Breaking through the Barriers

China is now Australia’s largest trading partner, and the Chinese economy a key driver of Australia’s economic performance, yet there has been relatively little attention on Australia’s foreign direct investment (FDI) into China.

Like other countries, Australia faces considerable formal barriers to FDI into China. Moreover, even if China were to remove all formal investment barriers, it is not clear that Australian FDI into China would be significantly greater because of the informal barriers and the apparent preference of Australian investors for economies with similar cultural, political and institutional frameworks. Despite this, Australian investment in China has continued to grow, albeit from a low base.

Foreign business groups operating in China believe that China’s FDI regime is now less welcoming. Despite this, business surveys indicate that foreign companies intend to continue to expand in China and are generally profitable.

From the Chinese perspective, foreigners are now facing more intense Chinese competition and an earlier bias towards foreigners has been removed. Furthermore, China no longer needs foreign capital. There is a Chinese view that, despite all the complaints, foreigners will come anyway.

Meanwhile, Chinese FDI into Australia is assuming greater importance for both countries. China’s increasing FDI footprint reflects its rising international foreign exchange reserves and a more explicit policy to ‘go global’, including for ensuring security of resource supply. China was the sixth largest source of global FDI outflows in 2009. At the same time that China’s FDI outflows have been increasing significantly, FDI inflows into China have also been rising and becoming globally more significant.

Following a significant increase in global FDI in the years leading up to the Global Financial Crisis (GFC), FDI fell sharply in 2008 and 2009. By contrast, FDI inflow into China increased in 2008 and the fall in 2009 was much less severe than the global total. Yet despite the rapid increases in recent years, China’s FDI inflows are still dwarfed by trade flows.

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Australian FDI Flows Into China

In contrast to the focus on the bilateral trade relationship and Chinese FDI into Australia, there has been relatively little attention on FDI flows the other way. However, in the context of the recent significant increase in actual and approved Chinese investment in Australia (and the barriers faced by China), there has been a renewed interest in the barriers faced by Australian investment in China.

In 2009 Australia accounted for only around 0.4 per cent of China’s total FDI inward stock. So while Chinese investment into Australia is rapidly increasing – and increasing in economic and political importance – the same is not true for the flow in the other direction.

It is worth noting that the distribution of Australian outward FDI is in marked contrast to the distribution of Australia’s trade (Chart 4B). Outward FDI is mainly directed to countries with similar market structures, legal systems and cultures – more than three quarters is located in North America, Europe and New Zealand.

China’s 0.7 per cent share of Australia’s outward FDI stock is substantially below simple measures of the China ‘economic opportunity’: a global GDP share of 12 per cent and economic growth projected to continue at around nine per cent per annum in coming years. With surveys showing China as the most desirable global FDI destination, the question is whether the distribution of Australian outward FDI is a reflection of:

  • perceived investment opportunities;
  • investment barriers – the greater comfort by Australian investors with countries that have similar markets, legal systems and culture;
  • risk aversion;
  • the delay in FDI responding to the economic opportunities; or
  • other (including historical) factors.

An independent study conducted by The Centre of Policy Studies in 2005 for the Australia-China FTA estimated that, even if all investment barriers were removed (in both directions), Australian FDI into China would be only eight per cent above the baseline.

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What drives Australian FDI into China?

Studies of FDI into China have emphasised the importance investors place on the Chinese market and using China’s lower costs as a base for exporting. For example, a 2009 UNCTAD survey reported that the top five factors favouring investment in China were, in order of importance:

  • growth of market;
  • size of local market;
  • cheap labour;
  • presence of suppliers and partners; and
  • access to international/ regional markets.

A study published in Economic Papers 27 (March 2008) argued that Australian FDI into China is driven by the size of that market, rather than the cost of labour. This is consistent with the view that Australian investors are transferring their Australian business model closer to their customers, rather than using China as a base for exporting (as other countries are doing).

From the Chinese perspective, a 2006 survey showed that Chinese respondents believed that the major motivation for foreign investment in China was for Chinese economic growth (and, to a lesser extent, market size) and not to exploit China’s resources or for export.

The challenges of FDI into China

As part of World Trade Organisation (WTO) accession in 2001, China liberalised its foreign investment restrictions but, in many respects, they remain relatively restrictive and opaque.

There are three major types of laws and regulations affecting foreign investment in China:

  • laws and regulations specifically targeted at foreign investment, including the corporate structure of the investment (such as joint venture (JV) or wholly-owned foreign enterprise (WOFE) and the categorisation of industry activities/ sectors (see box at right);
  • general laws and regulations applied to the economic activities of both domestic and foreign companies; and
  • bilateral or multilateral treaties on investment, trade and taxation relating to foreign companies.

Focusing on the laws specifically targeted at foreign investors, perhaps the most significant is the Catalogue for guidance of foreign investment industries, which allocates business activities into four broad industry categories:

  • “encouraged”, with a particular focus on advanced technology, energy saving and projects in central and western China;
  • “restricted”, including those industries using outdated technology, or deemed to be environmentally unfriendly; those using resources protected by law or regulations; and “industries that shall be opened gradually”; and
  • “prohibited”, including those that are deemed to endanger the safety of the State or damage social or public interests; those that pollute the environment, destroy natural resources or impair human health; those that occupy large tracts of arable land; those that endanger military facilities; or those that use Chinese craftsmanship or technology.

Chinese foreign investment restrictions for the finance sector

The finance industry of particular interest to Australian investors, given that this sector accounted for 28 per cent of Australia’s outward stock in 2008 and all the major Australian banks have a presence in China. This sector also highlights the complexity of China’s regulatory arrangements, as it falls into the “restricted” category, usually requiring a JV partner, with different requirements for each sub-sector. For example:

  • Banking – no maximum foreign holding specified in the Catalogue, but in practice a maximum of 19.9 per cent for any one bank, with a maximum ownership by a single foreign investor of two banks. An alternative (although slower) path, with perhaps better prospects of foreign investor control, is to set up a representative office, then move to a branch status and (after a minimum of two years) move to a locally incorporated subsidiary.
  • Insurance – maximum of 49 per cent foreign ownership for life insurance.
  • Security company – maximum of 33 per cent with activities usually excluded from trading in local Chinese shares. (Trading in Chinese shares listed offshore is permitted.)
  • Funds management company – maximum 49 per cent foreign ownership.
  • Trust business (a hybrid of banking, asset management and private investment) – maximum of 19.9 per cent for any one investor and 25 per cent aggregate for all foreign investors.

Where an industry does not fit into the above three categories, it is assumed to be “permitted”.

Limitations (in terms of maximum foreign equity proportion) on FDI vary across industries and can vary within each industry category.

Approval processes also differ, depending on the
category and the size of investment. In general, larger projects need to be approved by the National Development and Reform Commission (NDRC) after approval by the Ministry of Commerce. Approval is then required by the State Council. Smaller projects can be approved by the provinces/autonomous regions, with approvals in the restricted category reported to the State Council.

Foreign companies can invest in China via a WOFE for the encouraged and permitted industries. A joint venture is usually required for investment into the restricted industries, usually with majority ownership retained by the Chinese partner, often an SOE. In 2009, around 75 per cent of the value of FDI was from WOFEs, with the balance from various JV forms.

Provincial and local governments may also have enterprise zones within their jurisdictions, with their own set of requirements and inducements. In addition to these formal legal restrictions, there is a complex array of arrangements for approval and expansion.

A Japanese business survey rated China as the most desirable offshore investment destination. However, China also ranked the highest for “risks and issues”, particularly IPR and the legal system (its “undeveloped state” and “operation”).

The mood is, however definitely changing at ground level. A survey of Chinese attitudes towards trade and investment showed a positive attitude towards FDI because of its contribution to economic growth. There was also a recognition that funds from Western countries would be more likely to flow when there is openness, transparency and certainty in economic relationships. Furthermore, respondents saw the benefits to FDI from encouraging a more efficient and fair system of justice and good corporate governance.

John Larum
Former President of China Business,
UBS Global Asset Management