(Reprinted from HKCER Letters, Vol. 80 Jul-Oct 2004)
United States Direct Investment in China
"I remember distinctly my first meeting with Deng X'iao-ping, who at that time was China's supreme leader and great innovator. He was in many respects, the bluntest and most direct foreign leader I had ever met¡K.He wanted economic development for China as rapidly as possible.
Most importantly, particularly in light of materials presented in this book, he emphasized what he called China's two openings. Deng said that one opening was within China itself, and that was important, but it was not enough. China also had to open itself to the outside world, particularly to the United States. The reason, he said, was that China was backward and needed the knowledge, the technology and the markets that the rest of the world in general and the United States in particular had to offer. He spoke bluntly and, as events since that time show, prophetically."
¡X George P. Shultz, Former U.S. Secretary of States, in his Foreword to U.S. Direct Investment in China, by K.C. Fung, Lawrence J. Lau and Joseph Lee, AEI Press, 2004, Washington, D.C.
The relationship between the United States and China is a complicated one, with many areas of cooperation and potential conflict. In recent years, five developments have shaped the bilateral relationships. First, since the horrific terrorist attacks of September 11, 2001, the two countries have been cooperating to jointly fight global terrorism. Second, confronted with the nuclear threats from North Korea, China has now taken the leadership role in hosting multilateral talks to try to diffuse tension in the Korean Peninsula. Both of these events have created a more constructive climate of cooperation between the two countries. Third, the cross-straits political tension between China and Taiwan continues to be a potential obstacle to a smooth relationship between China and the United States. Fourth, the upcoming U.S. presidential election in November 2004 is still too close to call. Jobs and outsourcing to developing countries such as India, Mexico, Russia, Eastern Europe and China remains a key contentious issue. Rhetoric in the campaign can fuel negative feelings towards these economies, including China. The last recent development which significantly influences the bilateral relationship between the United States and China is mainly economic ¡X China's entry to the World Trade Organization (WTO) in December 2001 as its 143rd member.
Cooperation on global terrorism and on North Korea helps keep the two countries politically engaged. Economically, China's successful bid to join the WTO encourages foreign investors, including many U.S. firms to increase their presence in the Chinese market.
The status of direct investment between the United States and China is important for several reasons. The relationship affects the economic interests of the United States. China, with a population of 1.3 billion people, is the largest and fastest growing emerging market. A large percentage of the products produced by U.S. firms in China are sold in the Chinese market. Chinese per capita income has remained low, at about US$1,047 in 2003. But with the large population, even a small fraction of the consumers who can afford high-quality goods can mean a large demand. Moreover, the rapid economic growth of China, coupled with a domestic savings rate on the order of 40 percent, generates tremendous demand for fixed investment, which in turn means a large and growing demand for imported capital equipment and technology. Given that the United States is the most technologically advanced country in the world, China's increasing need of capital goods and technology transfer provides ample opportunities for U.S. firms. Compared to two decades ago, many U.S. multinationals are now doing successful business in China. For example, the profit margins of General Motors (GM) are at least twice as high on cars it makes in China as on similar models made in the United States.
Many foreign multinationals have shifted their focus to the Chinese domestic market. China is no longer just a low-cost manufacturing site for exports. Domestic retail sales illustrate the potential size of the market. Retail sales in China have grown more than twenty-seven-fold since 1979. That year, the first year of China's new open door policy, total retail sales of consumer goods in China were 147.6 billion Yuan. By 2002, total retail sales of consumer goods reached 4,091 billion Yuan. According to calculations based on data from the U.S. Department of Commerce, in 2002, the estimated rate of return of U.S. direct investment in China was 14.08 percent, compared with 8.15 percent for U.S. direct investment in all countries. Right now, any major U.S. corporation who wants to be a major player in the Asia-Pacific simply cannot afford not to be in China.
What are some of the more salient features of U.S. direct investment in China? We can provide answers to some of the more relevant questions.
Q. How large is U.S. investment in China?
A. According to U.S. government data, the average annual rate of direct investment in China is $1.4 billion a year ¡X foreign direct investment, or FDI as it is known, is the investment of foreign assets into domestic structures, equipment, and organizations. It does not include foreign investment into the stock markets. The $1.4 billion represents barely 1 percent of the total average annual U.S. direct investment of approximately $127 billion.
Chinese government data reports a higher average annual inflow of U.S. direct investment: approximately $3.69 billion a year, or nearly 9 percent of the average total annual inflow of FDI of approximately $41.2 billion.
Q. In the short term, is it profitable for U.S. firms to invest directly in China?
A. Yes, it is ¡X and it is becoming more profitable over time. From 2002 data collected by the Bureau of Economic Analysis of the U.S. Department of Commerce, the estimated rate of return of U.S. direct investment in China was 14 percent, compared with 8 percent for U.S. direct investment in all countries. That does not even include the $723 million in net payments of royalties and fees from Chinese firms to U.S. firms for technology transfers. In fact, investing in China is becoming more profitable for U.S. firms, since the average annual rate of return between 1994 and 2002 was estimated to be 10 percent.
Q. Does this profit come at the expense of American workers?
A. No. In general, U.S. direct investment in China does not compete with U.S. domestic producers and does not cause job losses in the U.S. On a net basis, in the United States, it is likely to be job enhancing, and not job displacing.
According to some survey data, more than 90 percent of U.S. firms with foreign investments produce goods abroad that are not directly competitive with those produced by their parent companies; two-thirds of the U.S. firms with investments in China produce products either totally different from, or of lower grade than, the products produced by their parent companies.
Most light industrial products that China does export to the United States ¡X such as garments, shoes, and toys ¡X generate low-wage, low-skilled jobs, which the United States lost three or even four decades ago, first to Japan, then to Hong Kong, then to Taiwan, and then to Southeast Asian countries such as Indonesia, Malaysia, the Philippines, and Thailand. The jobs that the Chinese workers have today are most likely to have been lost by workers in Hong Kong and Taiwan. China has gradually climbed up the technology ladder and has begun to produce high-tech items such as notebook computers, hard disc-drives, and computer chips. Nonetheless, China is still manufacturing items from the low-technology spectrum of the electronics industry. It may be competing directly with Southeast Asian countries such as Malaysia, but not with the United States.
Q. If cheap labor is not the main draw for U.S. firms investing in China, what is?
A. U.S. firms invest in China for many reasons. The primary reason is to establish a beachhead to penetrate the large and rapidly growing Chinese domestic market. The concentration of most U.S. direct investment is in regions where per-capita incomes, retail sales, and wage rates are relatively high by Chinese standards. This suggests that the focus of U.S. direct investment is the potential size of the local markets rather than the level of the local wage rates. Other reasons cited for investment include the abundant labor supply, preferential tax and tariff treatment given to foreign direct investors, avoidance of transport costs and tariff and nontariff barriers to trade, exploitation of China's natural resources, and establishment of a low-cost production base to supply Asian and other markets.
Q. What modes of direct investment do U.S. firms select?
A. Excluding joint development, the three most important modes of U.S. direct investment in China are the equity joint venture, the contractual joint venture, and the wholly foreign-owned enterprise. In an equity-joint venture, both the U.S. and the Chinese partners contribute capital to the venture, with profits distributed accordingly. In a contractual joint venture, the arrangements are flexible, with specific agreements on capital contributions (including contributions in kind) and profit distribution embodied in each contract. A wholly foreign-owned enterprise is owned and controlled solely by the U.S. direct investor; there is no Chinese partner.
A joint development venture is typically set up between a Chinese corporation or a ministry and a foreign partner to develop and explore natural resources such as coal, oil, and natural gas. In general this mode of FDI is not typical in China, although it is fairly significant in some U.S. direct investment in China ¡X in the petroleum industry for example.
Q. In what sectors do U.S. firms invest?
A. Based on U.S. government statistics, approximately two thirds of U.S. direct investment in China occurs in the manufacturing sector. Almost one quarter of investment in manufacturing industries is in electronic and other electrical equipment. U.S. firms also invest heavily in mining and utilities. Among the service industries, whole sale trade claimed the highest share of investment, with about 5 percent in 2002.
Q. How does U.S. direct investment affect trade between the two countries?
A. U.S. direct investment in China increases the demand for U.S. capital goods, intermediate goods, services, and technology. In particular, it increases intrafirm trade between different units of the same U.S. multinational corporations. U.S. direct investment also increases trade in services between the two countries. The United States has consistently run a surplus vis-à-vis China in trade in services.
Moreover, U.S. - and other foreign-invested firms in China are responsible for a large fraction of exports from China. In 2002, foreign-, including U.S.-, invested firms in China produced 52.2 percent of all Chinese exports. Likewise, foreign-invested firms in China produced a similar percentage of Chinese exports to the United States. Exports generated by foreign-invested firms have different economic welfare properties: The profits from such exports accrue in part to the foreign owners of those firms, not to the host country.
A large fraction of Chinese exports are related to processing and assembly activities. Since 1996 more than half of Chinese exports have been generated either by foreign-invested firms or through processing and assembly activities. Such exports from China are in part responsible for consumer goods in the industrialized economies, including the United States, remaining inexpensive; if the imported Chinese goods were supplied by their traditional domestic producers, prices would have been much higher. However, by most indications, the value-added content in China associated with processing and assembly activities for exports is relatively low.
Q. Does U.S. direct investment affect economic growth in China?
A. The U.S. government has estimated that outputs of U.S.-invested firms in China collectively accounted for 0.5 percent of the Chinese GDP in 2000. The effect is small, but not insignificant, especially considering that U.S. direct investment is only a very small fraction, approximately 1 percent, of the total annual gross domestic and foreign investment.
Qualitatively, however, U.S. direct investment should have a large long-term impact on the Chinese economy. Technologically the United States is the most advanced country in the world. To modernize, China needs to import advanced technology from the United States. Direct investment is the appropriate vehicle for the transfer of technology, with U.S.-invested firms maintaining control of and directly benefiting from their proprietary technologies and know-how. U.S. and other foreign direct investors are more advanced in management techniques, corporate governance, and market institutions. Their presence in China will accelerate the transformation of Chinese enterprises as well as the process of Chinese transition to a market economy. In the long run, the presence of U.S. and other foreign direct investment will significantly enhance the efficiency and the productivity of the Chinese economy.
K.C. Fung, Lawrence J. Lau and Joseph Lee, U.S. Direct Investment in China, with a Foreword by Former U.S. Secretary of State George P. Shultz, The AEI Press, Washington, D.C., 2004.
K.C. Fung, Hitomi Iizaka, Chelsea Lin and Alan Siu, "An Econometric Estimation of Locational Choices of Foreign Direct Investment: The Case of Hong Kong and U.S. Firms in China," in Eden Yu and Yum Kwan (ed.), Critical Issues of Chinese Growth and Development, Essays in Honor of Professor Gregory Chow, Ashgate Publication: UK, forthcoming, 2005.
* K.C. Fung is Professor of Economics, University of California, Santa Cruz and Senior Research Fellow of the Hong Kong Institute of Economics and Business Strategy (HIEBS), The University of Hong Kong.