average, and have contributed to the increase in the average size of FDI projects: in the 1980s, the average size was between US$ 1 and 2 billion and in the late 1990s between US$ 2 and 3 billion.

Jurgis Samulevicius and Tong Xiaoshuang 105

The relationship between FDI and China’s economic development During the five years from 1992 to 1996, foreign businesses invested US$ 151.537 billion in China, 13.9 per cent of China’s total fixed property investment for that period. In 1996 the industrial output value of FIEs was 1.32802 trillion RMB, a 24.3 per cent increase over 1995 adjusted for inflation, significantly higher than the increase (14.1 per cent) in the nation’s industrial output value. The FIEs’ proportion of the nation’s total value of industrial output rose to 15.1 per cent from 5.3 per cent in 1992.4 FIEs have increased China’s financial revenues and provided more job opportunities. The current 145,000 FIEs have directly employed 17.5 million people, about 11 per cent of the nation’s non-agricultural work force, an important channel for resolving China’s employment problems. During these five years, China’s foreigner-related tax revenues, which mainly came from FIEs, reached 210 billion RMB, with an average annual increase of 58.1 per cent, and its proportion of the nation’s industrial and commercial tax revenue rose to 11.9 per cent in 1996 from 4.3 per cent in 1992.5 FIEs have undoubtedly become an important component of China’s national economy and a major driving force for the economy’s rapid development. Since the 1980s, the establishment of Chinese–foreign JVs and cooperative enterprises has promoted the technical transformation of more than 120,000 state owned and collective enterprises, cultivated technical and modern managerial talent, speeded up the transformation of enterprise management mechanisms and the restructuring of enterprise assets and brought into being a number of modern, famous-brand companies. The state owned and collective sectors make up approximately 57 per cent of the property rights of the 300,000 FIEs in China.6 In this economy of mixed ownership, the value of the state owned and collective sectors has been preserved and has risen as FIEs develop. Experience has shown that the establishment of Chinese–foreign joint ventures, cooperative enterprises and limited liability enterprises has promoted the development of productive forces and is an effective method of transforming existing enterprises. The establishment of FIEs and the remarkable achievements attained in transforming existing enterprises through the use of foreign funds have promoted a change in China’s traditional ownership structure and actively helped to create a situation in which various sectors of the economy grow side by side, with the public sector playing the predominant role. In 2003, the National Bureau of Statistics of China reported that China’s GDP reached 10.2 trillion RMB in 2002, up 8 per cent from 2001. The three engines propelling growth in an adverse international climate included consumption, exports and investment. In particular, FDI, along with government investment, contributed to lifting overall investment in China. As in years past, Hong Kong, the Virgin Islands, the USA Japan, and Taiwan were the top sources of FDI to China (see Table 5.2). Third-quarter 2002 statistics show a sizeable increase in US investment in China – the number of new contracts,

106 China: FDI, WTO Accession, Future Perspectives

the value of new contracts and utilized investments were up 28.3 per cent 33.1 per cent and 14.8 per cent, respectively. After shrinking in 2001, EU contracted and utilized investment rose 16 and nearly 22 per cent, respectively.7 Despite Chinese enterprises’ continuing strong interest in forming JVs, WFOEs were the most favoured investment vehicle in terms both of number of projects and amount of contracted investment. In 2002, new WFOEs outpaced equity joint ventures (EJVs) at a rate of more than 2 to 1 (see Table 5.3).8 Table 5.2 Top regions/territories investing in China, January–September 2002 Number of contracts

Amount contracted US$ million

Amount utilized US$ million

Regions Asia Free ports North America EU

17,848 1,996 2,910 1,043

39,989.70 13,449.20 8,267.10 3,708.70

23,699.90 6,044.10 4,315.30 3,533.80

Territories Hong Kong Virgin Islands USA Japan Taiwan South Koreaa Singapore UK Germany Cayman Islands

7,874 1,453 2,403 1,973 3,608 2,803 661 247 239 149

20,950.10 10,187.50 7,332.10 4,555.60 5,716.00 4,035.40 2,612.40 879.2 690.8 1,779.50

12,826.70 4,489.60 3,952.20 3,195.90 2,829.10 2,074.60 1,832.40 1,042.90 901.2 868.1

Note:

a

China Monthly Statistics (December 2002).

Source: MOFTEC.

Table 5.3 China’s FDI, 2002, by types of FIE

Total FDI EJVs CJVs WFOEs Shareholding ventures Joint resource exploration Source: MOFTEC.

Number of contracts

Amount contracted value (US$ billion)

Amount utilized value (US$ billion)

34,171 10,380 1,595 22,173

82.77 18.5 6.22 57.26

52.74 14.99 5.06 31.73

19

0.74

0.07

4

0.06

0.27

Jurgis Samulevicius and Tong Xiaoshuang 107

Composition of FDI in China More than two-thirds of China’s incoming FDI flowed into manufacturing investments. A larger proportion flowed into higher value added sectors such as semiconductors than in earlier years, though most investors continue to resist transferring their highest value added operations to China. Investment increased most strongly in the electronics, telecoms equipment and chemicals sectors (see Table 5.4). Foreign investors put their investment into the manufacturing sector because the cost of human resources, the raw and other materials, were cheaper than in other countries. Many countries, such as Japan and South Korea, relocated their manufacturing facilities to China. Products made by these relocated facilities included clothing, furniture and light electronics. Japanese companies alone moved twenty-two facilities from Japan and other parts of Asia to China in 2002.

Table 5.4 China’s FDI 2000, by selected large sectors (number of contracts more than 500) Sector

2000 Projects

Agriculture, forestry, stock raising, fishery Agriculture Manufacturing industry Textile industry Chemical materials and products industry General machine manufacturing Special equipment manufacturing Electronic and telecommunication equipment Wholesale, retails and restaurant Real estate Real estate development and operation Society services Source: MOFTEC.

Contractual value (unit: US$ 10,000)

Realized value (unit: US$ 10,000)

821 484 15,988 801

1,48,314 69,248 4,60,4809 2,01,541

67,594 35,825 27,51,639 1,39,165

986

2,59,593

1,79,623

613

1,63,351

1,04,742

689

1,06,839

52,796

1,529

11,37,910

4,62,684

852 684

1,43,514 5,23,213

85,781 4,65,751

585 2,679

5,04,897 4,25,463

4,35,702 2,18,544

108 China: FDI, WTO Accession, Future Perspectives

Future trends of FDI in China As China’s economy boomed, FDI in China grew steadily. Many foreign companies, such as Volkswagen, General Motors Corporation, and Honda had been in the Chinese market for years and continued to invest heavily, feeding the world’s leader in low pricing and inexpensive labour. Nike, for example, produced 40 per cent of its shoes in China while Galanz, a microwave manufacturer, increased its global market share to 30 per cent thanks to the high-quality, low-cost products now produced in China rather than in Europe or the USA (Zhang 2001). Much of the foreign investment in China goes into Eastern China, some into Central China and the least into Western China (see Table 5.5). By the end of September 1997, the twelve coastal provinces, municipalities and autonomous regions had approved the establishment of 244,053 FIEs, making up 82.1 per cent of the nation’s total; the nine provinces and autonomous regions in Central China had approved 38,324, or 12.9 per cent of the nation’s total; and the nine provinces and autonomous regions in Western China had approved 14,857, or 5 per cent of the nation’s total.9 In order to gradually close the economic gap between China’s Central and Western Regions and the coastal areas in eastern China, these areas are to carry out a policy of energetically bringing in foreign investment. In the future, while continuing to strengthen the use of foreign investment in coastal areas, the Chinese government will intensify investment in the Central and Western Regions and positively encourage foreign investors to invest there. At the same time, the state will speed up the construction of parts of the infrastructure and a group of communications, energy and raw and semi-finished materials projects to bring in foreign capital in advance and encourage foreign investors to make technical transformations in SOEs in these regions. The state will support them in terms of foreign exchange, other funds and scope of operation and encourage foreign investors who have invested in the coastal areas to invest inland, and will provide a proper system of tax preferences.

Table 5.5 China’s FDI, average for 1985–97 Region

Share of FDI

Northern (%)

NorthEastern (%)

Coastal (%)

SouthEastern (%)

Southern (%)

Western (%)

11.02

6.42

71.28

4.76

4.54

1.98

Source: Calculated from data in the China Statistical Yearbook.

Jurgis Samulevicius and Tong Xiaoshuang 109

3 Overall evaluation of the influence of WTO entry on China The benefits of China’s accession After close to fifteen years of arduous negotiations, China entered the WTO on 11 December 2001, a major milestone in China’s economic development. Overall, in the light of long-term dynamic effects, the Chinese government predicts that China’s accession to the WTO will increase its GDP by 95.5 billion RMB (US$ 23.64 billion), or 1.5 per cent by 2005 (Groombridge 2000). The primary beneficiary of China’s entry to the WTO is the citizens of China themselves. The most vibrant sector in China’s economy now is the non-state sector, decades of poor leadership and the inherent failures of socialism have made SOEs archaic and moribund in the new economy. China’s entry into the WTO will help to strengthen the position of non-state enterprises and will allow more Chinese to work outside of the state system. Allowing more foreign firms to operate in China injects competition into the marketplace, which will raise wages for Chinese workers and help to improve both working and environmental conditions. Getting resources into the hands of the Chinese citizenry is also the best way for them to articulate their demands and press for reform over the long term. Chinese economists predict that WTO membership could create 12 million jobs in some sectors such as textiles, toys and footwear. Chinese firms also face a more stable export environment, one less subject to anti-dumping and special safeguard provisions (despite their WTO legality). The sector that may benefit most from the accession is textiles. The USA, EU, Turkey and others will formally cancel all quota restrictions on China’s textile exports by 2005. Next is the electronics industry. The World Bank in 2001 gave an optimistic estimate of China’s annual economic growth as 2 per cent (Zhang 2001). Telecoms and insurance will be the two major sectors open to foreign capital. However, there are worries about possible severe impacts on agriculture, SOEs and current product quality. With China drastically reducing tariffs on imports, foreign industrial and agricultural goods may be dumped into China, creating serious difficulties for competing Chinese products. It is estimated that in the four years from the beginning of 2002, the overall level of tariffs on industrial goods will drop from 15.3 per cent to 12 per cent, the decrease will affect over 70 per cent of tariff items, and low-tariff items (lower than 10 per cent) will increase to about half of all items. The average tariff rate for over 300 information technology (IT) products will be reduced to about 5 per cent, of which over 100 items will be tariff-free. By 2005, there will be further drastic changes, and items with a tariff over 25 per cent will be reduced by half, and constitute less than 5 per cent of all items. The general tariff rate will go below the average level of developing countries

110 China: FDI, WTO Accession, Future Perspectives

(9–10 per cent). The tariff for automobiles will go down from the current 70–90 per cent to a standard 25 per cent by July 2006 (Zhang 2001). This will create severe pressure on the domestic automobile industry. It is also estimated that with such competition and with economic restructuring, tens of millions of workers will be laid off. The impact on peasants will also be serious. China’s exports and imports after WTO entry China’s entry into WTO has not only contributed to China’s economic development, but also instilled new energy into neighbour countries, in 2002, China performed well in foreign trade and double-direction investment. In 2001 the global trade volume decreased 4.5 per cent; in the first half of 2002 it decreased 4 per cent. Against such a macro background, in 2002, China’s exports were surprisingly better than expected. Exports totalled US$ 325.6 billion, up 22.3 per cent on the previous year. This can be attributed to the changes in the domestic and international situation.10 China’s WTO entry also highlighted its advantages as the safest investment place, a market full of potential, and a low-cost manufacturing base. Meanwhile it triggered off a global industrial transfer and strongly stimulated export expansion. China’s entry also promoted the optimization of the global trade environment and provided multilateral protection for China’s foreign trade development and multilateral channels for trade disputes solution and checking trade protectionism. Part of the textile quota was cancelled, involving exports of US$ 4 billion and accounting for one-third of the textile exports with restrictions. WTO entry also promoted China’s foreign trade system reform and the decentralization of import and export rights. In 2002, China’s private enterprises achieved exports of US$ 32.8 billion, up 66.5 per cent, and became the main force in expanding exports. In 2002, China’s imports hit US$ 29.52, up 21.2 per cent and kept stable: (1) The growth rate of imports was below 1.1 per cent, (2) The foreign trade surplus topped US$ 3.04 billion, up 34.6 per cent, and its driving force for the economy was crucial. (3) The main force of import growth came from processing trade, which increased by 30.1 per cent; other trade imports grew only 13.8 per cent. (4) The import structure was optimized and the proportion of advanced technical equipment and rare materials in import was on the rise.11 New features of China’s foreign investment In 2002, the number of new registered FIEs reached 34,171 with a contract value of US$ 8.277 billion and an actual use value of US$ 5.274 billion, up 30.7 per cent, 19.6 per cent and 12.5 per cent, respectively.12 The whole country seized the opportunity brought by China’s entry to WTO, and the

Jurgis Samulevicius and Tong Xiaoshuang 111

level of foreign investment increased greatly. Six new features were particularly important: (1) With the enhancement of China’s attraction for foreign investment, the country was listed among the top choices of international direct investment. (2) Foreign strategic and long-term investment were strengthened, and large-scale multinational companies swarmed to China. Among the top 500, over 400 invested in China, and 218 investment companies and nearly 400 R&D centre of foreign investment were established. (3) Foreign investment extended to the IT industry while investment in the traditional textile industry blossomed. (4) The policy on foreign business participation in SOE reform is also improving; the government is ready to speed up SOE reform through attracting foreign investment. (5) Foreign businessmen expanded their purchase of Chinese enterprises in China, and a dynamic momentum began to be formed. (6) More fields are attracting foreign investment with an optimization of investment structures. The focus of foreign investment has shifted from manufacturing industry to service industry. Steady growth of China’s national economy Owing to the implementation of consistent policies of expanding domestic demand, plus the boost brought by China’s entry into the WTO, the national economy maintained a robust momentum in 2002. According to the preliminary statistics, in 2002 GDP surpassed 10.2 trillion RMB, up 8 per cent over the previous year, and the development rate was up 0.7 per cent. The value of primary industry reached 1.4883 trillion RMB (up 2.9 per cent), of secondary industry 5.2982 trillion RMB (up 9.9 per cent) and of tertiary industry 3.4533 trillion RMB (up 7.3 per cent).13 In 2002, the economy also displayed six key features: (1) Enhancement of economic development stability (2) Enhancement of economic growth autonomy (3) Expansion of domestic demand and a two-wheel (investment and consumption) strategy was being created. (4) Further improvement of economic growth quality and efficiency (5) Stable prices and employment (6) Steady increase in people’s income. On the other hand, there still exist some deep contradictions and problems which are worthy of attention, such as the danger of deflation, employment pressures and income differentials. We should not be overoptimistic about the present macro economy.

112 China: FDI, WTO Accession, Future Perspectives

4

The IT industry and digitization in China

Emergence of the IT industry After its entry into the WTO, China has become one of the most open markets in the world in the IT sector. The IT or ‘digital’ revolution and the dynamic expansion of market demand has brought about the rapid development of China’s economy, especially its electronics and information industry, which maintained an average annual growth rate of over 20 per cent in the years (1995–2000). The annual output value of China’s IT industry reached US$ 120 billion in 2000, realizing a sales revenue of US$ 70 billion and US$ 42 billion for operational services, topping China’s industrial list as a mainstay industry of the economy. The IT industry in China is expected to continue to maintain a steady and rapid growth over the years 2001–5 and double its business scale in 2000 with a total output value of US$ 300 billion by the year 2005.14 The industry average annual growth rate of total output value is expected to be 20 per cent, and operational revenue reach US$ 120 billion, with an average annual growth of 23 per cent. The added value of the IT industry (which has become a strategic industry for China’s economic growth and industrial structural upgrading) is expected to account for 7 per cent of China’s GDP. Attracted by the market potential, all the global IT giants have come to China with the aim of making it part of their global strategy. They have set up either JVs or wholly owned companies; some have even moved their Asia-Pacific headquarters to the country. Competition in this market is getting more and more fierce and it has become increasingly a matter of concern for IT companies to consider how to survive and succeed. China today is caught up in the relentless global process of the IT revolution. Ever since the reform and liberalization drive of the China government, China’s IT industry has been growing rapidly, at about 30 per cent annually. The development of IT infrastructure in China since the mid1990s has laid a good foundation for the emergence of its New Economy. In 2000, as shown in Figure 5.1, a total of 7.2 million PCs were sold in China. Domestic computer hardware sales (accounting for 76 per cent of total sales in the computer industry) registered a 45 per cent rise over 1999 to reach 189 billion RMB, while sales of software and information services products amounted to 54.7 billion yuan, a 29 per cent increase.15 China’s high-technology strategy Because of China’s current and expected strong economic growth, and the large business opportunities likely to emerge, growing numbers of large foreign MNCs are seeking strategic positioning and competitive advantage in China. Some foreign companies, such as Hewlett-Packard, National Semiconductor, IBM and numerous other firms from the USA, Europe and Asia (Maddison 1998), are now conducting more sophisticated R&D projects

Jurgis Samulevicius and Tong Xiaoshuang 113

No. of PC sold (000)

8,000

7,159

7,000 6,000 4,937

5,000

4,100

4,000

3,500

3,000

2,100

2,000 1,000 0

85

180

250

450

720

1,180

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year

Figure 5.1 Sales of personal computers in China, 1990–2000 Source: www.chinaonline.com.

in China, increasingly in cooperation with their R&D operations in other parts of the world. As a result, Chinese policy makers have prescribed stringent entry conditions for direct foreign investors. There are four key elements of China’s high-technology strategy: (1) Technology-transfer requirements: increasingly, foreign investors must bring advanced technology into China and produce current-generation products there. This policy on technology transfer is the most important tool Chinese policy makers have to start building a high-technology industrial base. (2) ‘Soft technology’ imports: Chinese government officials plan to intensify their focus on importing software, patents and technical services. China’s imports of technology and equipment more than doubled in 1995, partly because of increased government funding for technology purchases. The country signed $13 billion worth of technology and equipment import contracts in 1995, a 218 per cent increase over 1994. (3) Minimum export requirements: export requirements allow developing countries to stabilize their balance of payments. Although China now enjoys a favourable balance of payments, deficits were more common than surpluses in the 1990s. In September 1995 policy guidelines, the Electronics Industry Ministry set a 79 per cent export requirement for foreign manufacturers. (4) Local content requirements: China is encouraging or demanding high levels of local content. In a deal negotiated with General Motors – a more than $1 billion JV deal with Shanghai Automotive Industry Corporation – the parties agreed to an initial local content target of 50 per cent in 1998, to rise to 60 per cent and even to 80 per cent ‘as quickly as possible’.

114 China: FDI, WTO Accession, Future Perspectives

The Internet and e-commerce in China The digital opportunity brings challenges, given the fast pace of technological progress and market competition. According to the National Statistics Bureau of China, the index of China’s ability of digitization is 6.17, which is equivalent to a mere 8.6 per cent of the USA’s ability and only 15.2 per cent of Korea’s ability. According to World Bank statistics, compared to the average level of 63.1, the number of Internet connecting computers per 10,000 is only 0.16 in China. A study was undertaken during 2002 to ascertain the status of digitization in large companies. The top enterprise in utilizing IT was found to be Shanghai Motors.16 While Chinese enterprises are establishing networks, including intranets, many companies (over 60 per cent) have established a website, with 90 per cent having access to the Internet. However, e-commerce in China is underdeveloped with over 70 per cent of companies not venturing into the e-commerce market. With regard to investment in digitization to 2005, the top 100 companies in China have committed to investing a total 3.8 billion RMB in digitization, but the digitization of enterprises is still generally low. In the Ninth Plan of National Development (1995–2000), the digitization of the economy was cited as a key goal. The Chinese government introduced some policy measures, such as reducing the tax rate for software companies, the establishment of a venture capital fund and offers of financial support to key technologies and for the training of senior technicians. According to the Statistical Survey Report on the Development of the Internet in China, issued by the China Internet Network Information Centre in July 2002, as of 30 June 2001, the number of ‘www’ websites in China (including .cn, .com, .net and .org) was 293,213. The number of computer connections with the Internet was 1,613 million. The primary purpose of most Internet users (47 per cent) was to access information; only 0.3 per cent of Internet users reported their purpose as online purchase (Makawatasakul 2001). The growth of e-commerce in China faces a number of practical and regulatory challenges, but the Chinese government attaches great importance to e-commerce and social digitization, regarding it as a new chance for economy development and enhancing China’s international competitive capacity. During 2001–5, China will accelerate the construction of its urban information process and realize the interconnection of a construction information network with the national public information platform, greatly improving office automation and the processes of decision making and management modernization. According to this plan, the state government requires China’s IT industry to meet the following development objectives:

(1) The IT industry should develop three times as rapidly as national economic growth.

Jurgis Samulevicius and Tong Xiaoshuang 115

(2) The IT industry should expand the marketplace to be twice as large in 2005 as it was in 2000. (3) The IT industry should increase production to 5 per cent of GDP. In these five years, China’s urban information process should find its expression in three priority projects: (1) A digitization project for urban planning, construction, management and services. (2) An engineering and building a construction information network. (3) A residential housing and real estate information network (Gao 2002). The IT revolution presents China with a golden opportunity to propel itself into the New Economy. The number of Internet users in China grew by almost 50 per cent to 33.7 million in 2001, according to data from the China Internet Network Information Centre (CNNIC). In 2000, there were 22.5 million Chinese online (4 per cent of China’s population). CNNIC also predicts that there will be more than 30 million web users in China by the end of 2003 and about 200 million around the year 2005. Some 3.32 million online trading accounts were active in China by the end of 2001, and analysts believe that China may have the largest number of online stock traders in Asia by 2006. Almost 32 per cent of Chinese Internet users bought goods or services online in 2001; books, music and computer products were the most popular purchases. Less than 7 per cent of users bought from auction sites, and almost 14 per cent said that they had paid for goods that never arrived (Zhang 2002).

5

Future perspectives of China’s economy

According to the 10th Five-Year Plan (2001–5), three features of China’s economy will be key: (1) The economy will be driven by the development of new and high technology (IT in particular), so as to attain the objective of an average 7 per cent GDP growth rate in these five years (2) China will honour its WTO commitments and open up to the outside world in an all-dimensional and multi-level manner (3) China will deepen its economic restructuring and standardize the market. GDP is due to grow at 7 per cent per annum in this period, the economy should hit the 12.5 trillion RMB mark by 2005, when per capita GDP will be in the region of 9,400 RMB (Lam 2001). The 29th Olympic Games will be held in Beijing in 2008. Chinese economists have said that Beijing’s successful Olympic bid will help the city

116 China: FDI, WTO Accession, Future Perspectives

achieve modernization ahead of schedule. They predict that the ‘Olympic economy’ will catalyze China’s economic growth by attracting huge amounts of investment into sports facilities, communication systems and airport and highway construction. Beijing alone will invest as much as 280 billion RMB (US$ 33.86 billion) in the Games, tens of thousands of employment opportunities will be created and the Olympic-related economy will contribute 0.3–0.4 per centage points to China’s economic growth each year until 2008. The economists also predict that Beijing’s economy will achieve two-digit growth annually in 2001–10, and its goal of a per capita GDP of US$ 6,000 will be achieved ahead of schedule (2010) (Trondsen and Gonzalez 1991). The Olympics will also attract more FDI to China. At the Ericsson strategic and technological summit in Hong Kong in February 2002, the president of Ericsson said that in 2002–6 the company would invest US$ 5 billion in China in mobile communications, and increase its investment in R&D and human resources from US$ 290 million to US$ 572 million, seeking development opportunities during China’s preparations for the Olympics. The company will raise its output in China to US$ 10 billion.17 Many more foreign companies will be investing in China, and Chinese overseas companies will also grow. This will speed up China’s economic growth. Some economists predict that China will be challenging Japan for second position in the world economic league table by 2010, and that by 2020, or perhaps sooner, China’s economy could be larger than that of the USA.18

6

Conclusions

Two decades of reform have brought enormous gains to China’s economy and to the material well-being of its population. Even if China’s economic surge tails off, accomplishments since the 1980s represent an important event in global economic history. The style of China’s economy can be expressed as ‘start local, go global’. After the ‘open door’ policy was created, China began to access the world, attracting FDI to fuel its economy. FDI in China was negligible before 1978, but in 2002 the number of new registered FIEs reached 34,171 with a contract value of US$ 8.277 billion and an actual use value of US$ 5.274 billion. As the result, China’s total GDP rose from 362.41 billion RMB in 1978 to 10,200.00 billion RMB in 2002. WTO membership can give many benefits to China’s economic development: ● ● ● ●

Helping to strengthen the position of non-state enterprises Creating more jobs for citizens Increasing workers’ wages Helping to improve working and environmental conditions

Jurgis Samulevicius and Tong Xiaoshuang 117 ● ●

Keeping exports and imports stable Keeping national economy growth steady.

Foreign investors have been willing to put their money into high technology (the IT industry and digitization) in China. Using the Internet is the fastest way to collect information and connect with the world, and the rapid development of IT infrastructure in China since the late 1990s has laid a good foundation for the emergence of its New Economy. The added value of the IT industry is expected to account for 7 per cent of GDP and China’s high-technology strategy has attracted more and more global IT giants with the aim of making China part of their global strategy.19 Notes 1. ‘Doing Business in China’, PriceWaterhouseCoopers organization, 2002, http:// www.pwcglobal.com/Extweb/NewCoAtWork.nsf/docid/9F4225FD3F1351D78525 6C07004237C6. 2. People Daily, http://english.peopledaily.com.cn. 3. ‘How to Invest in China?’, 2000, Tibet Information web site, http://www. tibetinfor.com/en/market/status/sta_01f.htm. 4. ‘How to Invest in China?’. 5. ‘How to Invest in China?’. 6. ‘Foreign Investment’, US–China Business Council, March 2002, http://www. uschina.org/statistics/03–01.html. 7. ‘Foreign Investment in China’, US–China Business Council, May 2003, http:// www.uschina.org/statistics/2003foreigninvestment.html. 8. ‘Foreign Investment in China’. 9. ‘How to Invest in China?’. 10. People’s Daily. 11. People’s Daily. 12. People’s Daily. 13. People’s Daily. 14. ‘What Impact May China’s Accession to the WTO Have on Foreign Investment in China?’, American Chinese culture exchange centre, 2002, http://www.accec.org/ english/investment/faq/10.htm. 15. http://www.worldtrademag.com. 16. ‘Semi-Annual Survey Report on Internet Development in China’, CNNIC, July 2002, http://www.cnnic.net.cn/develst/2002–7e/indexshtml. 17. ‘Olympic Games to Rev Up Beijing’s Modernization Drive’, Xinhua News, 29 July 2001, http://www.chinadaily.com.cn/olympic/news/text/729modern.htm. 18. ‘Enter the Dragon: China’s Big Companies and the World Economy’, FT Mastering Management, 2001, http://www.ftmastering.com/mmo/mmo10_1.htm. 19. Lemoine, F. ‘FDI and the Opening Up of China’s Economy’, CEPII – Document de travail, 2000–11, http://www.cepii.fr/anglaisgraph/workpap/pdf/2000/wp00–11.pdf.

References Gao, F., ‘The Introduction to E-Commerce Legislation in China’, Baker & McKenzie (Global E-commerce Law), 2002, http://www.bmck.com/ecommerce/chinaarticle1.doc.

118 China: FDI, WTO Accession, Future Perspectives Groombridge, M.A. ‘The Case for China’s Accession to WTO’, Harvard Asia Quarterly, 4(2), 2000, http://www.fas.harvard.edu. Lam, W.-W., ‘Chinese Premier Commits to Radical Reforms’, CNN.com, 5 March 2001, http://edition.cnn.com/2001/WORLD/asiapcf/east/03/04/china.npc.01. Maddison, A., ‘Chinese Economy Performance in the Long Run’, OECD Development Centre, Paris, OECD, 1998, http://www.eco.rug.nl/. Makawatasakul, N., Tio, J., Kietparadorn, W. and Manophars, C., ‘Internet and E-Commerce in China’, California State University, Fullerton, Department of Information Systems and Decision Sciences, ISDS553Fall2001, http://faculty.fullerton.edu/schen/ISDS%20553/Week%2015/T5%20-%20China.doc. Ministry of Foreign Trade and Economic Cooperation (MOFTEC), MOFTEC Year Book, 1995–6, 1996–7. Trondsen, E. and Gonzalez, P., ‘High Technology in China: Opportunities and Threats’, Study Number: D96–1991, http://www.sric-bi.com/BIP/DLSS/DLS1991.shtml. Zhang, K., ‘China – The Pros and Cons of China’s Accession to WTO’, April Fifth Action, October Review 28(4), 31 December 2001, http://wss.hkcampus.net/~wss6489/en/02/020126.html. Zhang, M., ‘Meeting the Digital Opportunity: Accelerating the Pace of Enterprise Digitization’, Presentation on State Economic and Trade Commission, PR China, 2002, http://www.mofa.go.jp/policy/economy/asem/seminar/asem1/session/ p15.html.

6 Issues of Japanese Affiliates in Chinese Economy Takeshi Otsu

1

Introduction

Foreign direct investment (FDI) significantly contributes to the development of developing countries. It facilitates the transfer of new production technology, creates employment opportunities and strengthens the competitiveness of industries in host countries. Low-cost production resources and new markets give incentives to multinational enterprises (MNEs) to invest in developing countries. The Chinese economic reforms successfully attracted large FDI during the 1990s. According to the Japan–China Investment Promotion Organization ( JCIPO) in Japan, the cumulative sum from 1979 to 2002 was about US$424,000 in number and US$4.5 billion in value actually used. In May 2003, FDI grew by 40.3 per cent year-on-year a on contractual basis and by 34.3 per cent on an actually used basis. The empirical studies in the literature (Chen, Chang and Zhang 1995 for 1979–90; Zhang and Song 2000 for 1986–97; Sun and Chai 1998) for 1986–92) showed that FDI investment played an important role in economic development in China. Foreign affiliates in China increased their shares in industrial production from 14.3 per cent in 1995 to 27.3 per cent in 2000. Their shares in exports grew from 31.5 per cent to 47.9 per cent during the same period ( JCIPO in 2002). The importance of FDI or foreign affiliates is thus crucial in China’s recent economic growth. This chapter contributes to our understanding of the present economic environment in China by considering issues of foreign affiliates. It gives valuable information not only for foreign investors to decide their FDI strategy in China, but on the appropriate policies or necessary reforms that the Chinese government must take to sustain a further economic development. We use survey data published by JCIPO Japan, which conducts a biannual survey on Japanese affiliates in China since 1990. The questionnaires include various market and institutional conditions, and provide a unique 119

120 Japanese Affiliates in the Chinese Economy

opportunity to investigate the business environment of the Japanese affiliates in China. Although the survey data might be subject to sampling biases and are limited to Japanese affiliates, it is still helpful to understand issues of the business environment surrounding foreign affiliates in China. To my knowledge, there are only a few empirical studies on foreign affiliates in China with firm-level data. One reason is the limited availability of firm-level data and the other is that a certain passage of time is necessary to evaluate firms’ performance and identify their problems. Since FDI surged into China in the mid-1990s, it is only recently that empirical studies at the firm level have been possible. Beamish and Jiang (2002) empirically investigated determinants of profitability of the Japanese affiliates in China during the period 1983–99. They found that the Japanese affiliates’ profitability rose when Japanese ownership was low, the affiliates’ size large and the timing of entry earlier. They used information from Japanese Investment Overseas (Toyo Keizai Inc.). The advantage of their dataset is its wide coverage of affiliates in China, amounting to more than 3,000 firms. It includes the Japanese parent firms’ shares of equity, the number of employees of affiliates, the number of Japanese expatriates and the sales of affiliates. As for profitability, it records only a three-point scale for answers by managers: loss, break-even and gain. In contrast, the dataset used in this chapter includes a wide range of questions and can be used to investigate firms’ behaviour in more detail. It thus contributes to the existing literature by providing a complementary analysis. There are three main findings in this chapter. First, foreign affiliates face fierce competition with local products. Secondly, local procurement of goodquality intermediate goods is a key to surviving the competition in China. Finally, the deregulation by the Chinese government permits foreign affiliates to choose distributional channels. Affiliates thus circumvent credit recovery problems by choosing reliable wholesalers or retailers. The underdevelopment of the distribution channels and the credit recovery problem still remain. The plan of this chapter is as follows. In Section 2, we briefly discuss the characteristics of FDI into China and argue that studies on the Japanese affiliates may have implication to other foreign affiliates of non-Chinese origin. In Section 3, we identify issues concerning Japanese affiliates in China, based on survey data. We closely look at problems of credit recovery and distribution in Section 4 and at market competition and local procurement in Section 5. In Section 6, we consider problems of FDI policies in China that burden Japanese affiliates. In Section 7, we briefly discuss the future trends of the Chinese economic reforms. Section 8 gives some concluding remarks.

2

Background

The major foreign investors in China are from Hong Kong and Taiwan (around 64 per cent of cumulative FDI cases and 54 per cent of cumulative

Takeshi Otsu 121

FDI values at the end of 2002), followed by the USA and Japan (together amounting to 15 per cent in number and 17 per cent in value). As Sun and Tipton (1998) point out, the distribution of the FDI in China varies by source country. More than a half of the FDI from Hong Kong and Taiwan flowed into the southern coastal areas such as Guangdong and Fujian, and was more than 50 per cent of the overall FDI in the southern coastal areas. A large part of the FDI from Japan and other developed countries, such as the USA, UK and Germany, flowed into the eastern areas such as Shanghai, Jiangsu and Shandong (Otsu 2000, 115). The dominance of direct investments from Hong Kong and Taiwan stems from the fact that these countries are geographically and culturally very close to southern China. Many of the investors in Hong Kong and Taiwan are ethnic Chinese from the southern provinces (Yeung 2000). In contrast, the eastern areas, especially Shanghai, had close business relations with European countries at the beginning of the twentieth century. SEZs in the eastern coastal area, established in the beginning of the 1990s, stimulated FDI from European countries, the USA and Japan. The investment pattern of these countries is quite different from that of the Chinese merchants overseas and the Japanese investment pattern is very similar to that of Western countries. Although Japan is geographically close to China, it was not until 1978 that the two nations restored diplomatic relations after the Second World War. Japan does not therefore have a great advantage over other source countries in Chinese markets. Although investment from Hong Kong and Taiwan played a crucial role in developing the Chinese economy, investments from other developed countries are also essential to China’s further economic development. Tertiary industries in Europe and the USA can provide high-quality services valuable for China. It is thus very important for the Chinese government to adopt economic policies to attract FDI from Western countries and Japan. The similarity of the investment pattern between Japan and other developed countries such as the USA, UK and France means that studying Japanese affiliates’ issues in China will make it possible to understand business conditions and issues common to all foreign affiliates which do not have cultural advantages.

3

Japanese affiliates in China

In this section, we identify the characteristics and issues concerning Japanese affiliates in China. We use survey datasets compiled by JCIPO during 1998–2002, an appropriate period to examine the performance of Japanese affiliates because more than 43 per cent of the Japanese affiliates responding to the questionnaires were established in 1994–5 and took two– three years to get their business on the right track. The questionnaires were mailed to some 2,000 Japanese affiliates in China, and response rates were

122 Japanese Affiliates in the Chinese Economy Table 6.1 Profitability of Japanese affiliates, 1996–2001, per cent Year

1996 1997 1998 1999 2000 2001

Profit rates (current profit/sales) 3

3–0

0–3

3–6

6–9

9

15.1 14.2 28.3 23.1 14.4 11.5

7.0 7.1 5.2 6.0 4.9 6.2

17.3 20.2 22.0 19.1 19.9 23.6

17.8 15.4 15.6 13.2 16.3 17.1

10.8 11.1 6.9 11.2 13.4 13.0

31.9 32.0 22.0 26.6 31.0 28.6

Source: JCIPO (2002b:6).

around 20 per cent, 80 per cent of the affiliates were engaged in manufacturing industries. We first look at the profitability of the Japanese affiliates, measured by the ratio of current profits to sales. Table 6.1 shows the distribution of the profitability of Japanese affiliates operating for more than two years. Profitability dropped after the Asian Financial Crisis in 1997, but recovered afterwards. The non-profitable affiliates consisted were about 20 per cent in 1996 and 1997. In 1998 immediately after the Asian Financial Crisis, they were more than 33 per cent. The share of the affiliates in the red then decreased to 18 per cent in 2001, mainly due to the recovery of domestic sales in China. In Table 6.2, affiliates are classified into two types: export oriented (with more than 70 per cent of sales for export) and domestic oriented (with less than 70 per cent exports). The share of the export oriented affiliates in the red was nearly 30 per cent in 1998, and hovered around 17–18 per cent after 1999. The exported oriented affiliates rapidly recovered after the Asian Financial Crisis, and more than half made profits above 3 per cent after 1998. Turning to domestic market oriented affiliates, 37 per cent went into the red in 1998 and 41 per cent in 1999. The share of the domestic oriented in the red sharply decreased to 21 per cent in 2000 and further to 17 per cent in 2001. Nearly 60 per cent of domestic oriented affiliates made profits of more than 3 per cent after 2000. Both of the export and domestic oriented affiliates thus substantially improved their profitability. Although more than 80 per cent of the Japanese affiliates made profits in 2001, 46 per cent of the export oriented affiliates and 54 per cent of the domestic oriented affiliates answered that they had performed worse than planned. Table 6.3 summarizes frequency of answers chosen by the respondents. Two caveats for Table 6.3 are in order. First, the respondents can reply with multiple answers so the proportions in the table do not show the distribution of the firms, being just a normalized weight of each item. Secondly, the number of choices is different in the two surveys (1999 and 2001).

Takeshi Otsu 123 Table 6.2 Profitability of Japanese affiliates, by affiliate type, 1998–2001, per cent Year

1998 Export Domestic 1999 Export Domestic 2000 Export Domestic 2001 Export Domestic

Profit rates (current profit/sales) 3

3–0

0–3

3–6

6–9

9

23.9 33.3

5.2 3.8

27.6 16.7

17.2 10.6

7.5 6.1

18.7 29.5

12.0 34.4

4.9 6.9

20.4 15.6

19.7 8.1

12.7 9.4

30.3 25.6

12.1 16.8

6.0 4.2

19.8 20.4

25.9 8.4

11.2 13.8

25.0 36.5

10.8 12.4

7.5 5.1

27.5 21.5

21.7 13.0

10.8 13.6

21.7 34.5

Note: ‘Export’ means affiliates that export more than 70 per cent of sales, others are called ‘domestic’. Source: JCIPO (2002b:7).

Table 6.3 Japanese affiliates, reason for underperformance, 1999 and 2001, per cent 1999

Weak demand Exchange rate fluctuation Fierce competition Unexpectedly small market size Underdeveloped distribution channels in China Credit recovery Weak price competitiveness Others

2001

Export

Domestic

Export

Domestic

33.3 13.3 18.3 2.5

15.5 7.6 31.9 7.6

26.5 10.8 22.5 1.0

16.3 4.1 33.0 6.3

10.0 8.3 9.2 5.0

12.7 12.7 8.4 3.6

4.9 3.9 15.7 14.7

8.1 11.3 10.9 10.0

Note: See Table 6.2 for definitions of ‘export’ and ‘domestic’. Sources: JCIPO (2000:80, 2002b:84).

We choose items common to the two surveys, and items ignored took only a small share of the responses. With these caveats in mind, we may note the following three points. First, Table 6.3 indicates that fierce competition in the Chinese market is a main reason for the underperformance of the domestic oriented affiliates. Combined with weak price competitiveness, the competition factors have a weight of more than 40 per cent. It is thus crucial to raise market competitiveness.

124 Japanese Affiliates in the Chinese Economy

Although the competition factors also matter for the underperformance of the export oriented affiliates, they have more weight in the domestic oriented affiliates’ performance. This suggests that competition inside China is more severe than abroad. The performance of the export oriented affiliates more likely depends on weak demand than competition. This suggests that demand in China is strong enough but that the Chinese market is very competitive. The second point is that the domestic oriented affiliates have more difficulty in overcoming the underdevelopment of distribution channels than the exported oriented affiliates. Although the underdevelopment of distribution channels has a lower weight as a reason for underperformance in 2001 than in 1999, it has more weight for the domestic oriented affiliates (8 per cent) than the export oriented affiliates (5 per cent) even in 2001. Finally, the credit recovery problem is alleviated for the exported oriented affiliates, but its weight stays above 10 per cent for the domestic oriented affiliates. The survey also asked affiliates in China about their managerial problems and obstacles to gaining market share in China. The survey results are summarized in Tables 6.4 and 6.5. The same caveats as in Table 6.3 should be borne in mind. First of all, Table 6.4 shows that the affiliates have serious problems with the Chinese governments and their policies, especially in recent years. Secondly, the personnel problem and the local procurement of intermediate goods retains a large weight. These factors particularly influence the productivity and the competitiveness of affiliates. In Table 6.5, competition with local products and imports is a principal obstacle to affiliates’ gaining a foot hold in the Chinese market. The fourth point is that the problem of sales shows a decreasing trend in Table 6.4. A large part of the sales problem is due to credit recovery difficulties and its decrease is consistent Table 6.4 Japanese affiliates, managerial problems

Sales Personnel administration Relationship with Chinese governments Local procurement Chinese policy/law Exchange rate fluctuation Raising funds Relationship with Chinese partner/parent firm Infrastructure

1997 (%)

1999 (%)

2001 (%)

17.5 14.0

16.4 14.6

12.7 16.8

7.1 12.4 14.5 11.8 8.6

12.6 12.5 14.4 10.4 8.4

15.4 11.6 14.3 10.2 5.8

5.7 8.4

6.9 3.8

6.2 7.1

Sources: JCIPO (1998:46, 2000:53, 2002b:53).

Takeshi Otsu 125 Table 6.5 Japanese affiliates, obstacles to gaining market share in China, 1997–2001 Obstacle Credit recovery Competition with local products Competition with imports Underdeveloped distribution channels Lack of customers’ information Regulations Inundation of counterfeits Others

1997 (%)

1999 (%) 2001 (%)

36.1 19.5 5.8

25.9 19.7 8.3

26.4 30.9 11.0

15.7 9.9 6.5 3.3 3.1

15.6 11.8 10.6 5.2 3.0

8.4 8.2 7.8 4.9 2.4

Sources: JCIPO (1998:39, 2000:48, 2002b:47).

with the decrease of credit recovery as a factor among obstacles to gaining a foot hold in the market in Table 6.5. Finally, Japanese affiliates seemingly succeeded in developing distribution channels, as shown in Table 6.5. The underdeveloped distribution problem reduced its weight to 8 per cent in 2001, half of the 16 per cent in 1997 and 1999. The issues concerning Japanese affiliates can be summarized as follows. First of all, the distributional problem in China is being alleviated, and the credit recovery problem less likely to have a negative effect on economic performance. However, domestic oriented affiliates have more serious problem in recovering accounts receivable than the exported oriented ones. Secondly, although market demand in China is strong, market competition with local products and imported goods is becoming severe and is now the most serious problem. Government policy and law is still a burden to affiliates, the friction between affiliates and the Chinese government is one now of the most serious managerial problems.

4

Credit recovery and distribution channel

In Section 3, we saw that the credit recovery problem has begun to improve. The average duration of credit recovery was 3 months at the end of 1998, and 2.4 months in 2001. Table 6.6 summarizes the main payment methods adopted by affiliates. Japanese affiliates dealt with the credit recovery problem by switching payment methods from accounts receivable to prepayment and were more likely to adopt cash payment at delivery in 1999 than in 1997. They increased the weight of the prepayment further in 2001. Accounts receivable continued to reduce its importance from more than 65 per cent to less than 52 per cent. Credit recovery problems declined not because the credit payment system became well developed in China but

126 Japanese Affiliates in the Chinese Economy Table 6.6 Japanese affiliates, methods of payment, 1999–2001 1997 (%) 1999 (%) 2001 (%) Paid at delivery (cash only) Paid at delivery (cash and bills) Accounts receivable (cash only) Accounts receivable (cash and bills) Prepayment Others

16.9 11.1 37.5 27.7 – 6.8

22.4 11.0 33.0 21.6 9.8 2.1

17.8 10.8 29.2 22.7 14.5 5.1

Source: JCIPO (2000: 9, 2002b: 14).

because affiliates avoided the use of accounts receivable and became more likely to ask for prepayment. The distribution channel is another item that had lessening weight in affiliates’ problems, especially, in the period from 1999 to 2001 (see Table 6.5). A legal change played an important role in improving the distribution of commodities; foreign investment in retail trading began to be liberalized when the State Council enacted a provision in July 1992 making it possible for foreign retailers to establish affiliates in the form of JVs or cooperative ventures in Beijing, Tianjin, Shanghai, Dalian, Guangzhou, Qingdao and five SEZs (Shenzhen, Zhuhai, Shantou, Xiamen and Hainan). However, the provision was so restrictive and required such a complex approval procedure that local governments began to approve foreign investment in the retail industry on their own account beyond the authority of the State Council. Established under such permissions were the JVs with Carrefour (France), Walmart (the USA), B&Q (UK) and Metro (Germany). In June 1999, the State Economic and Trade Commission (SETC) together with MOFTEC promulgated a law of foreign investment for commercial businesses in China. This law not only increased the permissible number of foreign retailers’ affiliates, but also allowed foreign firms to enter the wholesale industry. Shanghai Baihong Trade Co. Ltd. was the first JV established under the law. A 51 per cent stake in Shanghai Baihong belonged to the Shanghai First Department Store (Group) Co. Ltd. and the remaining shares to a Japanese trading company, Marubeni Corp. In addition to limited rights to import and export, the affiliate can buy daily-use articles produced by domestic firms and sell to various retailers in China. This liberalization of the distribution sector expanded the choices of distribution channels that foreign affiliates might use. Table 6.7 shows how Japanese affiliates distributed their products in China. A large number of the Japanese affiliates gave up using Chinese retailers, switching to foreign distributors or reliable Chinese sales representatives. The use of Chinese wholesalers went down from 16.5 per cent in 1999

Takeshi Otsu 127 Table 6.7 Japanese affiliates, distribution channels (final goods), 1997–2001 1997 (%) 1999 (%) 2001 (%) Chinese wholesalers Chinese retailers Chinese sales agents Own retails Others (foreign distributors, etc.)

14.5 18.0 25.0 27.2 15.4

16.5 14.6 30.3 36.0 2.6

13.6 7.0 36.0 35.1 8.3

Sources: JCIPO (1998:38, 2000:46, 2002b:46).

Table 6.8 Japanese affiliates, relative frequency of payment method Industry

Food Textile Wooden products Pulp/paper Print/publishing Chemicals Rubber Ceramics Steel products Metal products General machinery Electric machinery Transport machinery Precision instruments Correlation

Chinese channels

Accounts receivable

1.33 0.64 1.00 0.00 0.00 0.29 0.20 0.60 0.00 0.06 0.11 0.21 0.23 0.50

0.71 1.08 0.00 1.33 0.75 1.45 0.80 0.91 2.17 1.31 0.63 1.24 1.44 1.00 0.56

Source: JCIPO (2002b:102–3).

to 13.6 per cent in 2001, while that of Chinese retailers were halved to 7 per cent in 2001, compared with 14.6 per cent in 1999. Japanese affiliates thus circumvented the problem of underdeveloped distribution channels by avoiding the Chinese-based distributors. We can find an interesting relation between the choice of distribution channel and that of payment method. Table 6.8 shows the relative frequency of Chinese distribution channels to other channels, by industry. The total frequency with which Japanese affiliates chose either Chinese wholesalers or Chinese retailers is divided by the frequency with which the Japanese affiliates chose other distributors. If this index is larger than one, it implies that Chinese distribution channels are used more frequently than other channels in the industry. As shown in Table 6.8, the food industry is most dependent

128 Japanese Affiliates in the Chinese Economy

on the Chinese distributors. The relative frequency of the use of accounts receivable is also computed. Half of the fourteen industries are more dependent on accounts receivable than other methods. The correlation between the two indices is – 0.56, which is statistically significant at 5 per cent level. If an industry uses Chinese distributors, it is thus more likely to adopt prepayment or payment at delivery as a payment method. Japanese affiliates hesitate to accept accounts receivable as a payment method when they deal with the Chinese distributors. The problems of distribution channels and credit recovery thus still remain. A well-established credit payment system and a well-developed distribution system are essential for the further development of the Chinese economy. One of the most serious problems is that no wholesaler can cover a whole province, not to mention the entire area of China. A network of the foreign chain stores is well established only in a few cities such as Shanghai and Beijing. Foreign affiliates usually need to find a number of sales representatives in other local cities. The credit system in China is far from completely modernized. Institutional reform in financial sectors is urgent to establish an efficient credit system. Chinese banks need to learn advanced management and risk-prevention strategies. Domestic enterprises in China also need to change their business customs so as to observe credit payment rules, and the government should ensure strict legal enforcement against those who fail to observe them.

5

Competition, procurement and personnel

Competition in the Chinese market is getting more and more severe owing to the restructuring of the SOEs and gradual trade liberalization. The 7th JCIPO survey asked Japanese affiliates how they dealt with the reduction of production costs, and Table 6.9 shows what kind of measures that the affiliates took. Japanese affiliates first paid more attention to reducing defect rates and raising the local procurement. As shown in Table 6.10, which summarizes the weight of production factors in production costs, it is obvious that intermediate goods such as materials and parts were more than 70 per cent for most Japanese affiliates. Local procurement is thus a key to reducing production costs. The main problem was the quality of the intermediate goods, which had a 40 per cent weight while procurement costs and delayed delivery had 30 per cent, respectively. Quality control of products has a great weight in cost reduction, and a high local procurement rate, together with an efficient distribution system, can help in avoiding the need to hold excess inventories and with delayed deliveries. Secondly, personnel expenses can be greatly reduced by decreasing the number of expatriate personnel from Japan and increasing local employment. Here, the problem is the quality of labour: it is very difficult to hire

Takeshi Otsu 129 Table 6.9 Japanese measures

affiliates,

cost

reduction

Measure

(%)

Reduction of defect rate Local procurement of intermediate goods Increase of local employment Reduction of inventory Reduction of employment Wage reduction Reduction of capital investment Rationalization with new facilities

19.9 18.6 16.6 16.0 11.2 7.4 6.2 4.0

Source: JCIPO (2002b:28).

Table 6.10 Japanese affiliates, production costs, per cent

Intermediate goods Personnel expenses Depreciation costs Others

0

0–10

10–30

30–50

50–70

70–90

90–100

2.2 0.0 0.6 5.5

2.2 53.0 59.2 30.0

6.2 38.2 35.3 60.0

18.5 7.0 4.6 4.1

31.1 1.8 0.3 0.5

34.8 0.0 0.0 0.0

5.2 0.0 0.0 0.0

Source: JCIPO (2002b:49).

Table 6.11 Japanese personnel problems Problem Recruitment (Managers/experts) Education/training (Managers) Wage/evaluation system Fringe benefit/residence Labor union

affiliates,

(%) 24.8 (16.2) 25.5 (17.6) 23.5 21.3 4.9

Source: JCIPO (2002b:53).

good managers and experts or to educate workers to make managers. In Table 6.11, these two factors had a 34 per cent weight in personnel problems. Foreign affiliates need to have good quality control on products and materials, and to find able Chinese managers if they are to survive the fierce competition in Chinese markets.

130 Japanese Affiliates in the Chinese Economy

6

Problems of FDI policies

Chinese policy and laws are listed as a managerial problem in Table 6.4 mainly because tax and tariff-related policies and legal revisions are a great concern of foreign affiliates. One of the problems is incomplete taxation regulation. A value added tax is levied on production, but the costs of fixed capital formation such as production facilities are not deductible. Manufacturers thus pay double taxes, and firms in capital-intensive industries have a heavy tax burden. In addition, the value added tax, sales tax and corporate tax are interlocked. The taxation system needs to be simplified and standardized as soon as possible. The ongoing institutional reforms and WTO accession require China to carry out extensive legal revisions, which will inevitably oblige affiliates to pay adjustment costs. China began to dismantle some regulatory barriers against foreign investors after the mid-1990s, preparations to joining the WTO, in March 2001 abolishing the requirement for foreign-funded firms to balance foreign exchanges, give priority to local procurement of intermediate goods and report their production and managerial plans. The ‘exporting obligation’ was restated as ‘exporting promotion’. In 2002, the State Council reviewed nearly 2,300 legal documents related WTO rules, and abandoned or amended half of them. Abolition preferential policy measures for foreign affiliates in exchange for import tariff reduction and abandonment of import quota is to be expected. Frequent rules’ revision is likely to persist for a while, however. In addition to an undeveloped taxation system and frequent legal changes, unclear and unpredictable administrative enforcement is another serious problem for Japanese affiliates, contributing to the poor relationship with the Chinese government shown in Table 6.4. The major complaints of Japanese affiliates are summarized in Table 6.12. More than half of the respondents claimed that the FDI policy was changed suddenly and notification circulated

Table 6.12 Japanese affiliates, complaints about FDI policy changes, 1997 and 1999, per cent Complaint

1997

1999

Too short notice No guarantee of vested preferential measures Thorough notification of enforcement Insufficient explanation of future policy Different enforcement over regions Insufficient coordination with affiliates

67.1 34.6 50.6 27.7 50.6 48.4

59.5 26.7 53.9 31.1 49.0 44.6

Total number of responding firms

419

469

Source: JCIPO (1998:45, 2000:53).

Takeshi Otsu 131

only through internal documents. Almost half complained that new laws were likely to be enforced for different firms and in different regions. In some cases, the Chinese government also took corrective measures to nullify the negative effects of new laws after they had been promulgated, responding to requests by foreign affiliates or their governments. A lack of coordination by the Chinese government meant that law enforcement could be different case by case. A typical example was the revocation of value added tax after China had introduced it in 1994. The Chinese government did not levy any tax on exports by ‘old foreign affiliates’ that had been established before 1993. China then began to revoke new taxes on the old foreign affiliates. The revocation rate was 17 per cent in 1994, down to 14 per cent in 1995 and to 9 per cent in 1996 because of insufficient government funds. According to the initial plan, the authorities were to levy all the new taxes on both the old and the new foreign affiliates after 1999. It turned out in 1998, however, that no new taxes had been charged on new foreign affiliates during 1994–8. The Chinese government had to deal with complaints by foreign affiliates at such patchwork measures. To increase administrative transparency and fair enforcement of new laws, the State Council issued an ordinance of notification of new laws and regulations in mid-December 2001 after China became a member of the WTO. It required that the local governments report to the State Council all the new laws and regulations that they intend to enact, so that the Council can review them to ensure their appropriateness. New laws will be officially announced only if the Council judges they are appropriate; otherwise, they will be sent back. This procedure, however, has not yet given rise to the expected results. In Table 6.13, Japanese affiliates’ complaints on unclear and unfair government administration is shown to have increased from 28.7 per cent in 1999 to 45.3 per cent in 2001. Administrative decisions sometimes depend on officials in charge, affiliates concerned and regions where affiliates exist. The complicated approval procedure and ambiguous approval criteria also have a large weight, 40.3 per cent. Although strict supervision by the State Council effectively restrains local authorities from abusing inspections and Table 6.13 Japanese affiliates, problems government policy, 1999 and 2001, per cent

with

Problem

1999

2001

Administration Approval procedure Abuse of inspection and charges Others

28.7 36.5 32.2 2.6

45.3 40.3 13.1 1.4

Source: JCIPO (2000:52, 2002b:52).

132 Japanese Affiliates in the Chinese Economy

arbitrary charges on foreign affiliates, the government needs to make further efforts to reduce such friction.

7

Future trends

In this section, we discuss the future trends in Chinese economic reforms related to the issues considered in this chapter. Along with the opening-up policy, the Chinese government began to deregulate the service sector, which is crucial for further economic growth. On WTO accession, China pledged to give foreign financial institutions the same treatment as Chinese banks: foreign banks are to be freed from all geographical and customer restrictions by 2007. Foreign participation in business has begun to stimulate domestic financial institution to improve their services and should culminate in fostering a good payment system. This will substantially alleviate the credit recovery problem for Japanese affiliates. A reformed credit system should contribute to boosting private consumption, leading to higher economic growth. China expected to complete national credit card integration among large and medium-sized cities by 2003, and foreign banks expected new regulations permitting them to enter the banking card business. It is estimated that more than 100 million people in China were financially eligible to apply for credit cards in 2002, and banking cards have started to prevail in cities such as Shanghai and Beijing. An efficient credit system is also essential to the future expansion of Chinese e-commerce. The inefficient distribution system is not only a serious problem for Japanese affiliates, but also an obstacle to further economic growth in China. No single wholesaler or distribution group can cover the whole areas even at province level, not to mention whole regions in China. Manufacturers in China need to find numerous agents and contract with them to distribute their products. In accordance with the China’s WTO commitments, China is gradually opening up the retailing and wholesaling industries to foreign investors. It is imperative that the Chinese government takes advantage of distribution technology developed in the USA, Europe and Japan. WTO commitments mean that the Chinese government must lift geographical restrictions on the distribution industry and relax the regulation on ownership shares of foreign firms by the end of 2004. All restrictions on franchise systems will also be lifted. Such liberalization will make it easier for foreign firms to establish their own distribution system after 2005. Japanese companies will take advantage of that opportunity to circumvent the problems with Chinese distributors already discussed. Liberalization of distribution sectors should also prompt domestic retailers to undertake transregional expansion that will improve efficiency. Fierce competition has made distribution business less profitable and only the financially strong multinational companies such as

Takeshi Otsu 133 Table 6.14 Expected changes in China’s FDI policy Items

Liberalization plans

Import tariff reduction

8.9 per cent on manufacturing goods by 2010 0 per cent on products for information technology by 2005 Abolition by 2005 By the end of 2004, given to all firms including foreign ones; details on conditions to be applied and date of enforcement are unknown Liberalized by the end of 2004; conditions on firm sizes and on domestic sales of goods imported by foreign affiliates, are unknown By the end of 2005, allowing 100 per cent foreign ownership; other detailed conditions are unknown

Import restriction International trading rights

FDI in distribution sector

FDI in international transportation

Source: ‘Business Environment After WTO Participation’ (JCIPO 2002c).

Metro, Walmart, Carrefour and Auchan can survive. They contribute not only to improving efficiency of their industries but also to exporting Chinese commodities throughout the world. International retailers purchased nearly US$30 billion of Chinese products in 2001, 12 per cent of China’s total export value. Further changes in FDI policy can be expected (see Table 6.14). For these policies to effectively attract FDI, detailed conditions and clear time schedules should be officially announced – otherwise the policies will be ineffective. Another reason that the FDI policies may be ineffective is if domestic trading rights are granted separately from international trading rights. Many foreign affiliates, especially Japanese, would like to import products from their parent companies and sell them in China. According to the 7th JICPO survey (2002b:51), Japanese affiliates have the greatest concern about the extension of trading rights among the possible merits of deregulation after WTO accession: 154 out of 383 Japanese affiliates (40.2 per cent) hoped that restrictions on trading rights might be lifted; 124 of 383 affiliates (32.4 per cent) also hoped for liberalization of distribution sectors. Japanese companies do not have many concerns about SEZs where they may enjoy preferential taxes unless they are allowed conveniently to trade with firms inside China. Expected FDI policy changes on international trading rights and distribution sectors may therefore not be very effective. Suppose that a foreign affiliate is allowed to enter the distribution sector after 2005 and to trade goods produced in China, it will also be allowed to trade internationally as shown in Table 6.14. But it is not known if this affiliate will be able to sell goods produced abroad in China. If it cannot sell imported goods in China, these policies may not successfully attract Japanese FDI.

134 Japanese Affiliates in the Chinese Economy

It is open to argument whether the Chinese government will give both domestic and international trading rights to foreign affiliates. The separation of trading rights may promote FDI in manufacturing industries with new technologies, and facilitate technology transfer into China. This argument presumes a large spillover effect via technological transfer. To my knowledge, however, among recent empirical studies only Liu (2002) found a possible spillover effect in the form of technological transfer through FDI in China. Other studies, such as Cheung and Lin (2003) and Li, Liu and Parker (2001) found that spillovers effects in local firms came mainly from competition with foreign affiliates or the mere presence of foreign firms in Chinese market, not from vertical technological transfer from foreign to local firms. These studies suggest that the separation of trading rights may not contribute to raising productivity in China and may even reduce the growth rate of productivity improvement. In addition, it is often said that Japanese companies do not often transfer new technology. Although detailed information or data are not available to compare the impact of FDI from Japan and other countries, one possible reason is that Japanese companies are afraid of the so-called ‘boomerang’ effect: technological transfer to Chinese companies will reduce the market shares of Japanese companies and squeeze their profitability. In the worst case, Japanese companies could be wiped out from the world market. A large body of the technology owned by Japanese firms is relatively easy to be copy, while high-quality labour with special or technical knowledge is essential to acquire the technology owned by US or European firms. As a result, the spillover effect of FDI via competition is more promising than via direct technological transfer. Separate approval of international and domestic trading rights may thus not be effective in terms of spillover effect. To facilitate new technology transfer into China, the Chinese government must take advantage of the large number of Chinese students and engineers in the USA or other foreign countries; they have abundant specialized knowledge and may have business experience. They will contribute to transplanting new technologies in China if their property rights are guaranteed. China should take advantage of this Chinese human capital abroad as well as the spillovers effect of FDI via competition.

8

Concluding remarks

This chapter attempts to contribute to understanding what needs to be done to promote further economic development in China by observing issues concerning Japanese affiliates. Japanese affiliates should have economic and institutional issues common to other foreign affiliates of non-Chinese origin because of the similarity of their FDI pattern in China. The main issues identified are the underdevelopment of distribution channels, credit recovery problems, market competition, administrative transparency of government, and the frequent changes in China’s policies and laws.

Takeshi Otsu 135

The gradual liberalization of the distribution sector gave Japanese affiliates a chance to deal with the credit recovery problem as well as the underdevelopment of the distributional system by using foreign-funded distributors to mitigate credit recovery problem or by asking for prepayment, but the credit recovery problem essentially remains. The distribution system is also far from covering all the regions in China. Further reforms in these two fields need to be made because a reliable credit system and an efficient distribution system underpin the development of all market economies. Secondly, market competition is fierce in China. Although economic liberalization in China has expanded business opportunities for foreign affiliates, it also implies withdrawal of policy measures such as preferential taxes. Foreign affiliates will thus face much more fierce competition in return for expanding business activities. Because a large part of production costs can be attributed to procurement costs of intermediate goods such as parts and materials, it is crucial for affiliates to realize local procurement of cheap intermediate goods and labour. Here, the main issue is quality; it is difficult to find many good experts and managers in China. The relatively high defect rates of the products and the low quality of intermediate goods worsen affiliates’ performance. The governments’ policies and laws inevitably tend to be subject to frequent and sudden changes in the course of economic reform, and is a burden to foreign affiliates. To reduce confusion in the market and keep steady economic growth, the Chinese government may need to notify firms of the changes of rules well in advance and make their administration transparent. References Beamish, P.W. and Jiang, R., ‘Investing Profitably in China: Is It Getting Harder?’, Long Range Planning, 35, (2002), 135–51. Chen, C., Chang, L. and Zhang, Y., ‘The Role of Foreign Direct Investment in China’s Post-1978 Economic Development’, World Development, 23(4), (1995), 691–703. Cheung, K. and Lin, P., ‘Spillover Effects of FDI on Innovation in China: Evidence from Provincial Data’, China Economic Review, 15(1), (2004), 25–44. Japan–China Investment Promotion Organization ( JCIPO), 5th Survey on Japanese Affiliates, JCIPO, (1998). ———— 6th Surrey on Japanese Affiliates, JCIPO, 2000. ‘On the Impact of Foreign Affiliates in the Chinese Economy’ (Chuugoku keizai niokeru gaishi no inpakuto ni tsuite), JCIPO News, 82, 2002a, in Japanese. ———— 7th Survey on Japanese Affiliates, JCIPO, 2002b. ———— ‘The Business Environment after WTO Participation’, JCIPO, 2002c. Li, X., Liu, X. and Parker, D., ‘Foreign Direct Investment and Productivity Spillovers in the Chinese Manufacturing Sector’, Economic Systems, 25, (2001), 305–21. Liu, Z., ‘Foreign Direct Investment and Technological Spillover: Evidence from China’, Journal of Comparative Economics, 30, (2002), 579–602. Otsu, T., ‘Roles and Issues of Foreign Affiliates in China’ (Chuugoku shinshutsu kigyou no yakuwari to kadai), in Y. Sazanami and F. Kimura (eds), Ajia Chiiki Keizai no Saihensei, Chapter 5, Library of Keio University Sangyo Kenkyujo, Tokyo, (2000), 111–35.

136 Japanese Affiliates in the Chinese Economy Sun, H. and Chai, J., ‘Direct Foreign Investment and Inter-Regional Economic Disparity in China’, International Journal of Social Economics, 25(2), (1998), 424–47. Sun, H. and Tipton, F.B., ‘A Comparative Analysis of the Characteristics of Direct Foreign Investment in China, 1979–1995’, Journal of Developing Areas, Winter, 1998, 159–86. Yeung, H.W., ‘Local Politics and Foreign Ventures in China’s Transitional Economy: The Political Economy of Singaporean Investments in China’, Political Geography, 19, (2000), 809–40. Zhang, K.H. and Song, S., ‘Promoting Exports: The Role of Inward FDI in China’, China Economic Review, 11, (2000), 385–96.

7 Technology Upgrading Strategies and Level of Technology Adoption in Japanese and US Firms in Indian Manufacturing Rashmi Banga

1

Introduction

Foreign Direct Investment (FDI) in India assumed critical importance in the context of the economic reforms process initiated in the 1990s. India’s FDI policy, as formulated under the Foreign Exchange Regulation Act (1973) had been one of the most restrictive in the world; however, an important measure undertaken in the reform process was a major relaxation of the policy regime relating to FDI. FDI was sought because it was expected to augment investible resources and, more importantly, improve technological standards and the skills, efficiency and competitiveness of domestic industry. It was also expected to bring ‘relatively’ later technology into industry, since markets for technology are imperfect, which makes the transaction costs for sales of technology by multinational companies (MNCs) to outsiders high (Buckley and Casson 1976; Caves 1996; Teece 1981). However, the question raised in this chapter is whether do foreign firms from different source countries differ with respect to their level of technology adoption in the same industry of the host country. Studies have found that the costs of intra-firm transfer of technology may differ between the different types of technology transferred and the different modes of technology transfers (Teece 1988). This gives us reason to believe that FDI that comes from different sources, with different types of technology and different modes of transferring technology, may entail different transfer costs. And this may lead to differences in the extent of technology adoption in the affiliates of foreign firms from different countries of origin in the same host country. It therefore becomes important to study the technology behaviour of foreign firms with respect to their country of origin. The issue may be of great relevance for small and medium-sized firms SMEs, who, in an attempt to upgrade their technology, collaborate with foreign firms and therefore need to choose between foreign firms of different countries of origin. 137

138 India: Technology Upgrading and Adoption in Japanese and US Firms

The two source countries chosen for the analysis are Japan and the USA Japanese MNCs, though latecomers on the scene as compared to US and European MNCs have intrigued economists by their ever-evolving technology. Many studies have tried to compare different aspects of technology in Japanese firms to that of their Western counterparts. Dunning (1994) finds that whereas in the 1950s and 1960s, the ownership advantages of US firms were primarily based on their ability to innovate new products and production processes and devise more appropriate organizational structures, on and their marketing and budgetary control techniques, the ownership advantages of Japanese firms in the 1970s and 1980s essentially comprised a capability to coordinate and manage the resources and capabilities within their jurisdiction so as to minimize their transaction costs. Schroath, Hu and Chen (1993) find that the USA has a higher proportion of its joint ventures ( JVs) in the high-technology category as compared with Japan. These results are supported by Balassa and Marcus (1990). In this respect, the concept of technology transfer to the host economy has also been extensively studied. However, the results are ambiguous. The literature posits that US FDI in manufacturing is usually undertaken in most technologically sophisticated industries with not yet standardized products that are more capital-intensive in nature, while Japanese FDI generally enters industries that are less capital-intensive producing standardised products that are less technology-intensive. The transfer of technology from Japanese firms has therefore been termed ‘orderly transfer’ of standardised production that differs from the American ‘reverse-order’ transfer of technology (Kojima 1978). It is argued that since ‘reverse-order’ transfer may be difficult to undertake in non-standardised products in most cases technology transfers from Japanese FDI are much greater and that Japanese FDI therefore contributes to the development of the host country with greater efficiency than US FDI (Kojima 1991). Ravenhill (1999) identifies four areas, – localization of management, sourcing of components and capital goods, replication of production networks and distribution of research and development (R&D) activities – in which Japanese MNCs’ subsidiaries frequently differ in their practices from their US counterparts. This will affect the prospects of technology transfer to the host economy. The study concludes that the subsidiaries of US corporations are more likely than their Japanese counterparts to interact with the host economy in a manner that facilitates local acquisition of technology. However, very few studies have empirically compared technology behaviour and extent of technology adoption by the subsidiaries of these firms operating in the same industry in the same host country, especially in the developing countries. None of the studies has tried to examine the impact of foreign ownership by country of origin on the extent of technology adoption in a firm.

Rashmi Banga 139

With respect to the Indian economy, the FDI and technology literature has, in general, ignored the country of origin of the foreign firm. This study therefore adds to the literature by comparing the technology upgrading strategies and extent of technology adoption in Japanese and US affiliated firms operating in the same industry in a developing country and examining the impact of Japanese and US equity ownership on the extent of technology adoption in a firm. The analysis is undertaken in three steps: ●

●

●

First, an univariate statistical criterion is adopted to compare the technology up-grading strategies of Japanese and US firms. Secondly, an index of technology adoption in Japanese and US firms is constructed using principal component factors where the factor scores coefficients are used as the weights for the different technology up-grading strategies to compare the level of technology adoption in these firms. Finally, empirical analyses are carried out using least squares and random effects models to analyse the impact of Japanese and US shares on the extent of technology adoption in the firms and to explain the different factors that affect their level of technology adoption.

The plan of the chapter is as follows. Section 2 discusses the dataset and the methodology adopted by the study. Section 3 presents the hypotheses and the variables used. Section 4 presents the results of the univariate statistical analysis that is used to compare the technology upgrading strategies and the extent of technology adoption in Japanese and US firms. Section 5 presents the ordinary least squares (OLS) results on the impact of Japanese and US shares on the extent of technology adoption in the firms. Section 6 presents the panel data estimates on the determinants of technology adoption in Japanese and US firms. Section 7 concludes.

2

Dataset and methodology

Dataset The data for the study are collected from the Capitaline package, produced by Capital Markets Ltd, an Indian information services (IS) firm. The database provides panel data for about 10,000 companies listed on an Indian stock exchange as well as some unlisted companies. However, one of the limitations of the Capitaline package is that it does not include fully foreign owned firms or all the JVs that are not listed on any Indian stock exchange. This is supplemented by data taken from various issues of Annual of Survey of Industries (ASI), National Accounts statistics and some publications of the Ministry of Industry. From the Capitaline database, a balanced panel data for 1,720 firms was extracted for the years 1995–6 to 1999–2000. Out of 1,720

140 India: Technology Upgrading and Adoption in Japanese and US Firms

firms, we find that there are 102 firms with a Japanese share in their equity and 174 firms with an American share in their equity. In our dataset a firm is defined as a ‘foreign firm’ if the foreign equity participation is 10 per cent or more in the total equity invested in the firm. In our analysis it is important to control for the industry-specific effects, so industry-level data for seventy-five three-digit-level industries were also extracted from the Capitaline database. These industries are further classified into fifteen broad industrial groups. Methodology Apart from the level of technology that a firm may start with – i.e. capital intensities – the extent of technology adoption in a firm depends upon the technology up-grading strategies adopted by the firms. However, the technology upgrading strategies may differ from industry to industry. To undertake a comparison of these strategies in Japanese and US affiliated firms only those industries are selected where both Japanese and US firms are simultaneously present. Three types of analyses are undertaken: ●

●

●

Firstly, a univariate statistical criterion is used to find whether the technology upgrading strategies differ between the Japanese and US firms. The univariate test applied here is a non-parametric test. Non-parametric tests have the advantage of not assuming any specific distribution of the population under analysis. Among the various non-parametric tests, for samples that are not related to each other the Mann–Whitney U-test is the most popular. It is equivalent to the Wilcoxon rank sum test and the Kruskal–Wallis test for two groups. The observations from both groups are combined and ranked, with the average rank assigned in the case of ties. The number of ties should be small relative to the total number of observations. If the populations are identical in location, the ranks are randomly mixed between the two samples. The number of times a score from group 1 precedes a score from group 2 and the number of times a score from group 2 precedes a score from group 1 are calculated. The Mann–Whitney U-statistic is the smaller of these two numbers. Secondly, to compare the extent of technology adoption in the firms an index of technology adoption is prepared using principal component analysis (PCA). The factor score coefficient matrix provides the weights for the variables used to prepare the index. A multivariate analysis using OLS regression is undertaken to compare the impact of Japanese and US shares in the firms on the extent of technology adoption in the firms. White hetroscedasticity-consistent standard errors are reported. A least squares model using five-year averages is used in place of panel data analysis, since the technology up-grading variables do not change from year to year. Finally, an attempt is made to compare the factors that determine technology adoption in Japanese and US firms using panel data estimates.

Rashmi Banga 141

Separate equations are estimated using the technology adoption index in the Japanese and US firms as the dependent variables.

3

Hypotheses and variables

Hypotheses FDI is sought by many developing countries as a conduit for state-of-the-art technology. But, this is not an undebated view and has triggered much discussion and empirical investigation on the nature of technology transfer from FDI. Based on this literature, we test two main hypotheses in the study. Hypothesis 1 The higher the foreign control in the firm, the higher will be the technology adoption in the firm. ‘Foreign control’ in the firm is the level of control of the parent technology supplier over the foreign affiliates. This is usually determined by the share of equity ownership of the foreign collaborator in the firm. ‘Foreign ownership’ can be divided into the following categories: ● ●

●

JVs (greater than 10 per cent foreign equity) Joint ventures with control in the subsidiaries (greater than 26 per cent foreign equity) Fully or majority owned subsidiaries (51–100 per cent foreign equity).

The extent of equity participation in the subsidiaries determines the costs of transfer and the risk involved in transferring technology to the subsidiary (Wang and Blomström 1992). If it is assumed that all technology transfers are intra-firm and the parent companies are the major suppliers of technology to their affiliates then the transaction costs and risks involved in transferring technology to the subsidiaries will be lowest in the case of majority owned subsidiaries. These subsidiaries will therefore have highest technology adoption. On the other hand, the lower the control of the parent firms in the affiliates the more limited will be the scope for appropriating returns from the exploitation of technology and greater will be the dangers of know-how dissemination. From this, we can expect that the degree of foreign control in the firms will influence the technology made available to the affiliates and thereby influence the technology adoption in the firms. Hypothesis 2 The extent of technology adoption by Japanese affiliates in India will be greater than the extent of technology adoption by US affiliates. According to Teece (1998) the rate at which technology is diffused worldwide depends heavily on the resource costs of transfer and the magnitude of the economic rents obtained by the seller. The resource costs depend on the

142 India: Technology Upgrading and Adoption in Japanese and US Firms

characteristics of the transmitter and on the institutional mode chosen for transfer. The costs are lower the greater the similarities in the experience of the transmitting and the receiving units – for the greater the similarities, the easier it is to transfer technology in codified form such as blueprint, formulae or computer language. Uncodified or tacit knowledge, on the other hand, is slow and costly to transmit. Studies show that US FDI is generally undertaken by large oligopolistic firms, which produce products that are not yet standardised and rely heavily on R&D and innovation. The technology transfers from these firms are ‘reverse-order’ types of transfer (Kojima 1991). Japanese FDI, on the other hand, is undertaken by small and medium-sized firms (SMEs), which produce standardised products and rely on relatively lower resource costs in the host economies. The technology transfers from these firms are generally ‘orderly transfers’ of technology of standardised products. The preferred mode of technology transfer is also seen to differ in these two sources of FDI. It is often said that the Japanese production model draws its strength from the human-related dimensions of engineering technologies, workplace practices and corporate culture more than in-house R&D or embodied technology imports as in the case of US firms. Given these differences in the type of technology adopted and the preferred source of transfer of technology by the parent firms of Japanese and US affiliates, it can be expected that Japanese affiliates in Indian manufacturing will be able to adopt a greater extent of technology as compared to US firms. Variables The differences in the strategies followed by Japanese and US firms have been a matter of discussion in the literature. We attempt to compare the technology up-grading strategies followed by Japanese and US firms. Six variables are used that represent different technology upgrading strategies. Technology up-grading strategies (1) (2) (3) (4) (5) (6)

Import of knowledge capital – i.e. royalty payments  ROY Lump-sum payments, commissions and technical fees  TECHFEE Import of capital goods  IMPCAP Import of spares and stores  IMPSPS Import of raw materials  IMPRAW R&D expenditures  RD.

To control for the scale effect all the above variables are taken as a ratio of sales. An index of technology adoption is constructed and is represented by TECH. The technology adoption index in the firm will depend on a number of characteristics of the firms – e.g. the equity structure of the firms, the asset structure of the firms, the output structure of the terms, the performance level of the firms and the type of industry in which the firms operate.

Rashmi Banga 143

Variables affecting the extent of technology adoption in the firms Equity structure The ownership structure is determined by the equity participation in the firms. The extent of technology adoption in the firms will depend on the ownership control of the foreign firm, as discussed earlier. The variables used under the equity structure of the firms to test the two hypotheses are as follows: (1) Control in the firm – i.e. foreign equity participation of above 25 per cent in total equity invested  CONTROL (2) Percentage of collaborator’s share  COLL (3) Japanese equity as a percentage of total equity invested  JEQ (4) US equity as a percentage of total equity invested  USEQ. Apart from these variables there are a number of firm-specific characteristics and industry-specific effects that may also affect the type of technology upgrading strategies and the extent of technology adoption in the firms. There is therefore a need to control for these variables. Three firm-specific variables are considered. Asset structure (1) Capital–labour ratio – i.e. Gross block–total employee cost  K/L (2) Ratio of fixed assets to total assets  FX. Output structure (1) Scale of operation – i.e. log of total sales  SIZE (2) Advertisement intensity  ADVT. Performance level (1) Gross profitability as a proportion of total sales  GP (2) Export intensity as a proportion of total sales  EXP. To control for industry-specific effects industry dummies are used along with the following industry-specific variables: (1) (2) (3) (4)

Effective rate of protection  ERP Concentration ratio  CR4 Size of the industry  SIZEIND Export intensity of the industry  EXPIND.

The extent of technology adoption in a firm will be higher if a firm is more capital-intensive, is larger in size, produces more differentiated products, has higher profitability and is more export oriented in nature. Technology adoption in a firm is also expected to be higher if the firm exists in an

144 India: Technology Upgrading and Adoption in Japanese and US Firms

industry which is more open (lower ERP, higher export-intensity); more competitive (low CR4, large size) and has higher R&D expenditure.

4 Comparison of technology upgrading strategies of Japanese and US firms: univariate analysis results The technology upgrading strategies adopted by the firms may vary from industry to industry, therefore to make a meaningful comparison of these strategies in Japanese and US firms it becomes important first to study the inter-industry pattern of the direct investments. Table 7.1 presents the industrial distribution of Japanese, US and domestic firms across fifteen broad industrial groups. An important result that emerges from Table 7.1 is that the industrial pattern of Japanese and US firms differs significantly in Indian manufacturing. Out of the fifteen industrial groups only three industries have a simultaneous presence of Japanese and US firms – Engineering, Electrical and Electronics and Auto. Apart from these three industries, Textiles can also be said to have both a Japanese and a US presence, though the number of Japanese firms is much higher than that of the US firms. However, the number of foreign firms in an industry may not provide the correct picture of the presence of foreign firms in an industry. It is also Table 7.1 Average number of Japanese, US and domestic firms in Indian manufacturing industries, 1995–6 to 1999–2000 Industries

Industry code a

Food Textiles Paper Leather Plastic Chemicals Aluminum Engineering Electrical Auto Computer Pharmaceuticals Glass Domestic appliances Others

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Total

Domestic firms 118 236 102 11 46 237 173 134 116 81 46 92 10 10 32 1,444

Japanese firms

US firms

1 18 7 2 3 17 2 11 10 17 – 4 5 1 4 102

13 8 6 1 8 35 16 16 12 15 8 18 – 2 16 174

Total

132 262 115 14 57 279 191 161 138 113 54 114 15 13 62 1,720

Note: a 1 Food and Dairy products; 2 Textiles and Textile Manufactures; 3 Paper and Packaging; 4 Leather and Leather Products; 5 Plastic and Rubber Products; 6 Chemicals and Allied; 7 Aluminum and Steel; 8 Engineering; 9 Electrical and Electronics; 10 Auto and Auto-Ancillary; 11 Computers; 12 Pharmaceuticals; 13 Glass and Glass Products; 14 Domestic Appliances; 15 Others.

Rashmi Banga 145

important to look at the amount of equity invested by the foreign firms. A comparison of the proportion of equity invested by Japanese and US firms in these industries is presented in Table 7.2. The average equity invested in the period 1995–6 to 1999–2000 by US firms is be higher in Automobiles and Auto-Ancillary and Electrical and Electronics. However, we find that around 10 per cent of both Japanese as well as the US equity is invested in these industries taken together. Table 7.3 presents the ownership structure in the two firms. We find that the number of Japanese firms with greater than 10 per cent Japanese equity participation and US equity participation are 34 and 36, respectively. Except for these four industries we find that none of the other industries has a presence of both Japanese and US firms. US firms are found mainly in Chemicals, Food and Dairy products, Aluminium and Steel, and Pharmaceuticals while Japanese firms apart from the four industries considered above are found in Glass and Glass products.

Table 7.2 Average proportion of Japanese and US equity invested in manufacturing industry, 1995–6 to 1999–2000, per cent Industry

Japanese equity

US equity

8.35 15.28 5.7 8.76 9.52

14.87 8.1 10.56 4.25 9.44

Auto and Auto-Ancillary Engineering Electrical and Electronics Textiles Average

Table 7.3 Ownership structure of Japanese and US firms in four manufacturing industries Foreign Auto and Engineering Electrical and Textiles All share in Auto-Ancillary Electronics four industries total equity Japanese US Japanese US Japanese US Japanese US Japanese US (%) firms firms firms firms firms firms firms firms firms firms 10 10–25 26–50 50 Total

3 9 3 2 17

3 6 5 1 15

3 2 4 2 11

3 3 6 4 16

Total number of Japanese firms with ⬎10% Total number of US firms with ⬎10%

3 2 3 2 10

5 5 2 0 12

13 0 3 2 18

4 1 2 1 8

22 13 13 8 56

15 15 15 6 51

34 36

146 India: Technology Upgrading and Adoption in Japanese and US Firms

The technology upgrading strategies followed by the subsidiaries of the two sources of FDI reflect the type of technology transferred by the parent firms to their subsidiaries in the host economy. These strategies include the import of embodied technology represented by the import of capital goods, spares and stores and raw materials and disembodied technology, i.e. royaltypayments, lump-sum payments, commissions and technical fees paid in foreign currency, and expenditure on R&D. Table 7A.1 (p.151) presents the average shares of these components in Japanese and US firms. US firms have higher average R&D expenditures (RD), import of raw materials (IMPRAW) and royalty payments (ROY), while the average shares of import of capital goods (IMPCAP), spares and stores (IMPSPS) and technical fees (TECHFEE) are higher in Japanese firms. The results of the comparison of technology up-grading strategies using the Mann–Whitney U-test for independent samples in Japanese and US firms are presented in Table 7.4. The results show that Japanese and US firms differ with respect to their upgrading of embodied and disembodied technology. US firms have higher imports of raw materials, they make higher royalty payments and they spend more on R&D as compared to Japanese Firms, while Japanese firms have significantly higher imports of spares and stores. However, these strategies independently do not give much insight into the extent of technology adoption in these firms. A technology adoption index has therefore been created using the principal component factor. The factor score coefficient matrix is presented in Table 7A.2 (p.151). The comparison of the technology adoption indexes shows that Japanese firms have significantly higher technology adoption as compared to US firms (Table 7.4). This shows that the extent of technology adoption by

Table 7.4 Univariate analysis of technology upgrading strategies and technology acquisition index in Japanese and US firms: Mann–Whitney U-test for two independent samples Component

1 RD 2 IMPCAP 3 IMPRAW 4 IMPSPS 5 ROY 6 TECHFEE TECH

Z-statistics

Level of statistical significance

Inference

2.37** 0.78 2.44*** 1.96** 5.45*** 0.76 3.27***

0.02 0.44 0.01 0.05 0.001 0.45 0.001

US  J

Notes *** indicates significant at 1% level of significance ** indicates significant at 5% level of significance US  USA.

US  J J  US US  J J  US

Rashmi Banga 147

Japanese firms in India is higher than that of US firms. The univariate analysis, however, does not take into account the inter-relationships between the variables therefore multivariate analysis is undertaken.

5 Factors affecting technology adoption in firms: results of empirical analysis To test the two hypotheses regarding the impact of foreign control and shares of Japanese and US equity on technology adoption in the firms we ran a simple least squares regression using five-year averages (1995–6 to 1999–2000) with the technology adoption index as the dependent variable and foreign control and Japanese and US equity in the firms as the principal explanatory variables. Least Square regressions using five-year averages are more appropriate here since the components of the technology adoption index (i.e. import of capital goods, spares and stores, raw materials, payments for royalty and technical fees and R&D expenditures) may not take place every year in a firm. Table 7A.3 (p.151) presents the correlation matrix of the explanatory variables used. High correlation is found between foreign control and Japanese and US equity, thus separate equations are estimated using these as the explanatory variables. None of the other explanatory variables is highly correlated. Higher correlation is found between the technology adoption index with Japanese equity, foreign control and export intensities in the firms. Table 7.5 presents the results of the Least Squares regressions estimating two equations for testing the two hypotheses. All firms, including domestic firms, in the four industries have been included in the analysis. Equation (1) shows that after controlling for firm-specific effects such as the size, asset structure and performance level of the firms and industry-specific effects such as extent of competition, degree of openness and R&D intensity in the industry, we find that foreign control in the firms has a significant impact on technology adoption in the firm. The higher the foreign control in the firm, the higher is the extent of technology adoption. Apart from foreign control, the export intensities and capital intensities in the firms affect the extent of technology adoption. The capital intensity has a significant positive effect on the extent of technology adoption, this is possible since the technology intensity of the firms is expected to be positively related to the capital–labour ratio. The export intensities of the firms are also expected to influence the technology adoption since the firm producing for the international markets has to keep up with international standards. Such a firm may follow technology up-grading strategies more closely than those firms producing for the domestic market. A higher level of competition in an industry in terms of lower ERP and larger size of industry also improves technology adoption in the industry’s firms.

148 India: Technology Upgrading and Adoption in Japanese and US Firms Table 7.5 Least squares regressions: dependent variable: heterosce-dasticity-consistent standard errors and covariance Variable

Equation (1) Coefficient

C CONTROL JEQ USEQ SIZE K/L FX GP EXP ADVT ERPIND CR4 SIZEIND EXPIND TEXT AUTO ENG N R2 Adjusted R2 Durbin–Watson statistic F-statistic

0.05*** 0.03*** – – 0.01 0.01*** – 0.001 0.09*** 0.06 0.07*** 0.09 0.03 0.02* 0.01 0.12 0.02

t-statistic 4.73 2.45 – – 1.34 4.42 – 0.54 3.25 1.12 4.13 1.18 3.56*** 1.79 0.78 1.32 0.77

674 0.43 0.34 2.02 17.17***

TECH,

White

Equation (2) Coefficient

t-statistic

0.05*** – 0.33*** 0.06 0.01 0.008*** – 0.007 0.08*** 0.08 0.01*** 0.08 0.04*** 0.02 0.01 0.11*** 0.005 N R2 Adjusted R2 Durbin–Watson statistic F-statistic

5.16 – 3.92 1.02 1.32 4.30 – 0.43 2.55 0.11 5.11 1.10 4.01 1.13 0.70 1.91 1.00 674 0.55 0.45 2.00 4.34***

Notes: *** indicates significant at 1% level of significance ** indicates significant at 5% level of significance * indicates significant at 1% level of significance

Equation (2) of Table 7.5 presents the results of the impact of Japanese and US equity shares on the extent of technology adoption in the firms. After controlling for firm- and industry-specific effects, firms with higher Japanese equity shares have a higher extent of technology adoption as compared to firms with higher US equity shares. This is plausible given the everevolving technology of Japanese firms. Studies have shown that intra-firm technology transfers are higher in case of Japanese firms because of the nature of technology transferred and the mode of transfer used. The technology acquired by the Japanese affiliates is of standardised products and undertaken by SMEs. The mode of transfer used by the Japanese firms is based more on human resources and therefore is easier to undertake as compared to the uncodified or tacit knowledge required in the production of the nonstandardised products undertaken by US firms. The result supports our hypothesis. Apart from the foreign equity shares the variables favourably affecting the extent of technology adoption are the capital–labour ratio and

Rashmi Banga 149

the export intensity of the firm, along with the large size of the industry and low effective rate of protection. The analysis thus highlights the importance of recognizing the heterogeneity of the FDI.

6 Determinants of technology adoption in Japanese and US firms: panel data estimates The differential impact of Japanese and US shares on the level of technology adoption in the firms is explained by analysing the factors that affect technology adoption in these two sources of FDI. Panel data estimates are carried out using the technology adoption index in Japanese and US firms as the dependent variables. The results of the random effects model are reported based on Hausman test and presented in Table 7.6. The results show that the factors that affect technology adoption in the firms differ in importance with respect to Japanese and US firms. The factors that explain Table 7.6 Technology adoption in Japanesea and US firmsa,b: random effects model estimates Variables

Constant CONTROL LOGSIZE EXPINT GBLEMC GP ERPIND SIZEIND EXPINTIND CR4IND ADVT AUTO ENG ELEC No. of observation Hausman statistic LM statistics

Equation (1) Dependent variable: technology adoption index in Japanese firms

Equation (2) Dependent variable: technology adoption index in US firms

Coefficient

t-ratio

Coefficient

t-ratio

0.48*** 0.24*** 0.23* 0.02 0.008** 0.11* 0.07*** 0.01** 0.06 0.05 1.01 0.02 0.11 0.01 280 15.58 398.38***

5.19 4.04 1.72 1.05 1.14 1.66 2.91 1.81 1.20 1.18 1.08 0.50 1.49 1.11

0.12*** 0.25*** 0.11 0.22*** 0.004 0.002 0.03 0.02 0.09 0.004 1.25 0.04*** 0.11 0.02*** 255 14.85 407.15***

5.80 6.12 1.10 2.99 0.54 1.22 1.85 1.77 1.81 1.72 1.00 2.50 1.42 2.23

Notes *** indicates significant at 1% level of significance ** indicates significant at 5% level of significance * indicates significant at 1% level of significance a Number of Japanese firms 56 and US firms 51. b Period of analysis 1994–5 to 1999–2000.

150 India: Technology Upgrading and Adoption in Japanese and US Firms

technology adoption in Japanese firms are the extent of foreign control, the size of the firms, the capital intensity of the firms and the profitability of the firms. Japanese firms that have, on average, higher control of the parent firm; are larger in size; are more capital-intensive and more profitable and tend to have a higher level of technology adoption after controlling for industry-specific effects. On the other hand, US firms that have higher control of the parent firm and are more export-intensive in nature adopt higher levels of technology. Competition in international markets is therefore the driving force behind technology adoption in the US firms. The technology adoption is found to be higher in US firms in Automobiles and AutoAncillary and Electrical and Electronics industries. However, industry effects do not turn out to be significant for Japanese firms.

7

Conclusion

The chapter has studied the differences in the technology upgrading strategies and level of technology adoption in Japanese and US affiliates in Indian manufacturing. The technology upgrading strategies adopted by the two sets of firms were compared using both univariate and multivariate analyses. The technology upgrading strategies with respect to both embodied technology and disembodied technology and R&D expenditures differed significantly between Japanese and US firms. However, to get a more meaningful picture an index of technology adoption was created using the principal component factor and the impact of foreign ownership on technology adoption was estimated. The results showed that after controlling for firm-specific and industry-specific effects, ownership of foreign firms and degree of foreign control in a firm had a significant impact on its extent of technology adoption. Japanese firms were found to have a higher level of technology adoption as compared to US firms in Indian manufacturing in the period 1994–5 to 1999–2000. Different factors were found to be significant in influencing technology adoption in Japanese and US firms. Apart from the control of parent firm, size, capital intensity and profitability of the firms were found to be significant factors affecting the extent of technology adoption in Japanese firms, while export intensity was found to be the most important factor affecting the extent of technology adoption in US firms. The study thus emphasizes the importance of taking account of the heterogeneity of FDI while studying the technology behaviour of the foreign firms. FDI from different source countries may follow different technology up-grading strategies and adopt different levels of technology in the same industry of the host country.

Rashmi Banga 151

Appendix Table 7A.1 Average share of technology upgrading strategies and technology acquisition index in Japanese and US firms Japanese firms

RD IMPCAP IMPRAW IMPSPS ROY TECHFEE TECH No. of firms

US firms

Mean

Std dev.

Mean

Std dev.

0.003 0.030 0.063 0.031 0.002 0.006 0.653 34

0.014 0.052 0.080 0.110 0.003 0.022 0.812

0.024 0.019 0.070 0.013 0.003 0.004 0.458 36

0.024 0.204 0.081 0.030 0.007 0.012 0.619

Table 7A.2 Factor score coefficient matrix: extraction method, principal component analysis Component RD IMPCAP IMPRAW IMPSPS ROY TECHFEE

0.242 0.257 0.43 0.435 0.327 0.446

Table 7A.3 Correlation matrix TECH

SIZE

JEQ

TECH 1.00 0.07 0.09 SIZE 0.07 1.00 0.09 JEQ 0.09 0.09 1.00 USEQ 0.007 0.02 0.08 CONTROL 0.08 0.08 0.58 GP 0.02 0.003 0.01 EXPINT 0.13 0.05 0.004 ADVT 0.002 0.03 0.05

USEQ

CONTROL

GP

0.007 0.02 0.08 1.00 0.65 0.02 0.02 0.01

0.08 0.08 0.58 0.65 1.00 0.02 0.02 0.03

0.02 0.003 0.01 0.02 0.02 1.00 0.03 0.02

EXPINT ADVT 0.13 0.002 0.05 0.03 0.004 0.05 0.02 0.01 0.02 0.03 0.03 0.02 1.00 0.07 0.07 1.00

152 India: Technology Upgrading and Adoption in Japanese and US Firms

References Balassa, B. and Marcus, N., ‘The Changing Comparative Advantage of Japan and the United States’, Chapter 3 in H.W. Singer, N. Hatti and R. Tandon (eds), North-South Trades in Manufactures (New Delhi: Indus Publishing, 1990). Buckley, P.J. and Casson, M., The Future of the Multinational Enterprise, London: Macmillan, 1976. Caves, R.E., Multinational Enterprise and Economic Analysis, Cambridge: Cambridge University Press, 1996. Dunning, J.H., ‘The Determinants of International Production’, Oxford Economic Papers, 25, 1973, 289–336. ———— ‘The Governance of Japanese and US Manufacturing Affiliates in the UK: Some Country-Specific Differences’, in B. Kogut (ed.), Country Competitiveness, Oxford: Oxford University Press, 1994. Kojima, K., Direct Foreign Investment: A Japanese Model of Multinational Business Operations, London: Croom Helm, 1978. ———— ‘Japanese-Style Direct Foreign Investment’, Japanese Economic Studies, 14(3), 1986, 52–82. ———— ‘Japanese and American Direct Investment in Asia: A Comparative Analysis’, in H.W. Singer, N. Hatti and R. Tandon (ed.), Foreign Direct Investments. New Delhi: Indus Publishing Company, 1991. Ravenhill, J., ‘Japanese and US Subsidiaries in East Asia: Host Economy Effects’, in D.J. Encarnation (ed.), Japanese Multinationals in Asia: Regional Operations in Comparative Perspective, New York: Oxford University Press, 1999. Schroath, F.W., Hu, M.Y. and Chen, H., ‘Country-of-Origin Effects of Foreign Investments in the People’s Republic of China’, Journal of International Business Studies, 1993, 277–90. Teece, D.J., ‘The Market for Know-How and the Efficient International Transfer of Technology’, Annals of the American Academy of Political and Social Science, 458, 1981, 81–96. ———— ‘Technological Change and the Nature of the Firm’, in G. Dosi, C. Freeman, R. Nelson, G. Silverberg and L. Soete, (eds), Technical Change and Economic Theory, London: Pinter, 1988, 81–96. ———— ‘Technology, Organisation and Competitiveness: Perspectives on Industrial and Corporate Change’, in G. Dosi, D.J. Teece and J. Chytry (eds), Oxford: Oxford University Press, 1998. Wang and Blomström, M. ‘Foreign Investment and Technology Transfer: A Simple Model’, European Economic Review, 36, 1992, 137–55. Womack, J.P., Jones, D.T. and Roos, D., The Machine That Changed the World: The Story of Lean Production–How Japan’s Secret Weapon in the Global Auto Wars Will Revolutionize Western Industry, New York: HarperCollins, 1991.

8 Digitalization and Foreign Direct Investment: An Indian Case Study Madhu Bala

1

Background: the digital divide and FDI

The United Nations Millennium Summit in 2000 adopted eight development goals (MDGs) to help the people of the developing world overcome the problems of poverty, unemployment and illiteracy. The strategies to achieve the set goals, however, although not decided, recognized the potential contributions of information and communication technology (ICT) and emphasized the need to harness them to the advantage of the poor. In 1984, the Maitland Commission, in its report, The Missing Link, referred to the lack of telephone infrastructure in developing countries as a barrier to economic growth. The information technology (IT) revolution in the 1990s led to a renewed debate on the role of ICT in development. One school of thought propounded the unprecedented capacity of ICT to help developing countries ‘leapfrog’ the earlier stages of development but also warned that the inability of these countries to get connected would further widen the gap between the developed and developing countries (UNDP 2001). The other view asserted that the benefits of having and using a computer were secondary to a reasonable amount of health and a minimum level of education (Bernant 2001). In fact, the view was that the latter combined with the lack of required infrastructure hampered the tapping of ICT potentials to their favour in developing countries. ICT began to influence the lives of people in developing countries much earlier than the advent of the Internet in these countries. In 1990, the computer industry accounted for more than 74,000 jobs and US$ 4 billion in revenue in Brazil. In 1988, India launched a set of policies to foster a software development industry whose exports had grown to US$ 5.7 billion by 1999–2000 (Steinberg 2003). However, it was not until the mid-1990s that the growth of the Internet led to a new debate on the shifting perspectives and paradigms of development and the emerging interest in issues such as the ‘digital divide’ or the uneven distribution of ICTs between developed and developing countries. Despite the difference of opinion on whether it has 153

154 India: Digitalization and FDI

increased or decreased, a number of studies have referred to the issue of the ‘digital divide’ as a major problem, particularly when people in the developing world are still coping with a lack of basic amenities such as sanitation, illiteracy, unemployment and ill health and trying to surmount foreign debts (World Bank 2001). The basic argument, however, is that by judiciously incorporating the technologies that may provide solutions to such obstacles, the gap between the technology ‘haves’ and ‘have-nots’ may be overcome. The ‘digital divide’ cannot be looked at in isolation. It is in fact rooted in the discussion concerning the perspectives of economic development, technology transfer and sustainable development. Despite shifts in the development perspectives from the ‘modernization paradigm’ of the 1940s and 1950s to the ‘dependency syndrome’ of the mid-1960s and then to the ‘information paradigm’ of the 1990s, the basic issue has remained the same can development of the developed countries trigger the underdevelopment of developing countries? The World Telecommunication Development Report 2002, while defining the present-day digital world as ‘Private, competitive, mobile and global’ acknowledged the existence of a ‘digital divide’1. Despite mixed trends, in 1991, the total telephone penetration (fixed plus mobile) stood at 49.1 per 100 for the developed world, 3.3 for emerging economies such as eastern Europe and China and only 0.3 in the least developed countries. Compared to this in 2001, the corresponding figures were 12.1, 18.7 and 1.1, respectively. If the figures are any guide, they reveal a narrowing of the gap between the developed and the emerging nations from 15.1 to 6.1 and the widening of that between the emerging and the least developed nations from 12.1 to 17.1. Despite some ‘stars’ such as China, which has emerged as the second largest Internet-using country in the world, the ‘Internet gaps’ remain significant. The developed countries that comprise 16 per cent of the world’s population command 90 per cent of Internet hosts. One in every two Americans is online, as compared to one in every 250 Africans, for example (Steinberg 2003). By attracting attention from various quarters the ‘digital divide’ has moved to the centre of a fundamental debate about of the role of the divide in the development of developing countries. Foreign direct investment (FDI) is one among many instruments that have been suggested to tackle this problem. Various factors have traditionally influenced the inflow of FDI to developing countries – savings and investments (classical models), technical progress (neoclassical models) and R&D, human capital, accumulation and externalities (new growth theories). Digitalization (or ICT) is considered as the main new determinant of FDI (Addison and Heshmati 2002). The Regional Round Table (2002) in its report on Information Technology and Development pointed out that, for the developing world, a modern telecoms infrastructure is not only essential for domestic economic growth

Madhu Bala 155

but also a prerequisite for participation in increasingly competitive world markets and for attracting new investments. In the advanced industrial countries of Europe and North America, universal telecoms services have penetrated every sector of society. As mentioned earlier, in many developing countries, on the other hand, limited availability of ICT services is constraining economic growth. Economic development policies in the industrial countries increasingly include telecoms as an essential component of economic infrastructure, initiated by industry’s demand for advanced telecoms equipment for competitive reasons. Developing countries have begun to acknowledge that inadequate telecommunications infrastructure will be a disincentive to new investment and therefore place existing industry at a competitive disadvantage. A wide range of studies indicates that expanded telecoms investment is essential, not only for growth but also to remain competitive within the increasingly information oriented global economy (Addison and Heshmati 2003). ICT infrastructure and skills are critical in integrating local producers into international ‘B2B’ networks, and in attracting FDI in services as well as manufacturing. Routine tasks such as customer support and data processing in financial services, as well as higher value added tasks such as design and product development, together with software development, are examples. MNCs providing business services and consultation are now large investors in India where they can draw on local ICT skills to develop business solutions for international clients. ICT capacity also influences FDI to produce manufactures and services for sale in the host country market, particularly in large markets such as Brazil, China and India. South Korean companies producing locally for the Indian consumer goods market are heavy users of local ICT skills that have national capacities to adapt ICTs to local needs (languages, preferences and regulations, see Addison and Heshmati 2003).

2

The ‘digital divide’ and ICTs in India

A number of research studies have pointed out the extent and seriousness of the ‘digital divide’ in India. Hanna (1994) made a comparative study of the developed, countries NIEs and developing countries. The study found that in India access to computers and telephones was far below the world average and well behind other NIEs such as Brazil and Taiwan. The reasons quoted were mainly lack of public infrastructure and a national policy framework (Hanna 1994: 14–15). A country report released by the World Economic Forum’s Steering Committee on Education (2002) stated that while no country has benefited more than India from the IT revolution, no country has a wider ‘digital divide’. India is emerging as a laboratory for testing new technologies and business models that may narrow the ‘digital divide’ between urban and rural people in a developing economy on the one hand and also between developed and developing nations on the other.

156 India: Digitalization and FDI

Efforts have been made by international- and national-level public and private sector organizations. Some of the private sector initiatives have been from Intel, Hp Labs, Te Net and NIIT. The focus of most of these projects has been on building sustainable business models for village entrepreneurs. Although subsidies and grants give these pilot projects the necessary seedcorn funding, the long-term objective is to evolve self-sustaining business models for rural access to IT. There is clearly a great deal of intent on all fronts about taking IT and ICT to rural India, and the villagers are also receptive.2

3

Growth of the ICT industry in India

The ICT industry in India witnessed explosive growth over the 1990s. According to the International Data Corporation (IDC) and the National Association of Software and Service Companies (NASSCOM), the share of IT industry in Indian GDP rose from 0.59 per cent in 1994-5 to 2.87 per cent in 2001–2. Compounded annual growth rates since 1990 were over 50 per cent – almost twice the growth rate experienced in the US software sector during the same period. However in 2001 (similar to trends worldwide), the Indian IT industry witnessed a lower growth rate of 32 per cent. IDC expects the market to firm up and the industry to grow at a compound annual growth rate of 30 per cent by 2006 (IDC 2002). The global and financial community is showing considerable interest in the Indian software and service sector, particularly to bridge the ‘digital divide’, and sustaining the growth of the software industry is at the forefront of the government’s agenda. Computer hardware, software and peripherals, networking and training sectors are expanded at a phenomenal rate in the 1990s. However, despite growth in the number of installed computers in 2000, there were only 5 computers per 1,000 persons (Singhal and Rogers 2001). As with international trends, the adoption of computers and the Internet in India in the 1990s affected both the economy and society, creating a new class division of ‘information haves’ and ‘information have-nots’. As compared to other mass media like radio, television, films, computers and the Internet have increased inequalities and have led to an ‘information gap’. While creating a new job market and a hope for increasing productivity with India’s competitive advantage, digitalization has led to deskilling and unemployment in the traditional sectors of the economy (Singhal and Rogers 2001). The Indian computer software industry has been built predominantly on an export-driven model and despite its 1 per cent share in the world export market India has emerged as an important player in the global IT industry. According to the World Bank, India’s share in the global cross-country customized software development market grew from 11.9 per cent in 1991 to 19.5 per cent in 2000. IT penetration in Indian commercial establishments and government, however, is well below international standards.

Madhu Bala 157

India is now acknowledged as an important base for offshore IT services, with more than one-third of the Fortune 500 companies outsourcing their software requirements to India. According to the 2003 NASSCOM survey, there was a structural shift in the delivery model of the Indian IT industry in the 1990s. In 1991–2, offshore services accounted for 5 per cent and onsite services for 95 per cent of total exports. During 2001–2, offshore services contributed more than 49 per cent of total exports. The main destinations of Indian software exports in 2001–2 were the Americas (63 per cent) followed by Europe (26 per cent) and Japan (4 per cent). This trend is similar to the direction of India’s exports in other commodities (Bala 2002). Unlike the IT exports market, which is completely software- and service segment-driven, the Indian domestic IT market has a strong hardware component, including peripherals, networking and hardware services. According to the data provided by the International Data Corporation (IDC) India Ltd, the domestic IT market grew by 30 per cent per annum in 1999–2000. Hardware had the major share (56 per cent), followed by IT services (24 per cent) and packaged software (10 per cent). Domestic IT spending slowed down substantially and recorded growth rates of 10 per cent per annum. The 2003 NASSCOM report showed that IT has created 92,000 new jobs and 2,50,000 indirect jobs in 2001–2 and continued to rank among the fastestgrowing sectors in the economy. India, with its competitive advantages of the largest pool of English-speaking low-cost scientific and engineering manpower (Hanna 1994) has an inherent competitive advantage in terms of software exports, and high growth rates provide the country with a strategic opportunity in the world market. Many global companies already source ITenabled services from India.3 Despite this India’s share in the world software market is still comparatively low. According to Patibandla and Peterson (2002), ‘the export competitiveness achieved in India, however, is without a domestic market base and [has] inefficient input industries and infrastructure’. The current challenges faced by the Indian ICT industry are a deterrent to its growth, including the lack of an adequate ICT infrastructure that includes an unreliable power supply and high bandwidth costs. Despite wide diffusion of the Internet worldwide during the 1990s, India had only 15 million Internet users in 2000, as against 300 million users globally (Singhal and Rogers 2001). Projected figures for Internet users in India were, however, 50 million by 31 December 2003 (NASSCOM 2003). With low PC dispersion and even lower Internet diffusion, domestic opportunities for web-based applications and e-commerce have not yet matured; computer dispersion is mostly restricted to English-speaking cities. There are efforts to develop applications and peripherals in local languages, but they are haphazard and small-scale. Internet Service Providers (ISPs) form the backbone for providing Internetrelated services. While their core services comprise providing connectivity and access to end-users, the market is rapidly growing for other value added

158 India: Digitalization and FDI

services such as web site hosting and virtual private networks (VPN). Videsh Sanchar Nigam Ltd (VSNL) is the dominant service provider and achieved a strong customer base of approximately 200,000 by December 1998. Apart from VSNL, which is the largest ISP, Mahanagar Telephone Nigam Ltd (MTNL), Satyam Infoway, Mantra Online, Wipro Net and Dishnet are the major ISPs in India, and policy since 1998 has encouraged many foreign companies to make alliances with domestic firms.

4

ICT policies in India

Recognising the importance of digitalization or ICT and its importance for the country as a whole, the government of India merged the Ministry of Research and Development in Electronics and the Ministry of Information and Technology into the Ministry of Communication and Information Technology and adopted new policies on telecoms and IT. The government adopted a forward-looking National Telecommunication Policy (NTP) in 1994, followed by a revised version in 1999. The government also adopted IT policies on software and hardware and a National Action Plan on IT in 1998. Since economic reform after 1991 aimed to improve India’s competitiveness in global market, attract FDI and stimulate domestic investment, the NTP’s main objectives included availability of telephones on demand, providing universal services (covering the maximum number of villages); providing world-class telecoms services on demand at reasonable prices; ensuring that India was a major exporter of telecoms equipment and protecting defence and security interests. Indian telephone density was 0.8 per 100 persons, much lower than the world (10 per 100) and other Asian developing countries such as China (1.7), Pakistan (2), Malaysia (13). So the NTP targets were revised to provide telephone availability on demand and universal services by 1997. Realising that there would be a ‘resource crunch’ for achieving such targets, and investment from the private sector was sought. Value added services such as electronic mail, voice mail, radio paging and cellular mobile telephones were opened to private sector investment. For some of the value added services the companies registered in India were permitted to operate but a system of tendering and granting licences was followed for radio paging and cellular mobile telephone services. The NTP had both technological and strategic aspects. It stated that: ‘Telecommunication is a vital infrastructure. It is also technology intensive. It is therefore necessary that the administration of the policy in the telecom sector is such that the inflow of technology is made easy and India does not lag behind in getting the full advantage of the emerging new technologies’. From a strategic point of view, it envisaged encouraging indigenous technology and setting up a suitable funding mechanism so that technology cannot only meet national demand but also compete globally. If India was to

Madhu Bala 159

become an IT superpower, a renewed telecom policy was necessary. Realising that the targets of the NTP remained unfulfilled, the government announced a new NTP in 1999. The new policy had the objectives of making telecoms not only affordable and effective for citizens and also reaching remote, hilly and tribal areas. NTP 1999 set targets of making telephone on demand available by 2002 and thereafter sustaining tele-density of 7 by 2005 and 15 by 2010. It had also set targets of achieving telecoms coverage of all villages in the country, providing Internet access to all district headquarters by 2000 and providing high-speed data and multimedia capacity using technologies including an Integrated Service Digital Network (ISDN) to towns with a population of more than 2 million by 2002. The new policy framework was expected to focus on creating an environment that attracted continuous investment in cellular mobile and other such satellite service providers. The Telecom Regulatory Authority, formed in 1997, was entrusted with the task of providing an effective regulatory framework and adequate safeguards to ensure competition and protection of consumers’ interest. The policy emphasised the standardisation of equipment and services, development of human resources (HR) and their training, R&D in telecoms and remote area telephony. In May 1998, the Prime Minister formed a national Task Force on IT and software development to formulate a long-term national IT policy and remove impediments to the growth of the IT industry. The Task Force submitted three key reports (on Software, Hardware and Long-Term National IT Policy) suggesting various measures to build India’s InfoTech Industry and increase the use of IT. While the Report on the Software industry included provision for local, educational and value added network services the report on the Hardware industry called for an integrated approach for the development of the industry, including minimising uncertainty with respect to duty regimes to encourage investment, discouraging the growth of a ‘grey market’, facilitating a competitive climate for investment and production and formulating rules related to customs, foreign exchange regulations, labour laws, banking facilities and support infrastructure. In order to create such a well-knit and integrated policy package, the Soft Bonded IT Unit (S-Bit)4 scheme was evolved. It treated hardware and software as two sides of the same coin, reversing the policies leading to steady decline of the IT hardware industry and making it internationally competitive. The scheme was intended to create an atmosphere comparable to Taiwan, the Philippines, Singapore, Korea and Malaysia in order to get maximum competitive advantage from a low-cost high-quality knowledge workforce and fast-growing internal market. The scheme proposed phasing out physical controls and meeting the demands of a zero duty regime under WTO-ITA by 2003 to achieve such targets.

160 India: Digitalization and FDI

The third component of the IT action plan was Long-Term National IT Policy. This emphasized not only IT research, design and development but also IT human resource development, content creation, IT infrastructure, financing of the IT sector and organizational structure. It aimed at a continuous upgrade of the productivity of the software industry and de-regulating the import of software productivity tools. The intention was to give suitable and sustainable opportunities for Indian companies in overseas markets by attracting FDI, establishing a government-funded consortium and emphasising IT-enabled training and education. Under microelectronics, the Long-Term National IT Policy stated that the government would proactively invite major electronic companies to set up mega-fabs in the country by giving them appropriate incentives and infrastructural facilities and would also encourage and subsidise high-tech parks with concessions and benefits. The policy also recommended the commissioning of a ‘Project Sankhya Vahini’, ‘for establishing a very high bandwidth. All India National data network and enrich it with educational, healthcare, and other knowledge oriented multimedia applications for supporting the technological and economic growth of the country.’5 Taking into consideration the fast-blurring boundaries between computers, communications and broadcasting, the policy recommended particular organisational structures for deriving maximum benefits from communications convergence. One such initiative, as we have seen, was the merging of the Ministry of Research and Development in Electronics and the Ministry of Information and Technology into the Ministry of Communication and Information Technology. A National Task Force on Human Resource Development was set up and an IT Act 2000 enacted to provide for legal recognition of transactions through electronic data. In 2001, a Convergence Bill was introduced in Parliament in order to promote, facilitate and develop the carriage and content of communication to create a national infrastructure for an information-based society (Government of India 2001). Indian telecoms and IT policies clearly appreciate that if India is to become an ICT superpower, a strategic approach is required that not only promotes indigenous efforts but also attracts foreign investments to get the latest technology and takes initiatives to bridge the ‘digital divide’. However, the policy does not give due attention to e-commerce aspects that can go a long way in bridging the ‘digital divide’. The Indian telecoms system also continues to be governed by the provisions of Indian Telegraph Act 1885 (ITA 1885) and the Indian Wireless Act 1933. Substantial changes have taken place since then, and the Acts need to be amended accordingly.

5

The model

Some studies have tried to estimate the impact of ICT investment on Indian economic growth. Pahojla (2000) used an augmented neo-classical model to

Madhu Bala 161

study the impact of ICT investment on economic growth. Gholami, Lee and Heshmati (2003) investigated a simultaneous casual relationship between ICT, FDI and economic growth by using Johansen cointegration tests. Addison and Heshmati (2003) used a panel data technique to estimate the casual relationship between FDI, GDP growth, trade openness and ICT for a large sample of countries. However, a fairly straightforward measure to assess the impact of FDI and digitalization on the growth of GDP of a country and the growth of human capital is to use both as dependent variables separately and estimate them in two different models. We therefore first regress standard measures of economic development on measures of human capital and foreign capital along with other variables. We start with an early form of production function: Y  A
L1
If we expand this function to include human capital and a measure of digitalisation, it will look like: Y  f (K,L,HK,D)

(1)

Y, K, L, HK and D refer to GDP, capital, labour, human capital and digitalization, respectively. K can further be split into domestic capital (DK), foreign capital (FK) and foreign capital in the digital sector (FKd). In fact, the model can be extended to cover m types of capital by writing the production function in Cobb–Douglas form (Nonneman and Vanhoudt 1996). The variables used for the model are in the form of proxy variables, percentages and composite indexes. Owing to the lack of consistent data on human development indicators, a proxy variable has been used, which is a composite index encompassing an output indicator (i.e. literacy rates) and an input indicator (i.e. gross enrolment ratios at secondary level). Domestic capital is measured as gross domestic investment as a percentage of GDP, foreign capital as capital imported through FDI as a percentage of GDP and FDI in the digital sector as a percentage of GDP. Digitalization is also a composite index of variables such as radios per 1,000 population, TV sets per 1,000 population, cable subscribers per 1,000 population, PCs per 1,000, Internet hosts per 1,000, fax machines per 1,000 and telephone mainlines per 1,000. Data used to estimate the model is from different sources. Sources include World Development Indicators, Economic Surveys and the Secretariat of Industrial Assistance (SIA) Newsletter of Ministry of Industry. Owing to the non-availability of consistent data, the period chosen for analysis is 1991–2001. It is important to note here that economic growth also results in educational and human capital growth. It has been shown in several research studies that the schooling system is a prerequisite to economic growth.

162 India: Digitalization and FDI

As mentioned earlier, the quality of human capital dictates the capital inflow to a country that adds to economic growth. Index of digitalization similarly reflects the importance of the digital economy in a country’s economic growth. Equation(1), takes human capital as a given that attracts FDI into an economy. However, FDI inflow combined with the index of digitalisation will have spillover effects including human capital accumulation in the host country. This impact on human capital accumulation will be estimated in the following model: HK  f (K,L,D)

(2)

where HK, K, L and D are as in (1). The relevant equations can now be re-written as follows: ln y 
  ln l   ln dk   ln fk   ln fkd   ln hk   ln d

(3)

and ln hk 
  ln l   ln dk   ln fk   ln fkd   ln d

(4)

where , , , ,  and  represent the elasticity of production relative to labour, domestic capital foreign capital and foreign capital in the digital sector, human capital and digitalization. With all these qualifications in the mind, an empirical test on our log linear statistical model was tested, the results of which are: ln y  10.36  0.16 ln l  0.15 ln dk  0.19 ln fk  0.04 ln fkd0.004 ln hk  2.26 ln d (0.96)

(0.25)

(0.30)

(0.68)

(0.41)

(0.02)

(3.02)* (5)

R2  0.98, R-adjusted  0.96, F  45.5 (6, 4 99 per cent), N  11 and figures in the brackets show T-values, where * means significant at the 95 per cent level of significance. The model shows that the variables selected provide most of the explanation for the change in GDP as R2  0.98 and the P-value for the F-statistics indicates the overall significance of the model at the 1 per cent level of insignificance. In normal circumstances, the signs of the coefficients in (5) are insignificant but opposite to the expected positive signs, which may be due to the small number of observations available for comparable and consistent data. Despite this, the model given in (5), is indicative of the fact that index of digitalization is the most important and significant factor in India’s economic growth. Considering the logic given earlier that capital inflow combined with the index of digitalization will have spillover effects including human capital

Madhu Bala 163

accumulation in the host country, the impact on human capital accumulation has been estimated: ln hk26.60  1.59 ln l  0.80 ln dk  0.81 ln fk  0.30 ln fkd 1.60 ln d (1.83)** (1.86)** (1.00) (2.51)* (2.6)* (1.52) (6)

R2  0.78, R-adjusted  0.58, F  3.75 (5,5 90 per cent), N  11, figures in the brackets show T-values, where * means significant at the 95 per cent level of significance and ** means significant at the 90 per cent level of significance. Similar to the model estimated in (5), the model in (6) also shows that the variables selected provide a fair amount of the explanation for the change in human capital (HK) as R2  0.78 and the P-value for the F-statistics indicates the overall significance of the model at the 90 per cent level of significance. The coefficient of digitalization, although negative, is statistically insignificant, implying that it has a positive impact on the growth of human capital. The negative sign may be due to the availability of only a few consistent observations. However, (6) does indicate certain trends compellingly – i.e. the inflow of foreign capital does have spillover effects and contributes significantly to human capital accumulation in India. The coefficient of foreign capital (0.81), despite the limitations of the data, is positive and also statistically significant. In fact regardless of low literacy rates, India has a history of support for technical education and has produced large number of technically qualified people. The country can export engineers and scientists to the USA, some of which have returned to become the backbone of rapid IT growth in India. ‘In 2000, of the total venture capital funding in India, 38 per cent came from firms headed by India-born investors’.6 According to NASSCOM, ‘From a base of 6,800 knowledge workers in 1985–86, the number was estimated to increase to 6,50,000 knowledge workers in 2003’ (NASSCOM 2003). This number is however, very few for a country, where the labour force is counted in hundreds of millions. Hardly any worker is likely to remain untouched – in railway reservations, banking services, health services or postal services – indicating a positive impact of FDI and ICT on human capital. However, in a labour-abundant country such as India, policy makers not only have to prevent the new jobs replacing old ones but also ensure the ‘on-the-job training’ which is an integral part of human capital accumulation.

6

Conclusion

In order fully to harness the benefits of digitalization particularly in the rural areas where a vast market still remains to be tapped, much more effort is required by the state, not only at the policy but also at the implementation level. UNCTAD (2003), based on indexes of connectivity, access and policy calculated from the indicators of IT for developing countries, notes that

164 India: Digitalization and FDI

India lags behind as far as indexes of connectivity and access are concerned, but is going ahead as far as the IT policy index is concerned. The policy analysis of the Indian ICT industry in earlier sections clearly supports this. Connectivity, access and infrastructure are still larger issues that need special attention. India has attracted FDI in the ISP sector to provide better services. The ‘802.11’ wireless LAN technologies have paved the way to handling the traditional bottlenecks of high-cost landline phone tariffs and PC prices, which were hindering PC penetration, especially in the rural areas. The adoption of new technologies in newer areas such as banking, health, telecoms and infrastructure will lead to the spread of these technologies into remote areas, thus helping in bridging the internal as well as international ‘digital divide’. Some initiatives have already been taken in collaboration with the government and the private sector at both national and international level. In 1994, the government, Apple Computers, Inc. and CMC India Ltd came together to start the India Healthcare Project to support village workers in a rural healthcare system. The idea was to bring in efficiency, reduce the paperwork burden and help the provision of timely care and information. The technology used for this purpose (the Newton message pad) was provided by Apple Computers, Inc. The preliminary phase of the project has come to an end, and has left certain lessons to be learned and replicated (Reddy and Graves 2000). The International Mobile Satellite Organization (INMARSAT), in association with the Department of Telecommunications (DoT) and VSNL signed a Memorandum of Understanding (MoU) in 1997 to provide village telephony to the villages in the remotest areas including hilly and desert areas (Gupta 2000). Besides these efforts, a lot more is required if the ‘digital divide’ is to be bridged. Policy initiatives have focused basically on the international, national and urban aspects; the rural dimension, although mentioned at the policy level, has not yet been given due attention, particularly in terms of availability of committed resources. State governments such as Karnataka7, Andhra Pradesh, Maharashtra and Tamil Nadu, have enacted some state-level policies to attract foreign investment and implement local ICT projects, but other states have yet to follow the suit. A report by the Ministry of Information and Technology (2003), based on indicators such as network access, network learning, network society, network policy, e-governance and network economy, pointed out that except for Karnataka, Andhra Pradesh, Maharashtra, Tamil Nadu, Delhi, Gujarat and Chandigarh few union territories were e-prepared. State-level initiatives need urgently to be expedited. While states have a significant role to play in providing infrastructure and policy support, research studies have shown that a timely intervention from the private sector has made a significant contribution to the successful

Madhu Bala 165

diffusion of ICT and human capital development. Private investment needs to be attracted that can help not only in providing upgraded technological assistance but also cater to local needs including translation into local languages. Rural projects that are successfully running in some areas need to be replicated in other parts of the country, so that the domestic along with the international ‘digital divide’ can be narrowed to some extent. The regression model estimated in this chapter shows us that while digitalization can significantly contribute to India’s economic growth, FDI can contribute particularly to the growth of human capital. The trend in the 1990s showed that the top sectors that attracted FDI (in the period under review) were in the telecoms sector and the electronics (including computers) sector. The Economic Survey 2002–03 (Government of India, 2001) reports that the telecoms sector was the major recipient of FDI during August 1991–June 2002. The implication of this analysis is that attracting FDI will contribute not only to economic growth but also help in human capital growth as part of a spillover effect. The chapter suffers from the limitation of a lack of consistent data for an adequate number of years to run a model equation. Future research needs to take these aspect, into account not only at the conceptual and policy level but also at the level of research itself.

Notes 1. According to the Report, at the beginning of 2002 more than half the countries had fully or partially privatised their telecoms operations; an overwhelming majority of countries now allow competition in the mobile and internet market segments; telecoms services are increasingly mobile, delivered by radio waves rather than over a fixed line network and globalization has affected the telecoms sector through (a) global operations, where not a single country is found without strategic foreign investors, (b) regional and multilateral agreements, where governments have chosen market-liberalising moves through treaty-level agreements and (c) new global services, such as mobile cellular and global satellite systems, etc. have emerged to help people get connected while away from each other. 2. http://www.wcld.net/digital.htm. 3. Two key elements of IT-enabled services are outsourcing and outlocation. A third element – web-based services – is also emerging as the Internet energises newer business models and allows companies to centralize services and/or operations at an optimal global location, and to enhance customer reach. India’s strengths as mentioned earlier, are based on the availability of a large pool of English-speaking and computer literate workers at a per capita cost that is attractive when compared with developed countries markets. 4. For a detailed analysis on S-BIT Unit, see Government of India (1998a). 5. Government of India (1998b). 6. www.economictimes.com, 21 February 2001. 7. Karnataka was the first state government in India to enact a state-level policy (1997).

166 India: Digitalization and FDI

References Addison, T. and Heshmati, A., The New Global Determinants of FDI Flows to Developing Countries The Importance of ICT and Democratisation (Helsinki: UNU/WIDER, 2003). Bala, M., ‘India-Australia Trade and Investment Relations in the 1990s’, in D. Gopal, Australia in the Emerging Global Order: Evolving Australia-India Relations, Delhi: Shipra Publications, 2002, 235–48. Bernant, C., ‘Gates Deflates Digital Dividend Moguls’, http://www.techweb.com/ wire/story/TWB20001018S0015, 2001. Bhatnagar, S. and Schware, R., Information and Communication Technology in Development: Cases from India, New Delhi, Sage, 2000. Easterlin, R.A. ‘Why isn’t the Whole World Developed?’, Journal of Economic History, 41(1), 1981, 1–19. Gholami, R., Lee, S.T. and Heshmati, A., The Casual Relationship between Information and Communication Technology and Foreign Direct Investment, Helsinki: UNU/WIDER, 2003. Government of India, National Telecommunication Policy (NTP), 1994. ———— National Telecom Policy, 1994 and 1999, http://www.gipi.org.in/telecom_ p.htm. ———— IT ACTION PLAN: New Policy Paradigm for the IT hardware Industry, 1998a. ———— Economic Survey: 2002–03, New Delhi, 2001. ———— National IT Policy, 1998, http://www.gipi.org.in/telecom_p.htm, 1998b. Gupta, R., INMARSAT Experience in Village Telephony, in S. Bhatnagar and R. Schware, Information and Communication Technology in Development: Cases from India, Delhi, Sage, 141–8. Hanna, N., ‘Exploiting Information Technology for Development: A Case Study of India’, Discussion Paper, 246 Washington, DC, World Bank, 1994. Hufbauer G. and Wada, E., (eds), Unfinished Business: Telecommunication after the Uruguay Round, Washington, DC Institute of International Economics, 1997. IDC, ‘Indian IT Industry to Cross $45B. by 2006’, Report, International Data Corporation, 2002. IDC, ‘Indian IT Industry to Cross $45B. by 2006’, Report, International Data Corporation, 2002. International Telecommunicatons Union (ITU), World Telecommunication Indicators Database, 6th edn, Geneva International Telecommunications Union; last update 16 December 2002, http://www.itu.int/ITU-D/ict/publications/world/world.html. Mankiw, N.G., D. Romer and D.N. Weil, ‘A Contribution to the Empirics of Economic Growth’, Quarterly Journal of Economics, 107, 1992, 407–37. Matambalya F. and S. Wolf, Performance of SMEs in East Africa: Case studies from Kenya and Tanzania. (Bonn: Center for Development Research (ZEF), 2001). Miller, R.R., ‘Leapfrogging? India’s Information Technology Industry and the Internet’, IFC Discussion Paper, 42, Washington, DC, World Bank, 2001. Ministry of Information and Technology, Ministry of Information and Technology, ‘E-Readiness of Indian States,’ Chapters of a Report submitted by NCAER to the Ministry, Government of India, 2003. Ministry of Information and Technology, ‘E-Readiness of Indian States’, Chapters of a Report submitted by NCAER to the Ministry, Government of India, 2003. National Association of Software and Service Companies (NASSCOM), ‘Indian IT Industry: A Success Story’, NASSCOM Fact Sheet, 2003. National Association of Software and Service Companies (NASSCOM), ‘Indian IT Industry: A Success story’, NASSCOM Fact Sheet, 2003.

Madhu Bala 167 NCAER, E-readiness of Indian States, Ministry of Information and Technology, New Delhi, Government of India, 2003, Chapter 2. Nonneman, W. and Vanhoudt, P., ‘A Further Augmentation of the Solow Model and the Empirics of Economic Growth for OECD Countries’, Quarterly Journal of Economics, 110, 1996, 943–53. Pahojla, M. ‘Information Technology and Economic Development: An Introduction to Research Issues’, Working Paper, 153, Helsinki, UNU/WIDER, 1998. Patibandla, M. and Petersen, B., ‘Role of Transnational Corporations in the Evolution of High-Tech Industry: The Case of India’s Software Industry’, World Development, 30(9), 2002, 1561–77. ———— ‘Information Technology and Economic Growth: A Cross Country Analysis’, Working Paper, 173, Helsinki, UNU/WIDER, 2000. Reddy, N.K. and Graves, M., ‘Electronic Support for Rural Health Care Workers’, in S. Bhatnagar and R. Schware, Information and Communication Technology in Development: Cases from India, New Delhi, Sage, 35–49. Regional Round Table, on Information Technology and Development, Report, New Delhi, 21–22 June 2002. Singhal, A. and Rogers, E.M., ‘India’s Communication Revolution: From Bullock Carts to Cyber Marts’, New Delhi, Sage 2001. Steinberg, J., ‘Information Technology and Development Beyond Either/Or’, Brookings Review, 21(2), 2003, 45–8. UNCTAD, World Investment Report: Cross-Border Merges and Acquisitions and Development, Geneva, UNCTAD, 2000. ———— Information and Communication Technology Development Indices, New York, United Nations, 2003. UNDP, Human Development Report, Geneva, UN, 2001. World Bank, Knowledge for Development, World Development Report, Washington, DC, World Bank, 1998–9). ———— World Bank Indicators, Washington, DC, World Bank, 2001. ———— World Economic Forum (WEF), 2002.

9 The Causal Nexus between Foreign Investment and Economic Growth in India K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj

1

Introduction

There is an ongoing debate about the impact of inflow of Foreign Direct Investment (FDI) on economic growth in a closed country. This is mainly due to two diversified views pertaining to the relationship between FDI and economic growth. The main arguments in favour of FDI promoting economic growth are: (1) The superiority of multinational corporations (MNCs) over local firms. Output per worker in MNCs taken as a group is often many times greater than in local owned operation. Wages paid by foreign affiliates are also higher than local owned operations in both developed and developing host countries, within the same industries and the same locations. (2) A shift towards greater use of non-equity and cooperative relationships with other enterprises such as alliances, partnership, management contracts or subcontracting arrangements serve corporate objectives. They can provide better access to technologies or other assets, allowing firms to share the cost and risk of innovatory activities and can reduce the production cost of labour-incentive products. (3) Emergence of a network type of organisation expands the scope of interactions between MNCs and enterprises from host countries which will create international economic integration. (4) MNCs create an integrated international product system through FDI. This will broaden the range of resources sought by MNCs in host countries, making firms more selective in their choices. This can also encourage FDI in countries that cannot provide a wide range of resources but have some specific advantage (accounting, technology, products, etc.).

168

K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj 169

(5) There is a direct relationship between inward FDI in relation to the size and economic development of a country. One of the strongest statements was made by Paul Romer, who suggested that, for a developing country that wishes to gain on the developed countries, or at least keep up with their growth, one of the most important and easily implemented policies is to give foreign firms an incentive to close the idea gap, to let them make a profit from doing so … The government of a poor country can therefore help its residents by creating an economic environment that offers an adequate reward to multinational corporations when they bring ideas from the rest of the world and put them to use with domestic resources. (Romer 1993: 548) Other views concern a negative relation between FDI and economic growth: (1) FDI comes to those sectors in which the domestic firms are themselves contemplating investment and it will act against the investment opportunities of domestic enterprises. If MNCs raise funds through their expansion programmes from the host country, it may harm domestic firms in financial markets owing to their weak competitive power. (2) The decision of MNCs to acquire domestic firms may lead to large inflow of foreign exchange which will create an climate for the appreciation of the host country’s currency. This may in turn make the host country’s exports less competitive and discourage domestic investment for export markets. (3) Fears have been expressed that FDI may asset-strip indigenous enterprises, simply replacing host country enterprises and financing without adding to capital formation or economic growth. This will create a situation of “Branch-plant economy” or plebeian aspect of MNC’s operation (p. 68, Robert E. Lipesy (April 2000) “Inward Foreign Direct Investment and economic growth in developing countries”, Transnational corporations, Vol. 9, No. 1). These arguments make the proposition of foreign direct investment leads to economic growth as weak. Economic growth also leads to FDI since higher levels of economic growth will be attained through efficient use of resources, which reduces the cost per unit of output, and also creates a market for the output produced. This will attract still higher levels of FDI. The phenomenon of economic growth and FDI is thus complex in nature. The causation nexus between the two may occur in four possible ways: (a) (b) (c) (d)

FDI causes economic growth Economic growth causes FDI There is a bi-directional relationship between FDI and economic growth There is an independent relationship between the FDI and economic growth.

170 India: the Nexus between FDI and Economic Growth

These possibilities arise mainly because the processes of growth are themselves interrelated. Capital formation may be effected by FDI inflows because they are a source of finance. FDI flows toward host countries may increase their productivity and exports, and productive growth may affect their exports. Institutional characteristics such as the legal system, enforcement of property rights and the extent of corruption in the host country are also likely to influence economic growth, inward investment and capital formation. The complexity of the FDI–economic growth phenomenon calls for an examination of the earlier literature, which will be immensely useful in identifying any gaps. Studies pertaining to the FDI–economic growth nexus can be classified as: (1) Cross-country studies, which are mainly focused on the role of MNCs and the determinants of FDI (2) Time series studies, which attempt to examine the nature of causal relationship between FDI and economic growth. Some of the important studies pertaining to category (1) are Scaperlanda and Mauer (1969), Dunning (1970), Verno (1971), Root and Ahmed (1978), Cable and Persaud (1987), Graham and Krugman (1989), Dunning (1992), Levine and Renelt (1992), Blomström, Lipsey and Zejan (1994), Chao and Yu (1994), Eaton and Samuel Kortum (1994, 1995), O’Sullivan and Geyikdagi (1994), Rugman (1994), Tsai (1994), Borensztein, de Gregorio and Lee (1995), Coe and Helpman (1995), Lin (1995), Mody and Wang (1997) and Temple (1999). The studies pertaining to category (2) are Lubitz (1966), Frances Van Loo (1977), Karikari (1992), Saltz (1992), Blomström, Lipsey and Zejan (1993), United Nations (1993), Pfaffermayr (1994), Gujarati (1995), Kholdy (1995), De Mello (1996), Kasibhatla and Sawhney (1996), Zapata and Rambaldi (1997), Shah, Tian and Sen (1997) and Lipsey (2000). The main limitations of the cross-countries studies are that they impose a common economic structure and similar production technology across different countries. These studies emphasize that the economic growth of a country is influenced not only by FDI but by factors such as domestic policies on monetary, fiscal and external matters. The simple two-variable relationship studies lead to simultaneous equation bias. The cross-country studies also assume a one-way causality, that FDI inflow leads to GDP growth. The estimated functions are thus open to debate due to the fact that the direction of causality on the basis of theoretical arguments is often mixed. Time series studies use the framework of a Granger-causality test (Granger 1969) that is based mainly on F-test statistics (United Nations 1993). It is now well established in the econometrics literature that F-test statistics are not valid if time series are integrated, as argued by Gujarati (1995) and Zapata and Rambaldi (1997). Most of the studies conduct their analysis on the basis of yearly data series, while economic growth processes may be

K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj 171

influenced in either the short run or the long run. Short-run impacts of the relationship between economic growth and FDI and country-specific studies pertaining to developing countries are limited in the literature. The present chapter investigates the causal nexus between FDI and economic growth with special reference to India. The rest of the chapter is organized as follows. Section 2 presents the methodology of the study. Section 3 presents empirical results and a discussion. Section 4 presents some concluding remarks.

2

Methodology

Simple ratio and percentage methods were employed to examine the trend and pattern of FDI in India. The Granger-causality test (Grangers 1969) was employed to examine the causal nexus between FDI and economic growth. The Granger causality-test states that if Y is not influenced only by the lagged value of Y but also the lagged value of X, then X causes Y. On the other hand, if X is influenced by lagged values of Y in addition to lagged values of X then Y causes X. If X causes Y and Y also causes X then there is a bidirectional relationship between X and Y. Further, if X does not cause Y and Y does not cause X then there is an independent relation between X and Y. A simple F-test can show whether the lagged values of X contribute significantly to the explanatory power of the Y-equation. The five steps involved in conducting a Granger-causality test are: (1) Regress the restricted equation (i.e. Yn 

兺

i1


i Yt  i  t ) and obtain

the residual sum of squares (RSSR) (2) Regress the unrestricted equation (Y 

兺

n i1


i Yt  i 

兺

n i1

i Xt  i  t

) and find out the unrestricted residual sum of squares (RSSU) (3) Test the null hypothesis that H0 : 
i  0 against an alternative hypothesis that H1 : 
i  0 (4) Apply the F-test to test the above hypothesis; it is given by F 

(RSSR  RSSU)/m (RSSU)/(n  k)

which follows the F distribution with m and n  k degrees of freedom. (5) If the computed F-value exceeds the critical F-value at the chosen level of significance, we reject the null hypothesis and accept that X causes Y. Steps (1)–(5) should be repeated by interchanging the X and Y variables in the regression equation to test whether Y causes X.

172 India: the Nexus between FDI and Economic Growth

The Granger-causality test assumes that data series are stationary at the first-order level. A prima facie causal or an independent relation between X and Y should exist under the Granger-causality test. To overcome these above defects, it is essential to verify the stationarity property of the selected time series data. The Dickey–Fuller test (Dickey and Fuller 1979, 1981) is employed to test the stationarity of the given time series data. A time series xt is said to be ‘stationary’ if the joint distribution of X(t1) … X(tn) is the same as the joint distribution of X(t1  ) … X(tn  ) for all t1, t2, … tn, . In other words, shifting the time origin by an amount has no effect on the joint distribution, which must therefore depend only on the intervals between t1, t2, … tn. This definition holds for any value of n. The Dickey–Fuller test is employed to examine the stationarity of the series, which requires the estimation of:  Xt  B Xt  1

n

兺 d X

i1

i

t1

 et

where n is large enough to make et white noise. The null hypothesis that Xt is I(0) is rejected in favour of an alternate hypothesis that Xt is I(i), provided that B is significantly negative. For testing purpose, the t-statistic is taken as the test ‘statistic’ though it does not follow the t-distribution (critical values are provided by Dickey and Fuller (1979, 1981). After confirming the stationarity of the series we can estimate the cointegration regression equation and error correction model.1 The necessary information was collected from various issues of The Handbook of the Indian Economy, the Reserve Bank of India bulletin, the World Investment Report and the Centre for Monitoring the Indian Economy for 1990–2002. The database is on a quarterly basis. Economic growth is quantified in terms of the industrial productivity index, because the national income database was not available on a quarterly basis. The major portion of FDI is channelled through the industrial sector of Indian economy.

3

Empirical results and discussions

This section examines the causal nexus between FDI and economic growth for 1990: I–2002-IV. Simple ratios, the percentage method, the Grangercausality test and the Dickey–Fuller test were employed. Table 9.1 shows the trend of FDI flows in developing countries during 1989–2001. FDI in the developing countries as a whole has risen nearly four times ($59.6 billion in 1989, $225 billion in 2001). The share of India’s FDI in developing countries is very meagre, ranging between 0.7 per cent and 1.9 per cent during the study period. The share of China and Brazil are prominent among the developing countries.

K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj 173 Table 9.1 Trends of FDI flows, selected host regions, 1989–2001 (%) Host region/ Economy

Indicators

1989–94 (ann. avg.)

1995

1996

1997

1998

1999

2000

2001

Developing countries (billion) Argentina Brazil China Indonesia India Malaysia South Korea Singapore Thailand Taiwan

in Billion

59.6

113.3

152.5

187.4

188.4

222.0

240.2

225.0

percentage percentage percentage percentage percentage percentage percentage percentage percentage percentage

4.5 2.5 23.5 2.5 0.7 6.2 1.5 8.1 3.2 2.0

4.9 4.9 31.6 3.8 1.9 5.1 1.6 7.8 1.8 1.4

4.5 6.9 26.4 4.1 1.7 4.8 1.5 6.8 1.5 1.2

4.9 10.0 23.6 2.5 1.9 3.5 1.5 6.9 1.9 1.2

3.9 15.1 23.2 0.2 1.4 1.4 2.9 3.3 2.7 0.1

10.9 14.1 18.2 1.2 1.0 1.6 4.8 3.2 1.6 1.3

4.7 13.9 17.0 1.9 1.0 2.3 4.2 2.7 1.0 2.0

 8.9 20.8  1.7     

Sources: World Investment Report 2001; UNCTAD Press Release (21 January 2002).

Table 9.2 presents the trend and pattern of FDI in terms of various categories in India for 1990–1 to 2002–3. India’s total FDI is $97 million in 1990–1 and went up to $4765 million in 2002–3. There are four categories of FDI: (1) Government approvals (SIA/FIPB), (2) RBI automatic approvals, (3) NRI investment, (4) Acquisition of share (see Table 9.2). The SIA/FIPB route implies that it is not necessary to get approval from the Reserve Bank of India for the inflow of FDI if it is more than 51 per cent of its holding. Instead permission has to be sought from the Secretariat for Industrial Approvals (SIA), or the Foreign Investment Promotion Board (FIPB) by the Reserve Bank of India (RBI) route. Table 9.2 shows that largest share of FDI in India came through the SIA/FIPB route ($66 million in 1991–2, $2473 million in 2002–3), which is more than 50 per cent of FDI during the study period. FDI coming through the RBI by the automatic route refers to investments in an industry that belong to one of thirty-five priority industries. FDI through this route shows a hike from $42 million in 1992–3 to $1,056 million in 2002–3. Its share ranged from 5.6 per cent to 22.2 per cent during the study period. Investment made by Non-resident Indians (NRI) has been a major source of external finance in India. The different avenues available to NRI are (1) Foreign currency non-resident banks (FCNR (B)), (2) the Non-resident (external) rupee account (NR (NR) RD) scheme, (3) Non-resident (nonrepatriable) rupee deposits (BR (NR)). The objective of scheme (2) is to retain the attractiveness of financial flows from NRI, but at the same time reduce any volatile elements and minimise the effective costs to the country. This category of investment increased from $63 million in 1991–2 to

174

Table 9.2 Trends and pattern of FDI, by category, 1990–2002 Direct 1990–1 1991–2 1992–3 1993–4 1994–5 1995–6 1996–7 1997–8 1998–9 1999–2000 2000–1 investment by category SIA/FIPB RBI NRI Acquisition of shares Total

2001–2

2002–3

0 (0) 0 (0) 0 (0) 0 (0)

66 (51.2) 0 (0) 63 (48.8) 0 (0)

222 (70.5) 42 (13.3) 51 (16.2) 0 (0)

280 (47.8) 89 (15.2) 217 (37) 0 (0)

701 (53.4) 171 (13) 442 (33.6) 0 (0)

1249 (58.3) 169 (7.8) 715 (33.4) 11 (0.5)

1922 (68.2) 135 (4.8) 639 (22.6) 125 (4.4)

2754 (77.4) 202 (5.6) 241 (6.8) 360 (10.2)

1821 (74) 179 (7.3) 62 (2.5) 400 (16.3)

1410 (65.7) 171 (8) 84 (3.9) 490 (22.4)

1456 (62.3) 454 (19.4) 67 (2.8) 362 (15.5)

2221 (56.9) 767 (19.6) 35 (0.9) 881 (22.6)

2473 (51.9) 1056 (22.2) 0 (0) 1236 (22.9)

97 (100)

129 (100)

315 (100)

586 (100)

1314 (100)

2144 (100)

2821 (100)

3557 (100)

2462 (100)

2155 (100)

2339 (100)

3904 (100)

4765 (100)

Note: For the definition of SIA, FIPB, RBI and NRI, see the text discussion. Source: Reserve Bank of India Bulletin (various issues) (figures within parenthesis indicates percentage of the total).

K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj 175

$715 million in 1995–6 but later gradually declined. FDI through the acquisition of shares showed an increasing trend in recent years ($11 million in 1995–6, $1236 million in 2002–3). This analysis reveals an absolute increase in the various categories of FDI except NRI. The absolute level of increase of FDI may not say much about the strength of FDI in fostering higher levels of economic growth, however, which calls for an analysis of the trend of real indicators of FDI. This can be examined in terms of FDI as a percentage of Gross Domestic Product (GDP) and exports. This result is presented in Table 9.3. It reveals that FDI as a percentage of GDP slowly increased during 1990–1 to 1996–7 and later slowly declined. In 2002, it was only 0.9 per cent of GDP. FDI as a percentage of exports showed a similar trend (0.6 per cent in 1990–1, 18 per cent in 1996–7, 13.4 per cent in 2001–2). The sudden decline of FDI in terms of GDP and exports in 1998–9 was mainly due to the Asian Economic Crisis. This analysis clearly reveals that the role of FDI in deciding economic growth in India has been very weak. Table 9.4 shows the results of the Granger-causality test between FDI and the Index of industrial production. The test was run up to lag 3,3. The computed F-value is insignificant throughout the experiment, so it can be concluded that FDI and the Index of industrial production are independent. The Granger-causality test results assume that the data series is stationary at the first-order level and fails to detect a prima facia causal relationship between the two series. This finding may be due to the assumption put Table 9.3 Trends of FDI flows and balance of payment indicators, 1990–1 to 2001–2 Year 1990–1 1991–2 1992–3 1993–4 1994–5 1995–6 1996–7 1997–8 1998–9 1999–2000 2000–1 2001–2

FI/GDP 0.0 0.1 0.2 1.5 1.5 1.4 1.6 1.3 0.6 1.1 1.1 0.9

FI/Exports 0.6 0.8 3.1 18.7 17.9 15.0 18.0 15.1 7.0 13.8 11.4 13.4

Note: FI  Foreign Investment. Source: Handbook of the Indian Economy, Centre for Monitoring the Indian Economy, Reserve Bank of India (2001).

176 India: the Nexus between FDI and Economic Growth

forward in the test statistics. To overcome this, we attempted to examine the issue with the help of cointegration analysis. Cointegration analysis requires that the stationarity of both the series are in an identical order. We conducted a Dicky–Fuller test; its results are presented in Table 9.5. In respect of the FDI equation, the B-coefficient is not negative and statistically significant at zero at the first-order level. We therefore accept the hypothesis that the FDI series is not integrated. The B-coefficient is negative and statistically significant in the case of the Index of industrial production equation at the first-order level. This confirms the stationarity of the Index of industrial production index series at the first-order level. However, the cointegration regression equation requires integration of both the series in an identical order. Since this condition is not satisfied in the case of the Index of industrial production index and FDI series, existence of cointegration Table 9.4 The Granger-causality test results: FDI and Index of industrial Production Lags

FDI → IIP F-value

IIP → FDI F-value

Inference

1,1 2,2 3,3

1.0089 0.5942 2.6732

0.451 0.197 0.522

Independent Independent Independent

Table 9.5 Dickey–Fuller test results Regression eq.

Order

FDIt  f(FDIt1)

0

FDIt  f(FDIt1,T )

0

 FDIt  f(FDIt1)

1

 FDIt  f(FDIt1,T) 1 IIPt  f(IIPt1)

0

IIPt  f(IIPt1,T)

0

 IIPt  f(IIPt1)

1

 IIPt  f(IIPt1,T )

1

Constant 0.386 (2.27)** 0.408 (2.18)** 0.033 (0.75) 0.169 (0.08) 3.05 (8.54)* 3.165 (9.62)* 0.0029 (0.059) 0.0076 (0.07)

FDIt1

IIPt1

0.887 – (16.94)* 0.87 – (10.88)* 0.128 – (0.89) 0.17 – (1.185) – 0.183 (1.33) – 0.30 (2.30)** – 0.46 (3.75)* – 0.462 (3.71)*

Trend

Adj.R2

–

0.85

286.9*

0.001 (0.3) –

0.85

140.8*

0.05 (1.623) – 0.0073 (3.22)* – 0.0002 (0.05)

F

0.004

0.798

0.07

1.73

0.015

1.77

0.17

6.23*

0.211

14.07*

0.194

6.89*

Notes: Figures in parenthesis are the t-value. *  Significant at the 1 per cent level; **  significant at the 5 per cent level.

K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj 177

between the two is completely ruled out. The present result thus also confirms an independent relationship between the two, which is also revealed from the Granger-causality test. The five possible reasons for an independent relationship between FDI and economic growth in India are: (a) In India, foreign investment is only 0.9 per cent of GDP and its high transaction cost in the form of corruption and unnecessary regulatory requirements fails to attract FDI (b) The lack of full integration of capital and financial markets (c) The lack of a highly educated workforce, which limits the benefits from FDI technological spillovers (d) Insufficient protection of physical and intellectual property rights (IPR) (e) Higher levels of economic growth may not attract foreign investment due to the lack of stability of the Indian rupee in international markets. This result calls for the following policy options to enhance economic growth through FDI: (1) There is a need for further liberalisation of FDI and emphasis should be given to outward oriented trade policies (2) There is a need to strengthen regional economic integration in organizations such as ASEAN and NAFTA (3) There is a need to maintain the stability of the Indian rupee in terms of foreign currency.

4

Concluding remarks

The Granger-causality test was employed to examine the causal nexus between FDI and economic growth in India. The Dickey–Fuller test was also employed to examine the stationarity of the series. The data series are on a quarterly basis and collected from various issues of the Reserve Bank of India Bulletin, The Handbook of the Indian Economy, the World Investment Report and the Centre for Monitoring the Indian Economy for 1990–2002. The analysis revealed an independent relationship between foreign investment and economic growth in India. The possible reasons are: (1) foreign investment is only 0.9 per cent of GDP and its high transaction costs in the form of corruption and unnecessary regulatory requirements fail to attract FDI (2) The lack of full integration of capital and financial markets (3) The lack of a highly educated workforce, which limits the benefits from FDI technological spillovers (4) The insufficient protection of physical and intellectual property rights (5) The high levels of economic growth which may not attract FDI due to the lack of stability of the Indian rupee in international markets.

178 India: the Nexus between FDI and Economic Growth

The present result calls for three policy options to enhance economic growth: FDI (1) A need for further liberalisation of FDI and emphasis on outward oriented trade policies (2) strengthening regional economic integration in organizations such as ASEAN and NAFTA (3) The maintenance of stability of the Indian rupee in terms of foreign currency. Note 1. The explanation of these models are not presented due to the fact that FDI and the index of industrial production as a proxy for economic growth are not integrated in the same order.

References Blomström, M., Lipsey, R.E. and Zejan, M., ‘Is Fixed Investment the Key to Economic Growth?’, NBER Working Paper, 4436, Cambridge, MA, National Bureau of Economic Research, 1993. ———— ‘What Explains the Growth of Developing Countries?’, in W.J. Baumol, R.R. Nelson and E.N. Wolff (eds), Convergence of Productivity: Cross-National Studies, and Historical Evidence, New York, Oxford University Press, 1994, 243–59. Borensztein, E., de Gregorio, J. and Lee, J.-W., ‘How Does Foreign Direct Investment Affect Economic Growth?’, NBER Working Paper, 5057, Cambridge, MA, National Bureau of Economic Research, 1995. Cable, V. and Persaud, B., ‘New Trends and Policy Problems in Foreign Investment: The Experience of Commonwealth Countries’, in V. Cable and B. Persaud (eds), Developing with Foreign Investment, London, Croom Helm, 1987. Chao, C.-C. and Yu, E.S.H., ‘Foreign Capital Inflows and Welfare in an Economy with Imperfect Competition’, Journal of Development Economics, 4, 1994, 141–54. Coe, D.T. and Helpman, E., ‘International R&D Spillovers’, European Economic Review, 39(5), 1995, 859–87. De Mello, L.R., ‘Foreign Direct Investment-Led Growth: Evidence from Time Series and Panal Data’, Department of Economics, University of Kent at Cantebury, 1996. Dickey, D.A. and Fuller, W.A., ‘Distribution of the Estimators for Autoregressive Time Series with Unit Root’, Journal of the American Statistical Association, 74, 1979, 427–31. ———— ‘Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root’, Econometrica, 49, 1981, 1057–72. Dunning, J.H., Studies in Direct Investment, London, Allen & Unwin, 1970. ———— Multinational Enterprises and the Global Economy, Wokingham, Addison-Wesley, 1992. Eaton, J. and Kortum, S., ‘International Patenting and Technology Diffusion’, NBER Working Paper, 4931, Cambridge, MA, National Bureau of Economic Research, 1994. ———— ‘Engines of Growth: Domestic and Foreign Sources of Innovation’, NBER Working Paper, 5207, Cambridge, MA, National Bureau of Economic Research, 1995. Graham, E.M. and Krugman, P.R., Foreign Direct Investment in the United States, Washington, DC, Institute for International Economics, 1989.

K. Sham Bhat, C.U. Tripura Sundari and K. Durai Raj 179 Granger, C.W.J., ‘Investigating Causal Relations by Econometric Models and CrossSpectral Methods’, Econometrica, 37, 1969, 424–38. Gujarati, D., Basic Econometrics. 3rd edn, New York, McGraw-Hill, 1995. Karikari, J.A., ‘Causality between Foreign Direct Investment and Economic Output in Ghana’, Journal of Economic Development, 17, 1992, 7–17. Kasibhatla, K. and Sawhney, B., ‘Foreign Direct Investment and Economic Growth in the US: Evidence from Co-Integration and Granger Causality Tests’, Rivista Internazionale di Scienze Economiche e Comerciali, 43(2), 1996, 411–20. Kholdy, S., ‘Causality between Foreign Investment and Spillover Efficiency’, Applied Economics, 27, 1995, 749–74. Levine, R. and Renelt, D., ‘A Sensitivity Analysis of Cross-Country Growth Regressions’, American Economic Review, 82(4), 1992, 942–63. Lin, A., ‘Trade Effects of Foreign Direct Investment: Evidence for Taiwan with Four ASEAN Countries’, Weltwirtshaftliches Archiv, 131(4), 1995, 737–47. Lipsey, E.R., ‘Inward Foreign Direct Investment and Economic Growth in Developing Countries’, Transnational Corporations, 9(1), 2000. Lubitz, R. ‘United States Direct Investment in Canada and Canadian Capital Formation, 1950–1962’, PhD dissertation, Cambridge, MA, Harvard University, 1966. Mody, A. and Wang, F.-Y., ‘Explaining Industrial Growth in Coastal China: Economic Reforms … and What Else?’, World Bank Economic Review, 11(2), 1997, 293–325. O’Sullivan, P. and Geyikdagi, Y., ‘Japanese Direct Investment in the United States’, Rivista Internazionale di Scienze Economiche e Commerciali, 9(41), 1994, 761–73. Pfaffermayr, M., ‘Foreign Direct Investment and Exports: A Time Series Approach’, Applied Economics, 26, 1994, 337–51. Romer, P., ‘Idea Gaps and Object Gaps in Economic Development’, Journal of Monetary Economics, 32(3), 1993, 543–73. Root, A. and Ahmed, A., ‘The Influence of Policy Instruments on Manufacturing Direct Foreign Investment in Developing Countries’, Journal of International Business Studies, 9, 1978, 81–93. Rugman, A. (ed), Foreign Investment and NAFTA, Columbia, SC, University of South Carolina Press, 1994. Saltz, I.S., ‘The Negative Correlation between Foreign Direct Investment and Economic Growth in the Third World: Theory and Evidence’, Rivista Internationale di Scienze Economiche e Commmerciali, 7(39), 1992, 617–33. Scaperlanda, A.E. and Mauer, L.J., ‘The Determinants of US Direct Investment in the EEC’, American Economic Review, 59, 1969, 558–68. Shah, J., Tian, G. and Sen, F., ‘The FDI-Led Growth Hypothesis: Further Econometric Evidence from China’, Economics Decision Working Paper, China Economy, 1997. Temple, J. ‘The New Growth Evidence’, Journal of Economic Literature, 37(1), 1999, 112–56. Tsai, P.L., ‘Determinants of Foreign Direct Investment and its Impact on Economic Growth’, Journal of Economic Development, 19(1), 1994, 137–63. United Nations, Foreign Investment and Trade Linkages in Developing Countries, New York, 1993. Van Loo, F. ‘The Effect of Foreign Direct Investment on Investment in Canada’, Review of Economics and Statistics, 59(4), 1977, 474–81. Verno, R., Sovereignty at Bay: The Multinational Spread of OS Enterprises, New York, Basic Books, 1971. Zapata, H.O. and Rambaldi, A.N., ‘Monte Carlo Evidence on Cointegration and Causation’, Oxford Bulletin of Economics and Statistics, 59, 1997.

10 Trends and Determinants of Foreign Direct Investment in Emerging Economies of Asia Rekha Mehta and Santosh Bhandari

1

Introduction

Foreign direct investment (FDI) provides financial resources for investment in a host country and thereby augments domestic saving efforts. It also plays an important role in accelerating the pace of economic growth. In view of the rapid economic liberalization process taking place the question of attracting FDI for economic development in the emerging economies has came into sharper focus. Interestingly, for analytical purposes, the definition of FDI has been refined since the 1980s. The IMF defined FDI in 1977 as an investment made to acquire lasting interest in enterprises operating outside the economy of the investor. The foreign entity or the group of associated entities that makes the investment is termed the direct investor. Some degree of equity ownership is almost always considered to be association with an effective voice in the management of an enterprise. (IMF 1977) The IMF revised the definition in 1992 by suggesting a threshold of 10 per cent of equity ownership to qualify an investor as a foreign direct investor (IMF 1992). A review of the literature indicates that the definition of FDI given by the Organization for Economic Cooperation and Development (OECD) has become a benchmark for analytical purposes. According to OECD: a foreign direct investment enterprise is an incorporated or unincorporated enterprise in which a single foreign investor maintains an effective voice by covering 10 percent or more of the ordinary shares or voting power in an enterprise or [covering] less than 10 percent of ordinary shares or voting power in an enterprise, yet will maintain an effective voice in the management. An effective voice in the management only implies that 180

Rekha Mehta and Santosh Bhandari 181

direct investors are able to influence the management of an enterprise and does not imply that they have an absolute control. (OECD 1992) FDI provides the much-needed foreign exchange to help bridge the balance of payments or trade deficit. Indeed, in the wake of the late 1990s debt crises, FDI came to be viewed as an increasingly important source of external finance for developing countries. Another important contribution of FDI lies in raising the technological standards, level of efficiency and competitiveness of the host country. FDI brings complementary assets such as technology, management and or organizational competences and there are spillover effects of these assets on the rest of the economy. Another benefit of FDI is that it helps the host country to improve its export performance. By raising the level of efficiency and the standards of product quality, FDI makes a positive impact on the host country’s export competitiveness. Because of the international linkages of transnational corporations (TNCs), FDI provides better access to foreign markets. FDI contributes to exports directly and an enhanced export possibility contributes to the growth of the host economies by relaxing demand-side constraints on growth. This is especially important for those countries which have a small domestic market and must increase exports to maintain the tempo of their economic growth. In this chapter, Section 2 deals with theories of FDI; Section 3 analyses trends in FDI in Asian countries and the role of FDI in domestic capital formation. Section 4 considers FDI policies in emerging economies and Section 5 makes an econometric analysis of FDI flows in order to identify some key determinants of FDI flows to the emerging economies of Asia. Section 6 concludes the chapter.

2

Theories of FDI

Growth and economic development are, of course, related to a number of factors, important among which are growth in inputs of skilled and unskilled labour, physical capital and production technology. Foreign equity participation in industrial and other commercial projects has come to be viewed as especially important, if not crucial, for the growth prospects of less developed countries in the modern global economy. In neoclassical economic theory, FDI mainly involves the movement of productive capital from one country to another. When productive capital flows from capital-abundant countries to capital-scarce countries, it promotes greater world production and economic welfare in the same manner as expansion of international trade in goods under trade liberalization theories, FDI is thus viewed as a substitute for international trade in goods (Mundell 1957). According to the ‘flying geese’ theory (Kamatsu 1961, 1962), FDI disperses production technology and know-how from a high-wage source country to one or more lower-wage host countries. This

182 FDI Trends and Determinants in the Emerging Economies of Asia

dispersion of technology and know-how ultimately influences trade patterns as the primary location of production is gradually transferred offshore by the high-wage source country to the lower-wage ‘follower’ countries (similar to the pattern formed by ‘flying geese’) with the emphasis on differential wage levels between countries and creation of overseas ‘export platforms’ by multinational firms (MNCs). The ‘flying geese’ theory of FDI in Asia provides an additional explanation for the remarkable performance of East Asian exports in the 1990s (Petri 1992; World Bank 1994). According to the Hymer–Kindleberger theory (Kindleberger 1969), the foreign owned firm will make an investment in the host country only if it possesses some compensating advantage, which allows it to compete on equal terms with indigenous firms. This is, however, not a sufficient condition for FDI since the firm has the option of licensing or exporting the product to the host country. Clearly, other conditions have to be satisfied for FDI to arise. Three such conditions are: (1) The advantage is internally transferable (2) It is more profitable for the foreign owned firm to exploit the advantage itself than to license it to an indigenous producer (3) Exporting the product to the host country is not possible or unprofitable due to tariff or transport cost barriers. A more general theory of TNCs traces their emergence to internalization of markets (Buckley and Casson 1991). The theory is based on three simple postulates: (1) Firms maximize profits in a world of imperfect markets (2) When markets in intermediate products are imperfect there is an incentive to bypass them by creating internal markets (within the firm) (3) Internalization of markets across national boundaries generates multinational enterprises (MNEs). Another important prediction of this theory is that unless transport costs are very low, returns to scale at the plant level are high, or the comparative advantage of one location is very significant, the international acquisition and exploitation of knowledge will normally involve international production through a world-wide network of basically similar plants. Following this theory, one can see an important difference between the MNEs operating in the early part of the twentieth century and those which emerged in the latter part of the century. It is argued that prior to the Second World War, the MNC was a by-product of the internalization of intermediate product markets in a multi-stage production process; in the post-war period it was a by-product of the internalization of the market in knowledge. The theories discussed above seek to explain FDI without making a distinction with regard to the country of origin. Kojima (1978) has argued

Rekha Mehta and Santosh Bhandari 183

that there is an inherent difference between FDI originating in the West and that in Japan. Kojima has developed a theoretical framework which integrates trade theory with FDI. Dunning’s eclectic theory of international production (Dunning 1988) explains both the ways in which overseas market are served by enterprises of different nationalities and the industrial and geographical comparison of such activities. According to Dunning’s theory, a firm will make a direct investment in a foreign country if the following three conditions are satisfied: (1) It possesses some ownership advantages vis-à-vis firms of other nationalities in serving particular markets (2) It is more beneficial for the firm to use the advantages itself than to sell or lease them to foreign firms (3) It is profitable for the enterprise to utilize these advantages in conjunction with at least some factory inputs outside the home country. Evidence from economic studies Although the empirical studies on FDI are far from unequivocal, the WTO review of empirical work and case studies (WTO 1996) supports the view that FDI contributes to improving international competitiveness and economic growth in developing countries. Entry by foreign firms also tends to promote increased exports by domestic manufacturing firms (Hill 1990; Aitken et al. 1997). FDI increases the productivity of domestic firms, increasing the rate of productivity convergence toward the level in the corresponding industry of the MNE home country (Caves 1974; Globerman 1979). FDI frequently stimulates competition, productivity and innovation by local suppliers, as local suppliers vie for lucrative contracts with MNEs that seek to integrate their foreign operations vertically in host countries (Lim and Pang 1977; Halbach 1989). FDI has a substantial positive effect on macroeconomic growth, particularly when the host country has abundant stocks of human capital and skilled labour (Blomström, Lipsey and Zejan 1996; Lee 1998).

3

Trends in FDI

World FDI inflows are on an upward trend. World FDI inflow rose to $735,146 million in 2001 and FDI inflows to developing countries increased from $44,396 million in 1991 to $204,801 million in 2001. The ASEAN-5 (Association of Southeast Asian Nations – Indonesia, Malaysia, the Philippines, Singapore, Thailand) countries have enjoyed robust economic growth since 1975. High FDI has contributed to high levels of investment and employment, rising productivity and skill development and sharply improved export performance. The ASEAN economies acted as a magnet to attract further inward investment flows. FDI acts as both cause and effect in economic growth and facilitates economic upgrading, but the

184 FDI Trends and Determinants in the Emerging Economies of Asia

share of the ASEAN-5 in world inflows declined to 5.5 per cent in 1997 from 8.1 per cent in 1991 and after the Asian Economic Crisis went to only 1.5 per cent of world inflows in 2001. The share of emerging economies (Bangladesh, China, India, Pakistan, Sri Lanka) rose from 6.6 per cent of world inflows in 1991 to 10.2 per cent in 1997; after 1997 it also started to decline and was 6.92 per cent of world inflows in 2001. Among the ASEAN-5, Singapore had the highest FDI flow during 1991–2001. The FDI flow, which was $4,887 million in 1991, increased to $11,803 million in 1999 but fell to $8,609 million in 2001; its shares in Asia fell from 20.1 per cent in 1991 to 8.4 per cent in 2001. Malaysia is the second largest recipient of FDI flows among the ASEAN-5. Its share fell from 16.6 per cent in 1991 to 0.53 per cent in 2001. FDI inflows increased from $175 million in 1991 to $2,026 million in 2000 but fell to $267 million in 2001. The share of FDI inflows of Indonesia, the Philippines and Thailand in Asia is also on a declining trend, but in terms of real value it increased during 1991–2001. A review of the evidence on resource flows to emerging countries points to a rising trend. Until the 1990s, FDI flows were quite minimal, and most countries in south Asia were not seen by international investors as attractive investment destinations; in the 1990s, however, these countries started to attract FDI under the impact of the globalization of business. The growing integration of financial markets, liberalization of economies and rapid innovation in financial instruments and communication technologies in the 1990s contributed immensely to FDI flows in the emerging economies. The emerging economies improved their share of total FDI inflows to the world, the developing countries and Asia over the period 1985 to 1990–2001 (Table 10.1). China accounted for an impressive share of FDI inflows to the emerging economies. It initiated reforms in 1991 and as a consequence FDI inflows accelerated from $10,189 million in 1991 to $46,846 million in 2001. However, a World Bank policy research report (World Bank 1997) questioned FDI growth in China by pointing out that the figures were overestimated due to the phenomenon of ‘round tripping’ of domestic money – it goes out of the country and comes back again to take advantage of tax breaks for foreign investors. The majority of investment flows in China also come from Taiwan and Hong Kong, which are an extended territory of Mainland China. Now Hong Kong has become part of Mainland China under the ‘one nation two systems’ formula this is of added benefit to China. Like China, India has also become a favoured country for foreign investors. It undertook sweeping reforms in 1991 in order to attract foreign capital and technology. As Table 10.1 shows, FDI flows to India increased from $74 million in 1991 to $3,403 million in 2001. The share of Indian FDI inflows in Asia, which was 0.30 per cent in 1991, rose to 3.33 per cent in 2001, showing a rising trend. India in fact attracted a greater share than all the other emerging economies except China.

Table 10.1 FDI inflows, 1985–2001, $US million Region

1985–90a

World Developing countries Asia ASEAN-5 Indonesia Malaysia Philippines Singapore Thailand Emerging economics China Bangladesh India Pakistan Sri Lanka

150,645

Note:

a

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

160,199 171,199 227,532 259,696 330,516 386,140 478,082 694,557 1088,263 1491,934 735,146

25,166 14,560 6,053 550 1,100 415 2,951 1,037

44,396 24,272 12,998 1,482 4,043 556 4,887 2,030

59,238 32,965 12,009 1,777 5,138 776 2,204 2,114

83,294 108,699 112,537 152,685 191,022 187,611 75,217 93,331 105,828 96,100 58,716 68,509 22,537 25,889 26,582 15,642 15,473 18,194 2,108 4,346 356 6,194 4,677 2,003 4,581 5,876 7,296 6,324 5,741 2,714 1,591 1,459 1,520 1,209 1,238 1,752 8,550 8,788 8,608 10,746 4,686 6,389 1,805 1,364 2,068 2,271 3,626 5,143

1,049.5 705 0.5 170 136 38

10,588 10,189 1 74 257 67

11,879 11,156 4 252 344 123

28,601 27,515 14 532 346 194

35,357 33,787 11 974 419 166

38,786 35,849 2 2,151 719 65

44,390 40,800 14 2,525 918 133

49,140 44,236 139 3,619 713 433

48,996 45,460 190 2,633 507 206

225,140 10,277 17,092 2,745 3,895 578 11,803 3,561 43,396 40,319 178 2,168 530 201

237,894 204,801 133,707 102,066 8,699 11,427 4,550 3,277 3,788 544 1,241 1,792 5,407 8,609 2,813 3,759 43,854 40,772 280 2,319 305 178

50,884 46,846 78 3,403 385 172

Annual average.

Source: UNCTAD (2002).

185

186 FDI Trends and Determinants in the Emerging Economies of Asia Table 10.2 FDI net inflows, 1991–2001, per cent of GDP Country

1991

1992 1993

Bangladesh 0.005 0.012 China 1.159 2.668 India 0.028 0.113 Pakistan 0.569 0.692 Sri Lanka 0.538 1.263 Indonesia 1.156 1.277 Malaysia 8.138 8.763 Philippines 1.198 0.430 Singapore 11.316 4.421 Thailand 2.050 1.896

1994

1995

1996

1997

1998

1999

2000

2001

0.042 0.033 0.005 0.033 0.329 0.431 0.391 0.594 0.165 6.372 6.228 5.119 4.921 4.925 4.623 3.909 3.554 3.817 0.201 0.302 0.604 0.629 0.873 0.637 0.485 0.503 0.707 0.677 0.811 1.191 1.456 1.147 0.813 0.908 0.507 0.653 1.881 1.420 0.430 0.863 2.850 1.224 1.127 1.061 1.096 1.268 1.192 2.150 2.724 2.168 0.373 1.961 3.029 2.321 7.483 5.829 4.703 5.036 5.128 2.997 4.922 4.207 0.629 2.277 2.483 1.994 1.831 1.484 3.509 0.752 1.658 2.510 8.031 12.109 10.470 9.334 11.265 7.800 14.504 5.911 10.143 1.443 0.945 1.232 1.286 2.775 6.314 5.079 2.783 3.313

Source: UNCTAD (2002).

Bangladesh introduced an ambitious reform programme in 1991. The ‘regularity framework’ for FDI permitted the establishment of 100 per cent foreign owned subsidiaries. FDI inflows increased from $1 million in 1991 to $78 million in 2001, and the share of Bangladesh in Asia’s FDI inflows has risen to 0.07 per cent in 2001, from 0.004 per cent in 1991. Sri Lanka’s efforts to attract FDI have not been very effective in view of the ongoing internal unrest. Nevertheless, the government appears to the committed to liberalizing and improving the economy. FDI inflows have increased from $67 million in 1991 to $172 million in 2001, although the share of Sri Lankan FDI inflows in Asia decreased from 0.27 per cent in 1991 to 0.16 per cent in 2001. Pakistan has also liberalized its economy, and FDI inflows have increased since 1991 from $257 million in 1991 to $385 million in 2001. The share of Pakistan FDI inflows in Asia was 1.05 per cent in 1991 but 0.37 per cent in 2001. Despite this growth, FDI as a proportion of the GDP of the emerging economies remains very low (Table 10.2). The share of FDI as a proportion of GDP for Bangladesh, India, Pakistan and Sri Lanka is still below 1 per cent, although for China it is 3.8 per cent. The Indonesian and Malaysian performance has been the worst. The role of FDI in domestic capital formation FDI played an important role in shaping rapid economic development of the ASEAN-5 countries in the 1980s and 1990s. Until China arrived on the scene, the ASEAN-5, especially Singapore, were the most favoured investment destination among developing countries. Contrary to the ASEAN-5’s positive perception about foreign investment and its ‘catalyst role’ in economic development, the emerging economies of India, Bangladesh, Pakistan and Sri Lanka were less positive towards FDI and unsure about opening the economy to foreign investors. There was no definite policy drive in these countries and their economies were invisible on world investment scene.

Rekha Mehta and Santosh Bhandari 187 Table 10.3 Inward FDI flows to capital formation, 1985–2000 Region World Developing countries Asia ASEAN-5 Indonesia Malaysia Philippines Singapore Thailand Emerging economics China Bangladesh India Pakistan Sri Lanka Note:

a

1985–90a 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 3.6

3

3

4

5

5

6

7

11

16

22

3.3 2.6 57.2 2.3 10.6 5.6 34.1 4.6

4 3 72 4 23 6 34 5

4 3 53 5 24 7 12 5

7 7 64 5 22 10 23 4

9 8 68 4 15 11 36 2

8 7 66 8 15 9 31 3

9 8 62 9 17 8 25 3

11 9 65 8 15 6 29 7

11 9 68 1 14 13 21 21

13 13 10 12 73 44 9 12 22 17 4 9 42 20 14 10

7.2 2.6 0 0 2.3 2.3

10 4 0 0 3 3

16 7 0 0 4 5

24 12 0 1 4 7

28 17 0 1 5 5

26 15 0 2 7 2

30 14 0 3 9 4

40 15 2 4 7 12

29 13 2 3 6 5

27 11 2 2 7 5

23 10 3 2 4 4

Annual average.

Source: UNCTAD (2002).

Table 10.3 gives a comparative picture of the significance of FDI in activating domestic investment in Asian countries. During 1985–90 the share of inward FDI flows to gross capital formation in the ASEAN-5 was 57.2 per cent, quite remarkable and much higher than the percentages of other developing countries. For emerging economies, the share was 7.2 per cent. In the 1990s the share of ASEAN-5 inward FDI flows to capital formation marginally fell to 32 per cent, a relative decrease possibly caused because other developing countries emerged as ‘favourable hosts’ to FDI, diverting the foreign investment of developed countries there. Inward FDI flows to capital formation in the emerging economies increased to 23 per cent in 2002 (although in 1997 the figure was 40 per cent). The inward FDI performance index: methodology The Inward FDI Performance Index (UNCTAD 2002) ranks countries by the FDI they receive relative to their economic size. It is the ratio of a country’s share in global FDI inflows to its share in global GDP. A value greater than one indicates that the country receives more FDI than its relative economic size, a value below one that it receives less (a negative value means that foreign investors disinvest in that period). The index thus captures the influence on FDI of factors other than market size, assuming that, other things being equal, size is the ‘base line’ for attracting investment (Table 10.4). These other factors can be diverse, ranging from the business climate, economic

188 FDI Trends and Determinants in the Emerging Economies of Asia Table 10.4 FDI performance index of emerging economies of Asia, 1994–2001 Country

Bangladesh China India Pakistan Sri Lanka

1994–6

1999–2001

Index

Rank

Index

Rank

0.021 4.667 0.467 1.018 0.825

131 16 104 79 85

0.111 1.107 0.159 0.200 0.271

125 59 120 116 111

Source: UNCTAD (2002).

and political stability, the presence of natural resources, infrastructure, skills and technologies, to opportunities for participating in privatization or the effectiveness of FDI promotion: INDi 

FDIi/FDIw GDPi/GDPw

where, INDi  Inward FDI performance index of the ith country FDIi  FDI inflows in the ith country FDIw  World FDI inflows GDPi  GDP in the ith country GDPw  World GDP The inward FDI potential index: methodology The inward FDI potential index captures several factors (apart from market size) expected to affect an economy’s attractiveness to foreign investors (Table 10.5). It is an average of the values (normalized to yield a score between zero, for the lowest scoring country, to one, for the highest) of twelve variables (no weights are attached in the absence of a priori reasons to select particular weights): ●

●

● ●

GDP per capita, an indicator of the sophistication and breadth of local demand (and of several other factors), with the expectation that higherincome economies attract relatively more FDI geared to innovative and differentiated products and services. The rate of GDP growth over the previous ten years, a proxy for expected economic growth. The share of exports in GDP, to capture openness and competitiveness. The average number of telephone lines per 1,000 inhabitants and mobile telephones per 1,000 inhabitants, as an indicator of modern information and communication infrastructure.

Rekha Mehta and Santosh Bhandari 189 Table 10.5 FDI potential index of emerging economies of Asia, 1991–2001 Country

Bangladesh China India Pakistan Sri Lanka

1991–3

1994–6

1999–2001

Score

Rank

Score

Rank

Score

Rank

0.136 0.190 0.149 0.134 0.126

101 56 94 103 111

0.131 0.225 0.165 0.133 0.137

110 45 84 109 106

0.115 0.259 0.160 0.099 0.119

121 40 84 129 116

Source: UNCTAD (2002).

●

● ●

●

●

●

●

●

Commercial energy use per capita, for the availability of traditional infrastructure. The share of R&D spending in GDP, to capture local technological capabilities. The share of tertiary students in the population, indicating the availability of high-level skills. Country risk, a composite indicator capturing some macroeconomic and other factors that affect the risk perception of investors. The variable is measured in such a way that high values indicate less risk. The world market share in exports of natural resources, to proxy for the availability of resources for extractive FDI. The world market share of imports of parts and components for automobiles and electronic products, to capture participation in the leading transnational corporation (TNC) integrated production systems (UNCTAD 2002). The world market share of exports of services, to show the importance of FDI in the services sector that accounts for some two-thirds of world FDI. The share of world FDI inward stock, a broad indicator of the attractiveness and absorptive capacity for FDI, and the investment climate.

4 FDI policies in the emerging economies of Asia Bangladesh Bangladesh initiated major industrial policy reforms in 1982. There are no distinctions between foreign and domestic private investors regarding investment incentives or export and import policies. Incentives for investors, which the government hails as the most liberal in Asia, include 100 per cent ownership in most sectors, tax holidays, reduced import duties on capital machinery and spares, duty-free imports for 100 per cent exporters and tax exemptions on technology remittance fees, on interest on foreign loans and on capital gains by portfolio investors. Bangladesh is signatory to the International Convention for the Settlement of Investment

190 FDI Trends and Determinants in the Emerging Economies of Asia

Disputes (ICSID), the Multilateral Investment Guarantee Agency (MIGA), and is a member of World Intellectual Property Organization (WIPO). Trade has been liberalized and duties reduced. Customs-bonded warehouses assist exporters. Free repatriation of profits is allowed, and the Taka is almost fully convertible on current account. No prior approval is required for FDI except registration with the Board of Investment. India India began to deregulate the industrial sector in the mid-1980s, and the process received considerable momentum after 1991. In the forty-eight highpriority industries, FDI up to 51 per cent is approved automatically if certain norms are satisfied. Foreign investment exceeding 51 per cent and up to 100 per cent is allowed in several sectors. A new package for 100 per cent export-oriented projects and companies in the Export Processing Zones (EPZs) was announced. A Foreign Investment Promotion Board (FIPB) authorized to provide a ‘single-window’ clearance was set up. Companies with more than 40 per cent of foreign equity are now treated on a par with fully Indian owned companies. New sectors such as mining, banking telecommunications, highways, construction and management have been opened to private (including foreign owned) companies. These policy reforms have been accompanied by active courting of foreign investors at the highest level. The rupee was made convertible first on trade account and finally on current account. Pakistan In Pakistan, the foreign private investment Act 1976 provides a legal framework for protecting FDI. Successive industrial policy statements have liberalized FDI policy and nearly all industrial fields, except for a few areas listed in a negative list, are now open to foreign investors. Foreign investment is generally subject to the same rules as domestic investment, with the exception of certain sensitive areas. Key features of Pakistan’s investment climate include: 1. Elimination of the requirement of obtaining a ‘No Objection Certificate’ (NOC) from the appropriate provincial government, except for areas which are classified as ‘negative areas’. 2. No requirement approval to set up an industry in any field, place and size except for arms and ammunition; high explosives; radioactive substances; security printing; currency and mint. 3. Exemptions or relief from import duties on imported plant and machinery. 4. Tax relief in the shape of first-year allowance (FYAs) has been provided for a number of industries.

Rekha Mehta and Santosh Bhandari 191

Sri Lanka In 1994 Sri Lanka removed all foreign exchange restrictions on current account transactions. Article 157 of the Constitution guarantees the safety of foreign investment. Sri Lanka also has entered in to bilateral investment guarantee agreements with twenty-two countries. These agreements provide for protection against nationalization, free remittance of profit, capital and business fees, and settlement of disputes under ICSID. Sri Lanka is also a founding member of MIGA. Capital goods and raw materials can be imported duty-free for projects approved by the Board of Investment (BOI). China China’s ‘open door’ policy and outstanding performance in economic growth have formed a strong pull force to attract foreign investors from all around the world. China has become perhaps the most liberalized country in hosting FDI. In addition to the advantages of cheap labour and huge markets, the Chinese government has provided foreign investors with many incentives. China underwent a paradigm shift in 1992 and began to gradually open certain sectors of its domestic market to MNCs, including telecommunications, transportation, banking and insurance. The most important consideration was undoubtedly to send a signal of commitment to the WTO. This institutional change, along with the increased purchasing power of the general population, led to a dramatic rise in FDI. In 1990 Amendments to the 1979 ‘Joint Venture Law’ were passed, greatly improving the investment climate in China. In January 1997 Shenzhen (the most important Special Economic Zone (SEZ)) permitted foreign-investment enterprises (FIEs) with advanced technology to sell 100 per cent of their products on the domestic market.

5

Regional integration and FDI

Regional integration typically reduces barriers to trade in goods as well as creating investment among members. Regional integration arrangements (RIAs) can change the level and pattern of FDI, and thereby affect trade in ways that are not fully captured in standard trade. Trade and investment liberalization will change the location-specific and firm-specific advantages. RIAs, for example, can encourage geographical concentration: MNEs can restructure their production bases to take advantage of reduced trade costs while exploiting scale economies and agglomeration advantages. This may lead to FDI outflows from countries. On the other hand, better access to a larger market may attract FDI to countries that have a strong location advantage. Economic integration can also affect the absolute and relative growth rates in countries and thereby influence the FDI that responds to the potential growth prospects of a region.

192 FDI Trends and Determinants in the Emerging Economies of Asia

In 1985, the South Asian Association for Regional Cooperation (SAARC) was established. All SAARC countries now actively encourage and seek FDI, and a range of measures have been implemented to enhance their attractiveness to potential foreign investors. South Asia also turned its attention to strengthening regional trade cooperation, culminating in the decision to implement a South Asian Preferential Trade Agreement (SAPTA) in 1995. The progress in trade and investment liberalization by South Asian countries is significant, but there is considerable room for further liberalization. Determinants of FDI: an econometric analysis The variables that generally determine the flows of FDI to a particular country or region are called its ‘determinants’. Research focusing on the determinants of FDI has mainly used three approaches: (1) aggregate econometric analysis, (2) survey appraisal of foreign investors’ opinion and (3) econometric study at the industry level. Unfortunately, these three approaches have failed to arrive at a consensus, partly due to lack of information pertaining to FDI flows to various economic sectors. One conclusion appears to enjoy unanimity among researchers, however: the determinants of FDI in different countries are likely to be structurally different. In the context of the emerging economies, the following determinants of FDI are used in our empirical study. Size of the market There is a well-established co-relation between FDI and the size of the market. We use GDP in the previous year and per capita income in the year t1 as an important determinant of FDI. Openness of the economy The second hypothesis is that greater openness attracts higher levels of FDI inflows. We use the degree of openness of the economy in year t, measured as exports plus imports. Empirical results To bring uniformity throughout the dataset, all flows are expressed in $US. The statistical estimates of the parameters of our calculation are based on time series data for the years 1991–2001. Using OLS for estimation, the estimated parameters are shown in Table 10.6. Results in Table 10.6 show that all the three determinants are statistically significant in every country. But the determinant of per capita income is more significant than other two determinants in each country. In next step, a log-log model was used. The results are shown in Table 10.7. The slope of coefficient 2 measures the elasticity that is a percentage change in FDI for a given percentage change in GDP. The elasticity of per capita income is more than the elasticity of GDP and openness in each country, so per capita income is the important determinant.

Rekha Mehta and Santosh Bhandari 193 Table 10.6 Linear regression results of FDI with various determinants for the emerging economies of Asia (OLS) Eq. no. Bangladesh 1.1 1.2 1.3 China 2.1 2.2 2.3 India 3.1 3.2 3.3 Pakistan 4.1 4.2 4.3 Sri Lanka 5.1 5.2 5.3

␤1

t-values of ␤1

0.01148* 2.360*

3.907 4.096

0.629 0.651

1.893 1.963

0.01900*

3.327

0.743

1.747

0.03936* 54.147*

4.214 5.344

0.664 0.760

0.617 0.889

0.08452*

5.054

0.739

0.629

0.01234* 15.718*

5.666 6.086

0.781 0.804

1.174 1.243

0.05289*

5.419

0.765

1.031

GDPt1 (Per capita income)t1 opennesst

0.01982* 5.105*

2.361 3.922

0.382 0.631

0.805 1.240

0.06086*

2.280

0.366

0.724

GDPt1 (Per capita Income)t1 Openness t

0.01337 0.338

1.397 1.480

0.178 0.196

2.087 2.087

0.177

1.406

0.180

2.006

X1 GDPt1 (Per capita Income)t1 Openness t GDPt1 (Per capita Income)t1 Openness t GDPt1 (Per capita Income)t1 Openness t

r2

DW

Notes * Significant at the 95 per cent level. 1 1 is the coefficient of X1. 2 2 r is the coefficient of determination for goodness of fit and DW is the Durbin–Watson d-statistic.

The combined impact of GDP, per capita income and openness on FDI has been examined in the second stage of analysis (i.e. multiple log linear regression analysis). The results (Table 10.8) show that elasticity of per capita income is again more than the other two determinants. However, in some countries it shows a negative sign which is not expected, and that there is a problem of multi-collinearity between independent variables.

6

Conclusion

FDI is widely viewed as being among the major forces propelling the ‘globalization’ of the world economy – that is, the increasing specialization of production and trade through global networks of production and distribution,

194 FDI Trends and Determinants in the Emerging Economies of Asia Table 10.7 Log linear regression results of FDI with various determinants for the emerging economies of Asia (log-log) Eq. no. Bangladesh 1.1 1.2 1.3 China 2.1 2.2 2.3 India 3.1 3.2 3.3 Pakistan 4.1 4.2 4.3 Sri Lanka 5.1 5.2 5.3

␤2

t-values of ␤2

R2

DW

GDPt1 (Per capita income)t1 Openness t

9.682* 16.149*

6.081 6.949

0.804 0.843

1.502 1.532

2.765*

3.245

0.539

1.546

GDPt1 (Per capita income)t1 Openness t

1.047* 1.256*

3.774 4.657

0.613 0.707

0.738 1.011

0.842*

6.246

0.813

1.100

GDPt1 (Per capita income)t1 Openness t

4.127* 5.569*

6.944 5.858

0.843 0.792

0.488 0.592

3.601*

6.388

0.819

0.611

GDPt1 (Per capita income)t1 Openness t

2.246* 4.632*

2.645 4.375

0.437 0.680

0.871 1.405

2.052*

2.525

0.415

0.758

GDPt1 (Per capita income)t1 Openness t

1.092* 1.460

1.962 1.757

0.300 0.255

1.933 1.888

0.984

1.880

0.282

1.850

X2

Notes * Significant at the per cent level. 1 2 is the coefficient of X2. 2 2 r is the coefficient of determination for goodness of fit and DW is the Durbin–Watson d-statistic.

pioneered and operated by MNEs (WTO 1996), Moreover, although advanced industrial countries dominate the global picture, developing countries accounted for one-third of the global stock of inward FDI in 1997, compared to just one-fifth of the global stock in 1991. Indeed, notwithstanding the Asian Financial Crisis, FDI flows steadily grew during the 1990s, including (in 1997) a larger and more stable component of total foreign financing for developing countries than either official development assistance (ODA) or foreign portfolio investment (FPI) (UNCTAD 1998). FDI has played an important role in the emerging economies. Economic liberalization has emerged as a fruitful policy track being pursued by many developing countries as it attracts invaluable foreign capital and technology in the form of FDI. FDI inflows to Asia grew at an accelerating pace in the

Rekha Mehta and Santosh Bhandari 195 Table 10.8 Multiple log linear regression results of FDI with various determinants for the emerging economies of Asia Eq. no. Bangladesh China India Pakistan Sri Lanka

␤1

␤2

␤3

r2

DW

36.832* (2.445) (0.906 (0.856) 10.362* (1.982) (0.9424 (0.038) 2.807 (0.7427)

80.422* (3.282) 1.384 (1.021) 10.735 (1.476) 3.998* (2.449) (3.752 (0.654)

1.076 (1.335) 0.611* (1.955) 1.280 (0.404) 0.643 (0.297) 0.792 (0.427)

0.928

2.744

0.838

1.169

0.880

0.495

0.698

1.160

0.341

1.947

Notes: * Significant at the per cent level. 1, 2 and 3 are the coefficients of GDPt-1, (Per capita income)t-1 and Openness t.

1990s and shifted from the ASEAN-5 to the emerging economies as the percentage of FDI of the emerging economies in Asia increased after 1991. China has accounted for an impressive share of FDI inflows to the emerging economies. The FDI performance index calculated by UNCTAD shows that the performance of China, India, Pakistan and Sri Lanka in 1999–2001 was not better than 1994–6, but the potential index of China and India had increased from 1991–3 to 1999–2001. FDI policy in different emerging countries has also been studied: a range of measures have been implemented to enhance FDI, including the provision of various tax duty and other incentives, removal of restrictions on repatriation of profits, current account convertibility, relaxation of ownership restrictions, and non-discrimination in favour of domestic investors and fast-tracking of FDI approvals. Different determinants such as the lag of GDP, the lag of per capita income and openness were also studied, all the variables in different countries were found to be significant, but the results shows that per capita income was a very important determinant.

References Aitken, B.J. and Harrison, A.E., ‘Do Domestic Firms Benefit from Direct Foreign Investment? Evidence from Venezuela’, American Economic Review, 89(3), 1999, 605–18. Aitken B.J., Hansion G.H. and Harrison, A.E., ‘Spillovers, Foreign Investment and Export Behaviour’, Journal of International Economics, 43, 1997, 103–32. Akamatsu, K., ‘A Theory of Unbalanced Growth in the World Economy’, Weltwirtschaffliches archiv, 86(1), 1961, 196–217.

196 FDI Trends and Determinants in the Emerging Economies of Asia Blomström, M., Lipsey R.E. and Zejan, M., ‘Is Fixed Investment the Key to Economic Growth?’, Quarterly Journal of Economics, 111(1), 1996, 269–76. Borensztein, E., de Gregorio, J. and Lee, J.W., ‘How Does Foreign Direct Investment Affect Economic Growth?’, Journal of International Economics, 45, 1998, 115–35. Buckley, P.J. and Casson M., The Future of Multinational Enterprise, London, Macmillan 1991. Caves, R.E., ‘Multinational Firms, Competition, and Productivity in Host-Country Market’, Economica, 41(162), 1974, 176–93. De Mello, L.R., ‘Foreign Direct Investment in Developing Countries and Growth: A Selective Survey’, Journal of Development Studies, 34(1), 1997, 1–34. Dunning, J., ‘Towards an Eclectic Paradigm of International Production: A Reassement of Some Possible Extensions’, Journal of International Business Studies, 19, 1988, 11–32. Elek, A., ‘Trade Policy Options for the Asia Pacific Region in the 1990s: The Potential of Open Regionalism’, American Economic Review, 82(2), 1992, 74–8. Globerman, S., ‘Foreign Direct Investment and Spillover Efficiency Benefits in Canadian Manufacturing Industries’, Canadian Journal of Economics, 12(1), 1979, 42–56. Golder, B.N. and Ishigani, E., ‘Foreign Direct Investment in Asia’, Economic and Political Weekly, 29 May 1999. Halbach, A.J., Multinational Enterprises and Subcontracting in the Third World: A Study of Inter Industrial Linkages, Multinational Enterprises Programme Working Paper No. 58, International Labor Organisation, Geneva, 1989. Hill, H., ‘Foreign Investment and East Asian Economic Development’, Asian-Pacific Economic Literature, 4(2), 1990, 21–58. Huffaur, L. and Malani, ‘Determinants of Foreign Direct Investment and Its Connection to Trade’, UNCTAD Review, 1994, 7–16. IMF, 1992, Balance of Payments Manual, Washington, DC. IMF, 1997, Balance of Payments Manual, Washington, DC. Kamatsu, A., ‘A Historical Pattern of Economic Growth in Developing Countries’, The Developing Economies, 1(1), 1962, 3–25. Kindleberger, C.P., American Business Abroad, CN, Yale University Press, 1969. New Haven. Kojima, K.: Direct Foreign Investment: A Japanese Model of Multinational Business operations, London, Croom Helm, 1978. Kokko, A., ‘Technology, Market Characteristics, and Spillovers,’ Journal of Development Economics, 43(2), 1994, 279–93. Kravis, I., ‘Trade as a Handmaiden of Growth: Similarities between the Nineteenth and Twentieth Centuries’, Economic Journal, 80(8), 1970, 50–72. Lee, C.H., ‘Korea’s Direct Foreign Investment in Southeast Asia’, ASEAN Economic Bulletin, 10(3), 1993, 250–96. Lim, L.Y.C. and Pang, E.F., The Electronics Industry in Singapore: Structure, Technology, and Linkages, Monograph Series No. 7, Economic Research Press, National University of Singapore, 1977. Mallampally, P. and Sauvant, K.P., ‘Foreign Direct Investment in Developing Countries’, Finance and Development, 36(1), 1999. Mansfield, E. and Romeo, A., ‘Technology Transfer to Overseas Subsidiaries by US-Based Firms’, Quarterly Journal of Economics, 95(4), 1980, 737–50. Mundell, R., ‘International Trade and Factor Mobility’, American Economic Review, 67, 1957, 321–5.

Rekha Mehta and Santosh Bhandari 197 Organisation for Economic Co-operation and Development, Trade and Competition: Frictions After the Uruguay Round, Paris, 1996. Petri, P., ‘Platforms in the Pacific: The Trade Effects of Direct Investment in Thailand’, Journal of Asian Economics, 3(2), 1992, 173–96. Riedel, J., ‘Intra-Asian Trade and Foreign Direct Investment’, Asian Development Review, 9(1), 1984, 111–46. UNCTAD, World Investment Report 1998, New York, United Nations, 1998. ———— World Investment Report, 2002, New York, United Nations, 2002. World Bank, East Asia’s Trade and Investment: Regional and Global Gains from Liberalization. Development in Practice Series, Washington, DC, 1994. ———— Private Capital Flows to Developing Countries: The Road to Financial Integration, World Bank Policy Research Report, Washington, DC, 1997. World Trade Organization (WTO), ‘Trade and Foreign Direct Investment’, WTO Annual Report, 1996, Geneva, WTO.

11 International Mobility of Human Resources of Science and Technology and its Complementarity to Foreign Direct Investment and Economic Development in Asia Vincent F. Yip

1

Introduction

Migration of the first homo sapiens out of Africa, the biblical exodus depicted in Moses and his people, and the post-Second World War migration waves from developing to developed countries are all examples of the high mobility of humans that has existed since the dawn of time. One of the key reasons for human migration was economic – to leave poverty and seek a better life elsewhere: the migrants typically never return to their ancestral homes and the movement was always one-way. With the greater ease in communications and transportation in the second part of the twentieth century, especially after the popularization of civilian air travel in the 1960s, migration and the associated socio-economic effects for both the sending and host countries become increasingly interconnected. Cross-border economic activities are not new, and some of the first companies whose activities (mainly in trade) spread a cross international seas were actually European in origin, such as the British East Asia Trading Company. However, post-Second World War GDP growth among developing nations has been increasingly related to foreign direct investment (FDI), now mainly in industrial manufacturing and technology-related activities rather than trade and agriculture. By the 1970s, modern transnational corporations (TNCs) such as Ford, Coca Cola, Mercedes, Unilever, Sony, AT&T, IBM and HP were household names around the world. A UNU/WIDER study (Addison and Heshmati 2003) confirmed casual relationship between FDI, GDP growth, trade openness, and information and communication technology (ICT). Among the determinants of increasingly 198

Vincent F. Yip 199

strong FDI inflows to developing countries are natural resources, geographical location, infrastructure, institutions and human capital.1 An economy’s excellent education and training activities can serve to complement its incentives in attracting FDI inflows from TNCs, the cases of Singapore, Taiwan, Malaysia, and now China being prominent examples (Noorbakhsh, Poloni and Youssef 2001). Saggi (2003) and other researchers have found theoretical and empirical evidence to underscore the importance of education, accumulation of human capital and research and development (R&D) as critical parts of a country’s absorptive capacity for FDI. Indeed, an emphasis on education and a high percentage of college graduates had been the trademark of many developing economies in East and South Asia. But these highly skilled human resources are typically very mobile and their migration decisions are often the result of the interplay of two or more factors (Papademetriou and Martin 1991), such as proximity, economic, social, political, academic, cultural and even religious factors. The migration loss of this valuable human capital (mainly to north America and Europe), commonly referred to as the ‘brain drain’, has been the bane of developing countries in Asia, Africa and South America. Since the phenomenal economic success of the Asian newly industrialized economics (NIEs) of Taiwan, Hong Kong, South Korea and Singapore in the mid-1980s, the trend began of looking at FDI and economic development from a human capital angle. The popular press2 began to notice the return home of ‘prodigal sons’ and the positive contributions they made to their home countries. The picture since the 1980s has been a much more fluid one, whereby there is talk of a ‘brain circulation’, a to-and-fro flow between sending and host nations and a win–win scenario for all. Saxenian has done admirable work on documenting the positive economic effects of ‘circulating’ human resources of science and technology (HRST) and came up with a figure that for every 1 per cent rise of first-generation immigrants from a sending country, California’s exports to that country rises 0.5 per cent (Saxenian 2002). While the current situation and data are not conducive to determining an incontrovertible casual relationship between FDI and human capital in statistical terms, this chapter will explore the phenomenon of the migration of HRST and its effect on FDI and the economic development of Asian countries. More discussions and empirical research needs to be spent on understanding the interplay between the mobility of these crucial HRST and their specific effects on determining FDI inflows/outflows and the general economic development of their sending and host nations. We choose to examine this relationship between Asian developing countries and the USA instead of a relationship between developed nations because: (1) Developing countries’ share in total global FDI flows (UNCTAD 1998) increased from 26 per cent in 1980 to 37 per cent in 1997, of which Asia received a disproportionately high 22 per cent compared to Latin America’s 14 per cent and Africa’s 1 per cent.

200 International HRST Mobility, FDI and Economic Development in Asia

(2) Europe’s FDI flows and migration figures contain much intra-Europe movement (Tremblay 2003), and the students’ staying time is low but the return rates of most European HRST to the sending countries are high and thus their economic effects are either minimal or not long-lasting. (3) Most migration into EU countries was pushed by purely economic, colonial-past or political reasons, such as after the fall of communism in 1989–90. In contrast, a disproportionate portion of the large Asian migrant waves from Taiwan, India and now China into the USA are for the pursuit of higher studies3 and technology-related employment. (4) The USA has long been the largest recipient of international skilled migrants and their economic effects on the sending as well as the host country are much more prominent and well documented than that of, say, African migrants to France or Eastern European migrants to Germany.

2

Foreign students as mobile human resources

In the world of science and technology (S&T), 2001 proved to be a watershed. April 2001 saw a ‘dotcom bust’ which wiped out equity, jobs and companies in the IT industry. The 11 September attack on New York City’s World Trade Center sent reverberations throughout the world. Global FDI inflows, which had peaked in 2000, suffered a drop of 41 per cent in 2001 and then another one-fifth in 2002 (UNCTAD 2003). On top of the obvious economic, social and political ramifications, the resultant changes in security arrangements and visa policies had potentially far-reaching effects on the international movement of students and skilled workers. Within weeks, separate anti-terrorism bills were introduced and passed the US Senate and House of Representatives; some of the proposed visa reforms and restrictions for foreigners raised concerns among educators and foreign applicants as well as students already in the USA.4 The New York-based Institute of International Education (IIE) keeps welldocumented records of foreign student enrolments in US colleges and releases its statistics in its annual report, Open Doors. The effect of 11 September was reflected in the Open Doors report for the school year 2003–4 released on 3 November 2003. Once again, the top five spots were occupied by Asian sending countries/economies: (1) India (74,603), (2) China (64,757), (3) South Korea (51,519), (4) Japan (45,960) and (5) Taiwan (28,017). But the economic downturn precipitated by the dotcom bust and new visa measures limited the rise of total enrolment to just 1 per cent over the previous year, and thirteen of the top twenty sending countries experienced a drop in enrolment. The foreign student population enrolled in the 2,700 American institutions reached 586,323 for the school year 2003–4, and again Asian students comprised the majority (51 per cent).

Vincent F. Yip 201

In 1989–90, there were 386,851 foreign students and scholars in the USA, and the ranking of the top five sending countries was only slightly different: (1) China (33,390), (2) Taiwan (30,960), (3) Japan (29,840), (4) India (26,240), (5) South Korea (21,710), reflecting the consistent emphasis of East and South Asians on securing a foreign college education, especially in the USA. The enrolment of foreign students is an important part of the study of migration of HRST simply because many of them, especially those whose studies are in science, engineering, medicine and other professional fields, tend to remain in the host country afterwards, and if they return to their own country they often leave an indelible mark on the local economy and society. An OECD study of enrolment of foreign students (Tremblay 2003)5 showed that student migration is often a precursor to actual migration of HRST. Cervantes and Guellec (2002) cited evidence that, based on data on foreign 1990–1 PhD graduates in S&T in the USA, 79 per cent of those from India and 88 per cent of those from China were still working there in 1995. This is especially true for foreign students’ migration to the USA, as contrasted to EU countries such as Germany, where the top four origins of foreign students in 1998 were Turkey, Iran, Greece and Austria, nations not traditionally known as producers of large numbers of mobile HRST. International migration of these skilled personnel unwittingly becomes an economic development strategy for Asian countries, as can be seen in the case of Taiwan, where the majority of the early-technology firms were started by returnees, mainly from the USA. Why do Asian students choose the USA? First, professional education, especially at the graduate school level in science, engineering and management is superior compared to Europe and elsewhere. Second, entrance into American colleges follows a time-tested routine of taking TOEFLs, SATs, GREs, GMATs, etc., all in English, and the relatively easy access to visas, until 2001, made the US an easy choice. Third, in most disciplines preferred by East Asians, there are plentiful scholarships and assistantships and the chance of securing employment and permanent residency in the USA is also significantly rosier than for other countries. According to National Science Foundation (NSF) Science and Engineering Indicators (2000), the stock in 1997 of immigrant science and engineering degree holders showed that five of the top eight spots were HRST of Asian origin: India (12 per cent), China (9 per cent), the Philippines (6 per cent), Germany (6 per cent), the UK (5 per cent), Canada (5 per cent), Taiwan (5 per cent), and South Korea (4 per cent). The dominance of Asians was at a much higher level (10.3 per cent) when the 42,705 doctorates conferred in 1997 were broken down by ethnic groups.6 The numbers are especially high for engineering (21.5 per cent), physical sciences (15.0 per cent), life sciences (16.3 per cent) and business and management (10.2 per cent). Historically, Asian foreign students in the USA grew tenfold in the twenty-five years 1955–80. Another point worth noting is that IIE Open Doors reports reveal that since the mid-1980s China and Taiwan

202 International HRST Mobility, FDI and Economic Development in Asia

dispatched disproportionately more graduate students, mostly in hard sciences and engineering disciplines, than other Asian countries. This general trend did not change until the 1990s when India and Japan began to join China and Taiwan in the front-runner position. There may be many economic reasons for the predominance of East Asians, especially ethnic Chinese, in the pursuit of higher education, but one socio-cultural reason stands out. China invented the world’s first comprehensive and systematic civil service examinations some 1,400 years ago in order to recruit the best brains for the needs of civil administration. Recruitment based solely on competitive written examinations was first introduced during the Sui Dynasty (AD 581–618) and became established during the Tang Dynasty (AD 618–906). Confucian values that glorify learning at the highest level7 benefited the Chinese just as the Talmudic tradition served the Jews in Europe – by providing a cultural predisposition towards scholarship and intellectual pursuits. The East Asian preference is also popular among other countries steeped in the Confucian tradition such as Taiwan, China, Hong Kong, South Korea and Japan. Large contingents of Asian students by the late 1980s thus began to return as a ‘brain gain’ to their own homelands. The economic miracle of the ‘Four Little Dragons’ of East Asia – Hong Kong, Singapore, Taiwan and South Korea – was largely due to this ‘reverse flow’. Taiwan boasted of its unique ‘PhD Cabinet’ and Singapore flaunted its efficient ‘technocrats’ (Yip 2003).

3

Migration of HRST

This international migration of highly skilled workers has become an important topic for study in developed as well as developing countries. HRST is now a widely accepted term for personnel identified on the basis of the International Standard Classification of Occupations (ISCO) and the 1995 OECD Canberra Manual. The OECD countries have monitored human resources through its Working Party on Migration and some of the OECD’s latest findings in statistics and policies are used in this chapter. The other important sources of data are the US NSF and its Scientists and Engineers’ Statistical Data System (SESTAT) and the annual IIE Open Doors survey data. Precise numbers on student flows and HRST migration are inherently difficult to come by. Unlike their unskilled counterparts, skilled professionals are typically mobile in domicile and occupation, and may even hold multiple passports and nationalities. It is not a straight emigration–immigration issue as with the older immigrant groups before the Second World War, when migrants were generations of people who sailed across oceans in ships and lived and died in their new home abroad. In today’s world of migration by jet plane, how do we classify an ethnic Chinese born in Hong Kong who was educated first in Taiwan and then the USA, worked in Silicon Valley and now

Vincent F. Yip 203

finds himself running a silicon chip foundry in Shanghai? Or an Indian citizen who came to the USA on a H1B visa, received his American ‘green card’ and now works in the software industry in Singapore? What about a Jewish–American academic who holds dual Israel/US citizenships and also joint academic appointments in both countries? To keep track of the complete picture would demand a forensic accounting study of immigration statistics, population censuses, foreign student numbers, labour surveys and TNC employment data. Such a static picture is not achievable and is certainly not a realistic depiction of the present fluid situation of ‘brain circulation’.

4

HRST complements FDI

A fundamental motivation for the spread and growth of FDI, a large proportion of which is invested by the 64,000 TNCs, is to locate in countries that access new markets and low-cost resources. As more and more TNCs have businesses in technological fields, the human resources needed are no longer of the assembly or blue-collar type, but rather HRST. The World Investment Report 2003, for example, showed a growing shift of industrial composition of FDI towards certain sectors, and among the top seven categories were telecommunications, petroleum, gas and related, pharmaceuticals and chemicals, electrical and electronics, and financial service (UNCTAD 2003). As indicated in the Introduction to this chapter, it is not our purpose to fix a definitive and mathematical causal relationship at this juncture. The aim is to identify a correlation and complementarity between the mobility of HRST and FDI and the economic consequences for developing economies, discuss the relevant issues and look deeper in some case study economies in Asia. A general comparison, the 2002 World Bank estimates for FDI inflows for regions of developing countries were (billion): East, South and South East Asia $57; Latin America $42; the Middle East $3. The corresponding foreign student figures from IIE for the US school year 2001–2 show a similar ranking: Asia 324,812; Latin America 68,358; the Middle East 38,545. We choose to examine the Asian economies of India, China, Taiwan, Hong Kong and Singapore because their economic vibrancy and rapid development permits comparison and correlation compared to other slower-growth Asian countries. The relatively stagnant Middle Eastern and Latin American economies are not popular sources of HRST emigrants. For host nations, we shall concentrate on mainly the USA (and also mention Canada, Australia and the UK), which keep credible figures on foreign student populations and have active S&T employment opportunities. While countries such as Japan, France and Germany may also be large hosts of foreign students and HRST, their composition is not as diverse and international, partly because of special language requirements and the pull from a colonial past or a traditional connection with only a few select sending sources.

204 International HRST Mobility, FDI and Economic Development in Asia

The following three anecdotal cases serve as evidence of the concrete connection between returned HRST and FDI investments and technology transfer: (1) Shanghai-born and MIT-educated Dr Morris Chang returned to Taiwan in the 1980s to build up the Taiwan Semiconductor Manufacturing Company (TSMC) as the largest microchip foundry in the world. (2) Dr B. J. Habibie received his PhD in Germany and utilized his connection with the German aircraft giant MBB to transfer manufacturing technology to Indonesia in the years prior to the downfall of the Suharto government, in which he served as Minister for S&T. (3) Hong Kong-born, Stanfordeducated cancer specialist Dr Edison Liu was recruited in 2001 by the Singapore government to head its new Genome Institute and its ambitious multi-million dollar research programme. Indeed, it is only logical that technology investments and R&D in developing nations should be connected through persons knowledgeable in that field as well as familiar with the nuances of operation in both countries and cultures; as such, returned students and HRST fit the job perfectly. In Asia and the Pacific, the top ten economies for FDI in 2001 (World Investment Report 2003) are listed in Table 11.1, together with the number of students enrolled in the USA in school year 2000–1 (data from IEE, Open Doors 2000–1 survey). As a further contrast, four of the Asian countries with the lowest FDIs are listed in Table 11.2 with their student numbers. These comparisons show that there is undeniably a complementarity between FDI inflows and number of students a developing Asian country sends abroad (to the USA) in that for high- or low-FDI countries, the number of students per $million FDI is around 1–4. The only exceptions were: (1) Urban states such as Singapore and Hong Kong historically succeed in attracting very high FDI for their populations, thus lowering the average student number.

Table 11.1 Correlation between FDI and foreign student enrolment in the USA, 2001

1 2 3 4 5 6 7 8 9 10

China Hong Kong Singapore India Malaysia Kazakhstan S. Korea Taiwan Vietnam Philippines

2001 FDI ($million)

2000–1 Students in USA

Students per $million FDI

46,846.0 22,834.3 8,608.8 3,403.0 553.9 2,759.7 3,198.0 4,109.0 1,300.0 1,792.0

59,939 7,627 4,166 54,664 7,795 540 45,685 28,566 2,022 3,139

1.279 0.334 0.484 16.063 14.073 0.196 16.554 6.952 1.555 1.752

Vincent F. Yip 205

(2) India and Sri Lanka traditionally send many students abroad regardless of their low FDI. (3) Malaysia suffered an artificially depressed FDI for 2001 due to the political crisis. (4) Kazakhstan’s huge FDI is mainly energy-related heavy industry with little direct relevance to foreign studies by students or emigrants. This correlation, while not numerically exact, confirms the belief that the number of foreign students sent abroad by a developing Asian economy can directly or indirectly reflect its FDI inflows. International skills migration has always been driven by ‘push’ and ‘pull’ factors. In the twentieth century, migrations of the top scientific minds in Europe, many of Jewish origin, were determined by wars and conflicts. In the late twentieth and early twenty-first century demand for IT specialist in OECD countries and the USA became great ‘pull’ factors which lured tens of thousands of students and HRST from East and South Asian countries, Ireland, Israel, Russia and the former Eastern Bloc countries. However, what was once stated as a ‘brain drain’ problem for the source nations, has in some cases become a ‘brain gain’ as Taiwan, South Korea and now India and China benefit from returned HRST who bring back with them skills, contacts and capital. There is now talk of a phenomenon of ‘brain circulation’, as these international HRSTs shuttle among source and host countries and even third countries. Research, mostly from the USA and Canada, has stressed that the presence of many foreign HRST bestows significant benefits to receiving (and in some cases, sending) countries (Stephan and Levin 1999; Zhao 2000). International migration of skilled workers, especially HRST, is no longer a zero-sum game.8 Mallampally and Sauvant IMF (1999) have shown that FDI plays a pivotal role in economic growth of developing countries, and the principal determinants affecting the choice of foreign TNC investors can be classified under the motives of seeking markets, resource–assets or efficiency. Under resource–assets are ‘technological, innovative, and other assists as embodied in individuals, firms and clusters’, which definitely refer to the availability of creative HRST, dynamic companies and science park clusters. Specialists Table 11.2 Low-FDI Asian Countries, Student numbers, 2001 2001 FDI ($million) Myanmar Cambodia Sri Lanka Laos

192 148 82 24

2000–1 Students in USA 673 187 1,964 96

Students per $million FDI 3.505 1.26 23.951 4.000

206 International HRST Mobility, FDI and Economic Development in Asia

at the OECD Directorate for Science and Technology and Industry (Guellec and Cervantes 2001) have indicated that FDI would theoretically either substitute or complement international mobility, that is TNCs would set up facilities abroad to use local cheaper labour instead of importing foreign unskilled workers for establishments in their home countries, or could be attracted to establish high-tech factories or R&D centre abroad to utilize the unique HRST, skills and creativity available in those countries. Physical capital and skills go hand in hand, so one can thus also conclude that FDI and the international transfer of HRST can be seen as complementary. Several TNCs have set up R&D centres in Israel and Hewlett-Packard has founded a 1,000-person software centre in Shanghai. US-educated HRST almost always play pivotal roles in these establishments.

5

HRST and Silicon Valley

Entrepreneurs in technology are ‘high-end’ migrants who channel their skills and capital back and forth between nations. The effect of Asian HRST on FDI inflows from their host countries (especially the USA) back to their sending source can be seen by the activities of Asian venture capital in Silicon Valley. The San Jose Mercury News (2001) quoted industry sources as estimating that there were dozens of such firms in Silicon Valley-31 from Taiwan alone, and others from Japan, Hong Kong, Singapore and Malaysia. The Indian subcontinent is represented not by official venture funds dedicated to India but by private financiers who help to see firms through the initial ‘seed-corn’ stage. As expected, much of the investment is used to fund nascent companies in IT, software, and semiconductors. The Taipei-based InvesStar Capital and Walden International, which started with Singapore and US funds, are just two of the more prominent venture capital funds that operated on both sides of the Pacific and were founded by Asian HRST professionals. In a landmark Public Policy Institute of California (PPIC) study (Saxenian 1999), research yielded figures which showed that in 1998 immigrant Chinese and Indians were running a quarter of Silicon Valley’s high-tech businesses and accounted for $16.8 billion in sales and 58,000 jobs. There is the popular saying that ‘Silicon Valley is made up of ICs’ (not Integrated Circuits, but Indians–Chinese). In an updated study (Saxenian 2002) using the 2000 California Census, Saxenian found that the figures had improved to 29 per cent of Silicon Valley’s technology businesses worth $19.5 billion in sales and 72,839 jobs. What was once a ‘brain drain’ situation had turned into a ‘brain circulation’ where international migration of high-skilled professionals benefits all countries, whether sending or recipient. In detailed case studies of how the international movement of HRST can effect enormous economic and social-political changes, we analyse the HRST scene in three prominent economies – the return flow of HRST to Taiwan and

Vincent F. Yip 207

now mainland China; the Indian diaspora and its impact on the Indian software industry; and the efforts of Singapore in mustering international and local HRST to build a prosperous Island State built on IT and technology (Sections 6–9).

6

Taiwan and the Hsinchu Science Park (HSIP)

For Taiwan, the 1960s–early 1980s was a serious period of ‘brain drain’ when thousands of top HRST went abroad (almost exclusively to the USA) for study or S&T jobs, and the return rate was considerably below 20 per cent. Starting in the late 1970s, Taiwan strongly began to promote high-technology based industries, specifically focusing on the Hsinchu Science-Based Industrial Park (HSIP), established 75 miles outside Taipei City near the Chiang Kai Shek International Airport. The majority of the electronics, automation, software and biotechnology companies and their entrepreneurs were tied in some way to US sources. The Taiwan ‘economic miracle’ of the 1970s–1980s was in no small way attributable to these returnee managers, engineers, entrepreneurs and ‘technocrats’, mostly from Silicon Valley or the Los Angeles area. The return rate of students steadily rose to a remarkable 32.2 per cent in 1988 (Su 1995). The influence of foreign returnees actually went beyond the sphere of S&T and investment into the political arena. In the new Taiwan Cabinet announced in early 1989, thirteen of the fourteen members had received their highest degree overseas, especially in the USA. Yip (2003) pointed out that ten out of the fourteen had doctorates, mostly from the USA, thus earning the name of the ‘PhD Cabinet’. By the 1990s, many ethnic Chinese engineers, entrepreneurs and businessmen were truly ‘circulating’9 among California, Hong Kong, Taiwan, and the increasingly open technology circles of coastal Chinese cities such as Shenzhen, Shanghai and Beijing. The rapid growth of returnee HRST not only changed the structure of human resources but also the investment profiles inside Taiwan’s IT industry, and this phenomenon is best represented in HSIP statistics. In 1984, all the PhD employees in HSIP were foreigners, but by 2000 the foreign PhD figure of 550 was complemented by 478 locally educated PhDs, demonstrating the rise of quality education in Taiwan higher institutions. According to the HSIP Annual Report 2000–2001, the actual capital investments of 113 returnee companies in 2000 was an astounding 202 billion NTD (or about 8 billion USD).

7

The Grand Dragon – China

Since the early 1990s, the economic, technological and sociological links between Taiwan and the Mainland of China have grown significantly. Even though it harboured an inward-looking civilization for 5,000 years, the legendary ‘Silk Road’ was in essence an ancient avenue for two-way transfer of investments and technology between China and the East with the West. In

208 International HRST Mobility, FDI and Economic Development in Asia

more modern times, Japan’s post-Second World War industrialization was strongly helped by returnees, and China’s atomic and space programmes owed their gestation to US-trained scholars driven home by the McCarthyism of America in the 1950s. Collecting reliable data from China has always been a daunting task owing to the large land mass, huge population, inefficient infrastructure and inadequate statistical framework. Prior to the ‘open door’ policy after 1989 led by Deng Xiao Ping, tight socialist control of all official statistics meant that data on movements of HRST and their economic consequences were either incomplete or inaccurate. China’s official Statistical Yearbook 2000 listed (for 1999) only 23,749 students studying overseas and the number returning a very high 7,748, even though it is obvious that the actual figure that left was many times higher and the return rate much lower. Zhang and Li (2001) were among the first researchers to use data from the Ministry of Public Security (MPS) and its Bureau of Entry–Exit Permit Management (BEEM) and they came up with a much more credible figure of 80,000 studying abroad and only a small percentage of 9,526 returning. From decades of sending tens of thousands abroad, especially to the USA, the cumulative figure of Chinese students in the USA is estimated to be an amazing 300,000. It is often quoted that 200,000 HRST, which each cost China at least 200,000 RMB ($24,000) to educate, amounted to a 40 billion RMB human capital loss for China, and they are often referred to as the ‘largest gift from China to the USA’. Most students who go abroad are now of the ‘self-supported’ type instead of those traditionally sent by the government or work units, and thus the outflow of foreign currency is very high, on top of the loss of human capital. In the highly sought-after discipline of electrical engineering more than 90 per cent of every graduating BSEE class of the top Qinghua University in Beijing will leave the country for greener pastures in the USA, Australia and the EU. The massive drain of China’s best and brightest HRST lasted throughout the 1980s, and peaked after the June 1989 Tiananmen-Square unrest and its clampdown, which subsequently produced a political climate unconducive to convincing Chinese émigrés to return. Zweig and Chen (1995) conducted a thorough and revealing study by interviewing 267 students in the USA with a 105-question questionnaire and counted a high 32.7 per cent as definitely intending to return to China. Most-cited reasons for returning were ‘higher social status’, 26.0 per cent, ‘better career opportunities in China’, 17.3 per cent and ‘patriotism’, 17.3 per cent. Events then took a rapid turn for the better when China’s economic growth under the Jiang–Zhu government accelerated to 7 per cent annual GDP growth from 1994–2002. The introduction of modern telecoms and IT infrastructure throughout China and the rapid influx of FDI fuelled demand for HRST back home. Beijing’s Haidian Experimental Zone took a leaf from HSIP and prospered into a minicity of high-tech establishments and R&D. TNCs such as Hewlett-Packard,

Vincent F. Yip 209

Motorola, VW and Janssen Pharmaceuticals maintained highly profitable operations in Chinese cities and many Taiwan-funded semiconductors operations left California and Taiwan for vicinity of Shanghai and its suburbs. The slogan among top HRST and businessmen in Taipei and their ethnic Chinese counterparts in California was to ‘go West’ – that is, west to Shanghai and the Yangtze Delta area. With China emerging as an economic and political giant on the world stage, the main ‘pull’ factor influencing their return was the much larger role they could play in China than remaining in USA. The pace of ‘brain circulation’ has been further expedited by the rapid digitization of the Chinese economy and the China’s accession to the WTO. Studies on e-commerce in China (Efendioglu and Yip 2003) showed that younger and better-educated Chinese were increasingly connected to the Internet and they made e-purchases, although not at the same frequency as their Western counterparts. Impending increased technology transfer and FDI in fields such as consulting, automotive, civil aviation, pharmaceuticals, telecoms, banking and finance post-WTO entry will only fuel the active demand for foreign-educated HRST to return and serve in the huge China market. In the People’s Daily, Overseas edn, a government report stated that (28 September 2003), China has officially sent 580,000 students overseas since 1978, and 150,000 have returned. The return rate is increasing by an annual rate of 13 per cent because of the poor economic outlook around the world in contrast with the rapid growth in China. China has now outperformed Taiwan’s ‘returnee miracle’ of the three decades of 1960–1999, in the few years 1995–2000. In late 2002, the newly appointed President of China Hu Jing Tao, had Politburo of nine members, all except one being technical graduates of China’s top universities. Pundits believe that by 2020 or so returnees from overseas, especially from the USA, will be among those governing China.

8

The Indian diasporas

As a large nation with ancient history and long association with the West, especially the UK, India has always been a net exporter of skilled labour to Europe and the USA. From the 1930s until the mid-1970s, India saw many top scientists, engineers and doctors leave for the UK, the USA, Europe and Australia. The mid-1970s until mid-1980s was a special era when many skilled Indians went to the oil-rich Middle Eastern States. Then came the massive Indian HRST diaspora, built on a combination of English-language and software skills, to the USA, the UK, Canada, Germany, Australia and Singapore. While not from the crucible of Confucian cultures, Indians nevertheless adopt a form of ‘Asiatic Calvinism’ (Kotkin 1993) with a common ethos of thrift, a work ethic and devotion to enterprise and intellectual pursuits.

210 International HRST Mobility, FDI and Economic Development in Asia

India emerged since the mid-1990s as leading software powerhouse, its IT industry accounting for revenues of USD 8.67 billion in 1999–2000, while maintaining a spectacular compound annual growth rate (CAGR) of 42.4 per cent over the five years 1995–2000. According to Dataquest, Indian software exports in 1997–8 were to the USA (65 per cent), the UK (10 per cent), other Europe (10 per cent), Japan (5 per cent) and other countries (10 per cent), and Indian HRST emigration was proportionate to these destinations. Nayyar (1994) has made the interesting deduction that net private transfer of currencies back to India can be correlated to the number of Indian immigrants to the countries using these currencies. Gayathri (2001) of the ILO further noted that while remittance of non-dollar currencies rose marginally from 1994–5, transfers of USD back to India increased threefold (from 73,228 million INR to 225,393 million INR) coinciding with the massive movement of H1B and other HRST workers into the American West Coast during the beginning of the ‘dotcom boom’. Ironically, the 11 September attacks actually speeded up some transfer of US operations and the associated FDI to India, and activities now span the entire technology spectrum of code-writing, product development, call centres, chip design, financial services, tele-marketing, consulting and other support services. India has become the ‘back office of the world’ just as China has emerged as the ‘factory of the world’. The intimate relationship between the very mobile software engineers and high-tech development in India is sometimes compared and contrasted with two other non-Asian countries, Ireland and Israel (Kapur and McHale 2003), which are the closest similar case studies. Perhaps the best-known studies of Indian engineers and entrepreneurs in the Silicon Valley IT industries were those by Saxenian (1999, 2002). In addition, Kapur (2002) estimated that 38 per cent of Indians between aged 18 and 64 had a graduate degree compared to 9 per cent of the US-born population; 37 per cent of these 18–64year-old Indians made more than 200 per cent of the US-born median income of $23,925 in 2001. At the peak of the H1B visa boom of 1999, 55,047 H1B visas were granted to Indians, mostly for work in software and engineering in the USA, compared to only 6,665 for China and 5,779 for Japan. While India still suffers from a net drain in its HRST, in recent years Nonresident Indians (NRI) have increasingly played an important role in putting software FDI back in India, especially the cities of Bombay, New Delhi and Bangalore. The Indus Entrepreneur (TIE) was first started by NRI as a business network group in the Silicon Valley, and new branches were subsequently established in Southern India and England. In January 2003, the Indian government and the Federation of Indian Chambers of Commerce and Industry organized the first global meeting of NRI, which attracted 2000 diaspora Indians from sixty-three countries to New Delhi. In 2001, then Prime Minister Vajpayee announced that legislation was to be passed to grant dual

Vincent F. Yip 211

citizenship to NRI living in the US, the UK, Australia, New Zealand, Canada, and Singapore. The government also implemented policies which would benefit venture capital FDI inflows as well outflows. However, a McKinsey report (New York Times, 11 January 2003) noted that while 20 million Indians living abroad generated an annual income equal to 35 per cent of India’s GDP, their FDI in India was only $1 billion compared to the staggering $60 billion invested by the 55 million overseas Chinese. Indian immigration to Australia dates back to the early nineteenth century, but the level was relatively low compared to other Asian immigrants such as those from Hong Kong, China, Vietnam, Malaysia and Singapore. The number of Indian immigrants rose steadily after Australia’s restrictive immigration policy was relaxed in 1966, and by 2001 the Australian Bureau of Statistics Census of Population and House put the number of Indians as 156,600, or 0.9 per cent of the total population. In contrast, the traditional immigration of Indians and other South Asians into the UK had been significant Indian Independence, and in the 1990s there was a further surge of IT-fuelled immigration at least proportionate to the Indian population already residing in the UK. Increasing number of Indian immigrants had gone to Canada – the 1996 Canadian Census placed India as the third largest sending origin behind Hong Kong and China – and most are in engineering and software employment. China and India have always been compared as two IT powerhouse, each with its own pros and cons. India has distinctive advantage of linguistic skills and a better legal framework, but suffers from poor infrastructure and bureaucratic red tape and corruption. China, on the other hand, has a superb infrastructure in its coastal cities, and strong government support and the largest influx of FDI of any developing country. Barring any destructive political upheaval India will have to content to play second fiddle to China in the global technology race, especially in non-software arenas. In 2002, China attracted $40 billion in FDI, or seven times by India, and it accounted for 3.2 per cent of its GDP compared to 1.1 per cent for India (UNCTAD 2003). Foreign affiliates now account for more than 50 per cent of China’s exports, and greater than 90 per cent in some high-tech areas such as ICs and mobile phones. UNCTAD (2003) made a special comparison to explain the difference in FDI performance between China and India (Table 11.3). UNCTAD (1993) also made special mention, unusual in official NGO publications, of the fact that China’s larger FDI flows were partly due to it being the destination of choice for the large number of overseas Chinese business networks and family connections ( guanxi). World Bank’s World Development Indicators (WDI) report of 2001 showed that the development path of China and India has widened in the past two decades and China’s per cepita GDP was rated as US$ 911 versus India’s $ 462, and that China boasts of 24,222,000 PCs compared with India’s mere 6,301,000.

212 International HRST Mobility, FDI and Economic Development in Asia Table 11.3 China and India: selected FDI indicators, 1999–2001 Item

Country

1999

2000

2001

FDI inflows ($million)

China India

3,487 379

40,772 4,029

46,846 6,131

Inward FDI stock ($million)

China India

24,762 1,961

348,346 29,876

395,192 36,007

FDI stock as percentage of GDP (%)

China India

7.0 0.6

32.3 6.5

33.2 7.4

Share of foreign affiliates in total exports

China India

12.6 4.5

47.9 n.a.

50.0 n.a.

GDP ($billion) in current prices

China India

388 311

1,080 463

1,159.1 484

Real GDP growth (per cent)

China India

3.8 6.0

8.0 5.4

7.3 4.2

Note: n.a. – Not available. Source: UNCTAD (2003).

9

The ‘foreign talent’ debate in Singapore

The small island state of Singapore presents an interesting contrast with India and China. Singapore has always relied on imported human resources for its development – the first immigrants were Chinese, Malays, Arabs, Jews, Armenians and Europeans. Immigration of Chinese, now comprising 76 per cent of its 4 million population, was recorded as far back as 1881 (Pan 1998), and key issues have been well documented by various authors and books. For Singapore, the ‘brain drain’ problem is especially acute, as the stability of the tip of the manpower pyramid (normally 5 per cent of a society’s population) is a matter of survival, not just quality of life. By the late 1980s, then Prime Minister Lee Kuan Yew noted that Singaporeans (mostly capable intellectuals and skilled workers) were emigrating to the West especially Australia, New Zealand, the USA and Canada at the same rate as the people of Hong Kong suffering the aftermath of the 4 June student unrest at Tiananmen Square and the spectre of an eventual communist takeover. The Singapore government began to push an official global ‘foreign talent’ search, for any and all nationality that was willing to come to live in and serve Singapore. The targets were no longer ethnic Chinese engineers and MBAs but included, for example, London bankers, American CEOs, Mainland Chinese nurses and sportsmen and Indian entrepreneurs and software engineers. Singapore’s Prime Minister Goh Chok Tong declared (Straits Times, 18 October 1997) that the nation had a vision of becoming an ‘oasis of talent, serving as a hub for business, talent, knowledge and information, with global networks linking the world’s three economic growth engines of Asia, Europe and the

Vincent F. Yip 213

Americas’. Singapore – once dubbed ‘the Intelligent Island’ by international media for its IT pervasiveness – is arguably the best host country for any foreign HRST in search of a good paying and challenging job in a secure environment. For decades, Singapore was able to conduct a steadfastly pro-FDI industrial policy and attracted disproportionately high amounts of FDI until China came into the picture in the early 1990s. Even in the recession year of 2002, Singapore attracted FDI inflows of $7.7 billion, ranking third behind China and Hong Kong. Wong (2001) detailed the government’s intervention in the Singapore labour market and noted that in 1994 there were 300,000 foreign workers employed in the economy and in 1995, 24 per cent of the IT professionals were non-Singaporeans. After 2001 there was a slowdown in the recruitment of ‘foreign talent’, corresponding to the onset of difficult economic times. In 2020 or so, a combination of geopolitical factors may mean that Singapore would have lost most of its present competitive advantages in the international talent race – desirable living conditions, a Western and Englishspeaking environment, high remuneration and a vibrant market – to Hong Kong, Shenzhen, Beijing and Shanghai, for example. Especially compared to a huge HR magnet such as China, by then perhaps the only two remaining attractions for HRST to migrate to Singapore will be the unique multi-racial and multi-cultural environment, and an efficient pro-Western government free of Cold-War type international politics.

10

Summary and observations

Global FDI has grown at a rapid rate since the 1970s, and developing countries (especially in East Asia) are becoming favoured destinations because they satisfy TNCs’ motives in seeking markets, resources or efficiency. By the late 1970s Japan has already emerged as a developed international industrial power, and the economic miracle of the ‘Asian Tigers’ followed in the 1980s. The ‘Asian boom’ coincided with the largest tide of foreign students yet sent from India, Taiwan, Japan, Hong Kong and South Korea to developed countries, especially the USA. In 1989, the fall of the Berlin Wall precipitated the collapse of the Eastern Bloc, ending the Cold War and shifting world attention away from Europe. The 1990s saw the economic and political prowess of Asia, especially India and China, again complemented by large contingents of students sent for further studies, almost exclusively in the hard sciences and professional fields. When and if these students return as experienced HRST, they serve as effective ‘bridges’ between sending and host nations in technology transfer and investment flows. The international movement of students/HRST from developing countries, using mostly Asian economies as case examples, is seen to mirror the flow of FDI since the 1980s. As IT and technology sectors become even more

214 International HRST Mobility, FDI and Economic Development in Asia

important constituents of Asian economies, the role played by Westerntrained HRST will be crucial, as bilateral relationships of East Asia–USA and East Asia–Europe become important considerations. In today’s world, HRST has become a major determinant of FDI and economic development, ranking high among other traditional factors such as natural resources, capital, markets and infrastructure. Talent is the name of the game in the twentyfirst century. Notes 1. See, for example, Proceedings of the OECD Meeting on ‘FDI, Human Capital and Education in Developing Countries’, Paris, OECD, 13–14 December 2001. 2. See, for example, Fortune, ‘Going Home: Asia’s Bright Businessmen Are Returning From the West’, 13 May 1985. 3. OECD statistics show, for example, that in the German adult population 35.0 per cent with upper secondary education and 15.2 per cent with tertiary education were foreigners, whereas in the USA the corresponding numbers were 24.1 per cent secondary and 40.9 per cent tertiary (see Guellec and Cervantes 2003). 4. See, for example, Chronicle of Higher Education, 26 October 2001. 5. In 1998 statistics on foreign students in OECD countries, out of 1,000 students enrolled, Germany had 81.6 foreign students, out of which 27 per cent were from EU countries and only 43.7 per cent were from non-OECD countries, whereas the USA had 32.4 foreign students out of 1,000, 61 per cent from non-OECD countries and only 9.5 per cent from EU countries. 6. See Chronicle of Higher Education, 8 January 1999. 7. A popular Chinese saying, ‘wan wu jie xia pin, wei you du shu gao’ actually implies that every profession is inferior when compared to the noble practice of scholarly learning. 8. A closer look at the background of Nobel Prize winners holding US citizenship will show that many of these top HRST were born in foreign countries and their work actually benefited both sending and host countries. Asian-born laureates who did their work in the USA included Yang and Lee (China, Physics, 1957), Salem (Pakistan, Physics, 1979), Esaki ( Japan, Physics, 1973), Chandrasekhar (India, Physics, 1983). However, the fact that two recent Japanese laureates Koshiba (Chemistry, 2002) and Tanaka (Physics, 2002) were home-bred researchers shows that Asian countries can mature to a stage where award-winning scientific work can be done away and independent from developed Western countries. 9. By the early 1990s, the Chinese phrase ‘tai kong ren’ (‘astronauts’) was coined to represent a new generation of Chinese HRST who spend most of their time ‘flying’ in mid air in the Pacific to facilitate technology transfer and investments.

References Addison, T. and Heshmati, A., ‘The New Global Determinants of FDI Flows to Developing Countries’, UNU/WIDER Conference on the New Economy in Development, 10–11 May 2003, Helsinki. Cervantes, M. and Guellec, D., ‘The Brain Drain: Old Myths, New Realities’, OECD Observer, 7 May 2002. Efendioglu, A. and Yip, V., 2003, ‘Technology and Culture: E-Commerce in China’, Chapter in H.S. Kehal and V.P. Singh (eds), The Digital Economy: Impact, Influences, and Challenges, New York, Idea Group Publishing.

Vincent F. Yip 215 Gayathri, V., ‘Rethinking High-Skilled International Migration: Research and Policy Issues for India’s Information Economy’, OECD Proceedings of the Paris Conference on International Mobility of the Highly Skilled, Paris, OECD, 2001, 208–10. Guellec, D. and Cervantes, M., ‘International Mobility of Highly Skilled Workers: From Statistical Analysis to Policy Formulation’, OECD Proceedings of the Paris Conference on International Mobility of the Highly Skilled, Paris, OECD, 2001, 71–98. ———— ‘International Mobility of Highly Skilled Workers: From Statistical Analysis to Policy Formulation’, OECD Proceedings of the Paris Conference on International Mobility of the Highly Skilled, Paris, OECD, 2002. Kapur, D., ‘Diasporas and Technology Transfer’, Journal of Human Development, 2(2), 2002, 265–86. Kapur, D. and McHale, J., ‘Sojourns and Software: Internationally Mobile Human Capital and High-Tech Industry Development in India, Ireland, and Israel’, in A. Arora and A. Gambardella (eds), Software in Emerging Nations, 2003. Kotkin, J., ‘Tribes – How Race, Religion, and Identity Determine Success in the New Global Economy’, New York, Random House, 1993, 99–101. Mallampally, P. and Sauvant, K.P., ‘Foreign Direct Investment in Developing Countries’, Finance & Development, 36(1), 1999. Nayyar, D., ‘Migration, Remittances and Capital Flows: The Indian Experience’, New Delhi, Oxford University Press, 1994. Noorbakahsh, F., Poloni, A. and Youssef, A., ‘Human Capital and FDI Inflows to Developing Countries: New Empirical Evidence’, World Development, 29(9), 2001, 1593–1610. Pan, L. (ed.), The Encyclopedia of the Chinese Overseas Chinese, Washington, DC, American Association for the Achievement of Science, 1998. Papademetriou, D. and Martin, P. ‘Migration and Development: A Review of the Evidence’, in D. Papademetriou and P. Martin (eds), Migration and Development: The Unsettled Relationship, Greenwood Press, 1991, 1213–14. Saggi, K., ‘Trade, Foreign Direct Investment, and International Technology Transfer: A Survey’, Background Paper for the World Bank ‘Microfoundations of International Technology Diffusion’ Research Project, 2003. Saxenian, A., Silicon Valley’s New Immigrant Entrepreneurs, Public Policy Institute of California, San Francisco, California, 1999. ———— ‘Local and Global Networks of Immigrant Professionals in Silicon Valley’, report published in 2002 by the Public Policy Institute of California, San Francisco, California, 2002. Stephan, P.E. and Levin, S.G., ‘Exceptional Contributions to US Science by the Foreign-Born and Foreign-Educated’, Science, 285(5431), 1999. Su, J.C., ‘The Return of Overseas Professionals and Its Impact on the Technology Acquisition of Hi-tech Industries in the Hsinchu Science Industrial Park’, unpublished thesis, National Central University, Taiwan, 1995. Tremblay, K., ‘Student Mobility Between and Towards OECD Countries: A Comparative Analysis’, International Mobility of the Highly Skilled, Paris, OECD, 2003. UNCTAD, World Investment Report, 1998. ———— World Investment Report, 2003. Wong, Poh-Kam and Chee-Yuen Ng, ‘Industrial Policy, Innovation and Economic Growth: The Experience of Japan and the Asian NIEs’, Singapore University Press, 2001. Yip, V., The Talent War in Asia, Taipei Tsaiku Human Resource Publishing Company, 2003, 175–6 (in Chinese).

216 International HRST Mobility, FDI and Economic Development in Asia Zhang, G. and Li, W., ‘International Mobility of China’s Resources in Science and Technology and Its Impact’, OECD Proceedings of the Paris Conference on International Mobility of the Highly Skilled, 2001, 189–94. Zhao, J., ‘Brain Drain and Brain Gain: The Migration of Knowledge Workers from and to Canada’, Education Quarterly Review, 3, 2000, 8–35. Zweig, D. and Chen, C., China’s Brain Drain to the United States – Views of Overseas Chinese Students and Scholars in the 1990s, Berkeley, CA, The Institute of East Asian Studies, 1995.

Index Accumulation 6, 12, 14, 22, 154, 162, 163, 199 Africa 12, 96, 198, 199 Andhra Pradesh 164 Austrian Credit-Anstalt 12 B2B networks 155 Bandwidth costs 157 Bickerdike theorem 15 Border economic cooperation areas 51 Borderlands 2 Brazil 36, 42, 96, 103, 153, 155, 172, 173 Bridge 34, 156, 160, 181 Buffer zones 2 Business models 155, 156, 165 Business solutions 155 Capital inflow 162 Casual relationship 161, 198, 199 Cellular mobile 158, 159 Chandigarh 164 China 172, 173, 179, 184–216 Classical models 154 Cold War 213 Colonization 8 Commercial establishments 156 Communications 50, 108, 116, 160, 198 Community 156 Comparative advantage 41, 49, 52, 53, 60, 74, 78, 152, 182 Competition 42, 44, 74, 78, 94, 112, 114, 124, 144, 154–9, 169, 202, 213 Competitive advantage 112, 156, 157, 159 Computer 83, 112, 115, 142, 144, 153, 156, 157, 165 Computer hardware 112, 156 Computer industry 112, 153 Connectivity 70, 74, 157, 163, 164 Consumer durables 7, 8, 12, 17, 20 Contracted FDI 43, 46, 50, 52, 53, 102 Consumer goods market 155

Convergence Bill, 2001 160 Creditor nations 1 Current-account exchange controls 13, 17, 18

6,

Dawes Plan 9, 11, 15 Defence 6, 9, 11–21, 158 Defence externality 6–18 Deng Xiaoping 51, 54, 56, 59, 101–2 Dependency 4, 13, 154 Dependency syndrome 154 De-regulating 160 Design 59, 90, 155, 160, 210 De-skilling 156 Determinants of foreign direct investment 98, 180 Developing economy 155 Developing nations 155, 198, 204 Developing world 153–4 Development 154–65 Development goals 153 Digital divide 153–65 Digital world 154 Digitalization 154, 156, 158, 160–6 Direction of India’s exports 157 Dishnet 158 Dominant-country reactions 12 Domestic investment 13–14, 17, 158, 161, 169, 187, 190 Duly regimes 159 E-commerce 114, 117, 132, 160, 209, 214 Economic reforms 35, 119–20, 132, 137 Economic Survey 165 Education 53, 61, 68, 70, 74, 88, 129, 153, 155, 160, 163, 199, 200–2, 207 Electronic-mail 158 Electronics 55–6, 71, 78–9, 107, 109, 112–13, 144–5, 150, 158, 160, 165, 203, 207 Emerging economies 154, 180–2, 184, 186–96

217

218 Index Emerging new technologies 158 End-users 157 Equity Joint Venture Law 64, 81 Europe 86, 108, 112, 121, 132, 154–7, 199–214 Exchange controls 6, 10–14, 16–21 Exchange rates 16, 20 Experimentation 49–50, 60 Export-driven model 156 Export-oriented FDI 49, 57, 70 Export-oriented labour-intensive products 49 Export upgrading 54 Externally imposed trade liberalization 5, 10 Extortionary domestic attacks 14 Foreign direct investment 23–41, 46, 101–2, 119, 137, 153–4, 168, 180, 198 Four Asian Tigers 2, 16–19 GDP 23, 39, 51, 57–8, 64–5, 80, 101–17, 156, 161–2, 170, 175–7 Germany 1–3, 13–19, 55, 96–7, 106, 121, 126, 200–4, 209 Global companies 157 Global IT industry 156 Global markets 54, 108, 158 Globalization 59, 70, 78, 98, 165, 184, 193 Globalized production 59 Government of India 158, 160, 168 Grants 75, 156 Growth miracle 2–4, 6, 13–14, 18–20 Gujarat 164 Health 68, 153–4, 153–64 Hegemony 5–6, 9, 13, 18–19 High-quality knowledge 159 High-tech parks 160 High-technology strategy 112–13, 117 Hong Kong 2, 13, 16, 49, 58, 66–8, 85, 96–7 103–6, 116, 120–1, 184, 199, 202–4 206–7, 211–13 Human capital 23–4, 57, 60–1, 134, 154, 161–3, 165, 183, 199, 208 Human development indicators 161 Human resource development 160

Human resources 70, 77, 88, 107, 116, 148, 159, 198–200, 202–3, 207, 212 Hyperinflation 6, 12 ICT 153–65 Ideology 4–5, 7, 9, 18, 22, 54 Illiteracy 11, 153–4 Index of Technology Adoption 139, 140, 142, 150 India 18–19, 23–4, 31, 41–2, 48, 57–60, 96–7, 137–8, 140–2, 146, 148, 153–65, 170–7, 184–200, 202–6, 209–15 Indian Wireless Act, 1933 160 Industrial upgrading 55 Information and communication technology 153, 198 Information gap 156 Information technology 24, 54, 109, 133, 153–4, 158, 160 Input industries 157 Intel 156 International Data Corporation (IDC) 156–7 International Monetary Fund (IMF) 10 International standards 147, 156 Internet 70, 114–17, 153–7, 159, 161, 165, 209 Internet access 159 Internet diffusion 157 Internet gaps 154 Internet hosts 154, 161 Internet Service Providers (ISPs) 157 Internet users 114–15, 157 IT revolution 112, 115, 153, 155 IT-enabled services 165 Karnataka 164–5 Keynes’ animal spirits 19 Korea 2, 13, 16–17, 23–4, 55, 67, 80, 85–6, 96–7, 107, 114, 159, 173, 199–202, 205, 213 Labour-abundant countries 163 Latin America 12, 18–19, 36, 199, 203 Law on Cooperative Ventures 49, 64 Law on Enterprises Operated Exclusively with foreign Capital 49, 64 League of Nations 10, 12 Leapfrog 153

Index 219 Least developed countries 154 Life cycle of a joint ventures 31 Linear statistical model 162 Local ICT skills 155 Local producers 155 Localization of management 138 Long-term national IT policy 159–60 Low-costs 33, 108, 110, 119, 157, 203 Maharashtra 164 Maitland Commission 153 Malaysia 23, 57, 71, 77, 80, 85, 96–7, 158–9, 173, 183–7, 199, 204–6, 211 Mantra Online 158 Military threats 9 Millennium Summit 86, 153 Ministry of Communication and Information technology 158, 160 Mobile Communication 116, 154, 158–9, 164–5, 188, 199–202, 210–1 MTNL 158 Multilateral Agreement on Investment (MAI) 71, 90, 92 Multimedia applications 160 Multinationals 79 NASSCOM 156–7, 163 National Action Plan on IT, 1998 158 National defence 13 National task force 159–60 National Telecommunication Policy, 1994 158 National tourist and resort areas 51 Networking 156–7 New investments 155 New technology 35, 40, 134 NIIT 156 Non-parametric tests 140 North America 26, 106, 155, 199 Nuclear weapons 2 Offshore IT services 157 Olympic-related economy 116 Open coastal cities 50 Open coastal economic areas/zones 50 Open door policy 48, 50–2, 54, 60, 64, 102, 116, 191, 208 Optimal (policies) 9 Orderly transfer 138 Outsourcing 157

Overvalued exchange rate 11, 17 Ownership advantages 138, 183 Paradigm, information 154 Paradigm, modernization 154 PC penetration 164 PC prices 164 People, rural 155 Peripherals 156–7 Perspectives 101–2, 104, 106, 108, 110, 112, 114–16, 153–4 Philippines 57, 71, 77, 80, 96, 97, 159, 183–7, 201 Physical controls 159 Poor 1, 14, 17, 24, 55, 60, 109, 130, 153, 169, 209, 211 Poverty 1, 24, 153, 198 Predicting growth miracles 17 Principal component factor 146, 150 Private sector 33, 76, 84, 110, 132, 154, 156, 158, 164–5, 189, 190, 206, 210 Private sector initiatives 156 Private sector investment 158 Product development 155, 210 Productivity tools 160 Production networks 138 Project Sankhya Vahini 160 Provisions of the State Council on the Encouragement of Foreign, Investment 50, 81 Pudong New Zone 50 Radio paging 158 Random effects model 149 Realized FDI 46, 50–2, 54 Regional Round Table 154 Research and development 138, 158, 160, 199 Rural access 156 Sanitation 154 Satellite service providers 159 Satyam Infoway 158 Scientific and engineering manpower 157 Sector, private 84, 156, 158, 164 Sector, public 105 Sector, telecom 158 Security interests 158 SIA Newsletter 161

220 Index Simultaneous casual relationship 161 Sino–foreign joint ventures (SFJVs) 64, 103 Sino–foreign cooperative ventures (SFCVs) 103 Small-country response 10 Socialist market economy 51, 102 Society 86, 107, 155–6, 160, 164, 201, 212 Soft Bonded IT Unit 159 Software development 153, 155–6, 159 Software exports 157, 210 Software sector 35, 156 Software sector, Indian 35 Southeast Asia 18–19, 26 Special Economic Zones 48, 64, 102 Spillover effects 162–3, 181 Subsistence agriculture 21 Sustainable business models 156 Sustainable development 154 Tamil Nadu 164 Tariff-rationalizing externalities Technical progress 55, 154

4

Technology adoption 137–50 Technology-intensive industries 53, 56, 60, 102, 138, 158 Telecom Regulatory Authority 159 Tele-density 64, 159 Telephone penetration 154 Transaction costs 137–8, 141, 177 Transparent legal framework 50 Uncertainty 29, 37, 51, 159 UNCTAD 23, 163, 173, 185–6, 187–9, 194, 195, 198, 200, 203, 211, 212 Venture capital funding

163

Web-based applications 157 Welfare effects 2, 12 Wholly foreign owned enterprises (WFOES) 48 World Development Indicators 161 World Economic Forum 155 World Telecommunication Development Report 154 WTO Investment Rules 93