Book Review
November 23, 2002
Foreign Direct Investment in China
A New Perspective
Selling China: Foreign Direct Investment during the Reform Era by Yasheng Huang, Cambridge University Press, New York, 2002.
Murali Patibandla
Vasheng Huang's book is a very important and significant contribution on the issue of foreign direct investment (FDI) in China, and FDI in general. The book brings out fresh and rich insights into the institutional factors that explain the large inflows of capital into China since the early 1990s. What is most impressive about the book is that Huang is able to bring out powerful insights by making use of simple analytical tools, which is rare in the economics profession. Most studies on FDI on China take the causes of large FDI flows as obvious and focus on the economic effects of FDI, government policies and performance of multinational firms (MNCs). Huang focuses on the underlying causes of large FDI inflows into China but not on the effect of FDI on China's economic growth. Within this objective, he focuses on the research question of why FDI inflows increased at the expense of contractual capital, especially in the labor-intensive export industries, during the period from the late 1980s to the late 1990s. He probes the issue systematically by asking interesting and important questions and traces the underlying institutional mechanisms of China, which led to excess dependence of the Chinese economy on foreign capital. These insights bring forth quite a few new perspectives on FDI in China.
The Chinese state, in its attempt to mix its communist philosophy of public ownership of capital and its desire to utilise foreign capital and technology created exceptional institutional conditions, which led to excess dependence on FDI. FDI dependency is conceptualised in two dimensions: FDI inflows relative to the investment activities undertaken by firms and FDI activities relative to contractual and trade based alternatives. The distinction between FDI and contractual alliance is that under an FDI arrangement the foreign firm has legal control over the enterprise whereas the foreign firm does not have legal control over the production facility under a contractual alliance.
Let us take a couple of simple questions Huang probes in the book to bring out the logical explanations. Why is it that small MNCs undertake a major part of the production of low-tech manufactured goods for export markets which could have been done by local firms through contract-based capital financing (outsourcing)? Why is it that small multinational companies from Taiwan and Hong Kong dominate the production of even age-old traditional Chinese arts and handicrafts such as ivory and jade sculptures, carpets, personal ornaments, silk handicrafts, porcelain and cloisonné?
One of the dominant theories of FDI is that of intangible assets pioneered by Hymer (1976). He argued that for a firm to conduct foreign production it must possess some kind of firm-specific ownership advantages, such as superior technology (patent), brand name and marketing, which provide it with an advantage over local firms in the host country. The decision to invest in a foreign country is essentially a decision to control the firm-specific proprietary asset rather than transact it via the market. The benefits to the local economy arise because property rights on intangible assets being underdeveloped, they are partially public goods and others can use assets developed by one firm at a small cost which, in turn, causes development of local industries under specific conditions [Patibandla and Petersen 2002]. The main issue, in the present context is that the intangible asset theory shows that MNCs are generally present in imperfectly competitive markets (oligopoly and monopolistic competition) but not in perfectly competitive markets with a large number of small firms producing relatively homogeneous goods. The Chinese experience, to a considerable extent, defies the theory of intangible assets. As Huang shows, a major part of FDI in China has been in export-oriented labour-intensive manufactured goods by small MNCs from Taiwan, Hong Kong and Singapore. In these industries, there has been preponderance of an ownership arrangement, i e, FDI, over contractual arrangements. Secondly, a considerable portion of FDI in China is 'round-trip', whereby a firm exports money, registers a company in Hong Kong or Singapore, and then brings the money back as FDI to make use of the incentives given to FDI. Huang observes in the introduction of the book, "The central claim of the book is that FDI has come to play a substantial role in the Chinese economy because of systematic and pervasive discrimination against efficient and entrepreneurial domestic firms. This discrimination was not purposely instituted to benefit foreign firms; at least this was not a dominant consideration. It was instituted mainly to benefit the inefficient State Owned Enterprises (SOEs). As such, China's large absorption of FDI is not necessarily a sign of the strength of its economy; instead, it may be a sign of some rather substantial distortions." The two main institutional elements, as I understand, that caused foreign equity arrangements replacing contractual based export intensive production are, first, the state support of highly inefficient SOEs squeezed domestic capital availability to the more efficient local private entrepreneurs1 and, second, until recently (1999) Chinese private entrepreneurs were denied private property rights, while property rights of foreign investors were protected. The Chinese institutional mechanism created a political pecking order in which at the top are the inefficient SOEs and at the bottom are the most efficient private firms. Furthermore, under the China's decentralised economic system, local governments restrict trade and capital flows to other regions; domestic firms are not allowed to invest outside their regional jurisdiction while there are no similar restrictions on foreign firms. These factors caused larger than necessary FDI inflows, a considerable part of it is for getting access to foreign equity finance and to convert a local firm into a foreign one [Huang 2001].
The interesting aspect is that the Chinese economy had one of highest savings rate in the world: between 1994 and 1997 it was 42 per cent of GDP and between 1986 and 1992 36 per cent. Most of the capital was channelled to subsidise the inefficient SOEs and access to capital to private firms was made very difficult. Consequently, equity arrangements with foreign firms became necessary to get access capital for the efficient private firms. Secondly, as mentioned earlier, legal property rights were denied to private entrepreneurs. These two factors, in conjunction, created an incentive for private sector firms to convert their businesses into foreign-owned firms. This operated to the extent that even capital constrained private firms took capital out to neighbouring regions and countries such as Hong Kong and Singapore and brought it back as foreign capital (the round-trip FDI) to be legally recognised as foreign-owned firms.
The next issue is that of joint ventures between MNCs and SOEs. One can ask the question why do SOEs, which have generous access to capital, enter into equity joint ventures with multinational companies? Huang deals with this issue extensively in Chapter 5 of the book. Most SOEs are in capital-intensive sectors catering to the domestic market. In other words, these industries can be considered to be those in which intangible assets matter for FDI. However, the China's institutional mechanism created distortions that caused FDI to become a means of privatisation of SOEs, which imposes additional costs on the local economy. As Huang observes, generous credit and other backing have allowed SOEs to build up valuable asset bases, but they still have been unprofitable because of operating inefficiencies. As a result, they became potential acquisition targets for foreign firms, as domestic private firms are not allowed to acquire them. The FDI that went to SOEs in essence financed privatisation transactions and this is where equity arrangements are important: they bring about an ownership change. In other words, given China's institutional mechanisms, which did not permit property rights to local private agents and did not allow them to acquire SOEs, FDI functioned as an indirect way of privatisation. Joint ventures with MNCs, in turn, improved the management of the inefficient SOEs. As I understand it, in the case of joint ventures between MNCs and SOEs, MNCs have contributed to the development of local industries by bringing in intangible assets of better management practices and technologies. But this imposed additional costs on the Chinese economy owing to the peculiar institutions of China that had refused to bestow private property rights on local agent until recently. If the local agents were given property rights and allowed to bid and compete with MNCs, it could have resulted in higher growth benefits through competitive dynamics.
China and India: Comparison and Implications
Huang's book is very useful in bringing out comparative analysis of China and India's institutional aspects. It is pertinent to caution here that Huang's book should not be misinterpreted to justify India's relatively poor performance in attracting FDI. While China created an institutional mechanism that has overplayed the role of FDI, India created an institutional mechanism, which underplayed FDI for achieving economic growth. India's democracy generated an institutional mechanism of powerful vested interest groups who block FDI even in those areas where it can contribute significantly to achieving higher economic growth.
Let us take the issue of property rights in India and its implications for investment. India's democracy gave property rights to people on paper but in practice they are highly skewed and distorted, limiting economic freedom to a large section of its populace. One can argue that private property rights in India facilitated the emergence of a large base of matured, private, large-scale and small-scale (unorganised) sector, which took care of most of the lower-end manufacturing, assembly line and commercial services sector. Consequently, the major part of a much smaller amount of FDI in India had been in the infrastructure sector, including such areas as telecommunications, transportation, and power and fuels and service sectors such as software, rather than in manufacturing [Patibandla and Rosario 2002]. The question is how come India's manufactured sector could not achieve an export success similar to that of China. I argue that the pervasive government controls and intervention at all levels which impose entry barriers on efficient entrepreneurs and new entrants is tantamount to denying property rights to a larger section while a few reaped rents at the cost of the rest. It is well documented in the literature on Indian economy that the industrial licensing and other government policies facilitated a few incumbent industrial houses, politicians and bureaucrats to reap large sums of rent. This mechanism not only took away consumer surplus but also channelled a large part of public savings into the rents of the powerful groups. In the case of the labour-intensive small-scale sector, reservation and other fiscal policies constituted disincentives for the relatively efficient firms to grow and become internationally competitive.
There are a few islands of competitiveness in the Indian industry such as diamond-cutting and the garments industry in Tirupur in which exports are based on contractual alliances [Ghemawat and Patibandla 1999]. The other example is India's software industry which presents the case of an internationally competitive high-skill intensive industry in which multinational firms have played an important role for its competitive evolution [Patibandla and Petersen 2002]. A part of the reason for its success is that it is relatively a new industry in which vested interest groups for seeking rents in the domestic market have not taken root as it has been mostly export-oriented.
Let us take the issue of public savings and capital formation. As mentioned above, Huang documents how a high level of domestic savings in China were channelled to the inefficient SOEs and more efficient private entrepreneurs were denied access to capital. India achieved a high annual savings rate of 20 per cent during the period of 1970s and 1980s, but a very low economic growth rate of 3 per cent [Bhagwati 1993]. The explanations could be traced from the misallocation and inefficient use of public savings by the public sector financial institutions and the public and private sector monopolistic corporations with a high degree of moral hazard. The government of India created public sector financial institutions such as IDBI, IFCI, ICCI and UTI to facilitate industrialisation by channelling public savings to the organised private and the public sectors. Most of these institutions were captured by interest groups, which converted public savings into rents. At present these institutions are saddled with huge amounts of bad loans and non-performing assets. Some estimates show that the government of India has earmarked over Rs 2,00,000 million of taxpayers' money in the year 2002 to bail out just three of the public financial institutions - UTI, IFCI and IDBI [Patibandla 2002b]. The destroying of the public savings through the financial institutions and ill-functioning stock markets is similar to mitigating property rights. The modern property rights approach of Grossman and Hart (1986) shows establishing property rights means enforcing contracts through which economic agents try to arrive at efficient control structures themselves or finding ways improve the efficiency of control rights directly. In the presence of highly inefficient market institutions, as prevalent in India [Patibandla 1997], the control rights are mitigated at several spheres which causes pervasive economic inefficiency and consequently low economic growth.
Comparison of China's and India's institutional mechanisms of privatisation of the public sector throws out interesting issues. India also created a large presence of the public sector under the so-called mixed-economy model which led to the presence of the public sector in a wide spectrum of activities ranging from producing satellites, steel, running airlines, hotels, trading firms, consultancies, textile corporations, chemical and pharmaceutical organisations and consumer goods. In a few spheres of high-technology areas, India's public sector made significant contribution to generating a pool of public goods of knowledge. However, the rest of the public sector is highly inefficient, and sucks in a large amount of capital for unproductive and rent seeking activities.
In China's case, the government appeared to have recognised the inefficiency of SOEs and used FDI to privatise SOEs. Although the denial of property rights to local private agents incurred indirect costs, the equity joint ventures between MNCs and SOEs improved the operational efficiencies of SOEs. In the case of China, private property rights to local private agents were a threat for the ruling party but not FDI. In the case of democratic India, the public sector had become an effective means for political patronage by political parties. Consequently, privatisation would be perceived by the ruling parties as a threat of losing powers of patronage. Since the initiation of reforms in 1991, there have been lackadaisical efforts at privatisation. The present BJP-led coalition has made some progress in privatisation. Unlike in China, the Indian government pursued a domestic privatisation policy and thus it did not need FDI to play this role. In China, the relatively more efficient SOEs are sought after by MNCs. Similarly, in India, the relatively more efficient are put up for sale. This is a rational and justifiable outcome - any rational buyer would like to get a higher quality product at any given price. Information economics shows that if buyers do not have information about the quality of products in the market, market price settles at the average, which in turn makes higher quality products to leave the market - the well known adverse selection outcome. In this context, the government has to generate an institutional mechanism where the information about the public units for sale is transparent and open bidding by all players, both local and foreign, takes place in order to realise prices in line with quality of the assets of the public sector units. However, under democracy the creation of these institutions is subject complex calculations. Politicians can perceive the public sector as a long-term interest of political patronage or a one-shot rental gain through privatisation. A ruling party that perceives its tenure as long-term will resist privatisation, as the Congress Party in India which was responsible for the pervasive presence of the public sector prior to the reforms. A ruling party which perceives its tenure as short can promote privatisation to obtain large one-shot rents and for denying the public sector as a means of political patronage for the next elected (competing) party.2 In order to gain one-shot rents, there is an incentive for ruling politicians to keep the privatisation process non-transparent and sell the assets at heavy discounts through collusion with private buyers. However, in a democracy the free press can play an effective monitoring role and reduce these hazards. At the same time, political controversies through the press can derail the privatisation process. At present, privatisation is imperative for the resource-starved Indian government to release resources for reducing the large fiscal deficit and for investing in developmental objectives. The critical issue is not about whether units taken for privatisation are the more or the less efficient ones, but realising appropriate prices for the assets which requires institutional mechanisms that bring in transparency and open the bidding to a large number of both domestic and foreign players.
Huang's book shows that China created favourable macro economic conditions to attract FDI inflows but has severe distortions at the micro level [Kynge 2002]. India, on the other hand, has better micro level conditions of better property rights and capitalist institutions, but the macro level institutional conditions are beset with pervasive inefficiencies. Government policy should be aimed at reducing macro level inefficiencies and improving micro level conditions by reducing transactions of business and exchange. The role of the government is that of playing an effective regulatory role - being neutral to domestic and foreign capital. The regulatory role requires adoption of a well-defined competition policy which monitors and restrains anti-competitive conduct of firms, ie, any behaviour that harms consumers and constrains the entry of more efficient firms and entrepreneurs.
India's software and services industries have clearly demonstrated the benefits of opening up to international trade and investment. Apart from this, a few manufacturing industries appear to developing competitiveness to become global players in response to the reforms. The example is the two-wheeler industry which was opened to MNCs at the earliest stage of the reforms, i e, in the mid-1980s. The competition dynamics between domestic firms and MNCs have made this industry highly dynamic [Patibandla 2002a] and it is showing healthy signs of becoming internationally competitive.
Similarly, in the car industry, the entry of quite a few MNCs in the recent years has generated the industry cluster in the coastal region of Tamil Nadu which shows potential for becoming internationally competitive. The case of the textile industry shows that the reforms led to substantial decline in prices of higher quality textiles which, in turn, increased real incomes of low-income groups [Ghemawat and Patibandla 1999].
India, in comparison to China, moved faster on domestic reforms but lagged on the external front. These partial reforms have resulted in a doubling of annual average growth rate to 6 per cent since 1991 with the same, savings rate of 20 per cent of the 1970s and 1980s. By speeding up liberalisation, India can narrow the gap with China. In other words, if Indian policy-makers are able to reduce macro level distortions and improve micro level conditions in the economy, India may do as well or even better than China in the long run. If Indian policy-makers remain trapped in myopic vested interest policies, India will remain perpetually an under-achiever with the largest number of poor and illiterate people in the world.
Huang's book is an outstanding contribution and is very useful for students and research scholars in the fields of foreign direct investment, institutional economics and economics of development. This book is a good example to students in that if one is motivated to understand and explain the world around us, good questions and simple analytical tools can take us a long way.
Notes
1 Until 1998, the largest Chinese banks were instructed not to lend to private firms.
2 A few sections of the present coalition ruling party which resist privatisation in the name of economic nationalism appears to have got their calculations all wrong. All the indications are that the present party is not going to come back to power in the next general elections. If this section of ministers of the BJP-led coalition government were rational, they would push for privatisation, at least for denying the next elected party the powers of political patronage.
References
Bhagwati, J (1993): India in Transition: Freeing the Economy, Oxford University Press, Oxford.
Ghemawat, P and M Patibandla (1999): 'India's Exports since the Reforms' in India in the Era of Economic Reforms, edited by J D Sachs, A Varshney and N Bajpai, Oxford University Press, Delhi.
Ghemawat, P, M Patibandla, and B Coughlin (2000): 'India's Software Industry at the Millenium', Harvard Business School Case Study, No 9-700-036. Grossman, S and O Hart (1986): 'The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration,' Journal of Political Economy, 94 (4), 691-719.
Huang, Yasheng (2001): 'Why More Is Actually Less: Interpretations of China' s Labour-Intensive FDI', Working Paper No 375, The William Davidson Institute, The University of Michigan.
Hymer, Stephen H (1976): The International Operations of National Firms: A Study of Direct Foreign Investment, The MIT Press, Cambridge, Massachusetts. Kynge, J (2002): 'Creaking Economy Needs Stronger Foundations', Financial Times, October, 30.
Patibandla, M (2002a): 'Policy Reforms and Evolution of Market Structure: The Case of India', The Journal of Development Studies, 38(3), 95-118. - (2002b): 'Equity Pattern, Corporate Governance and Performance: A Study of India's Corporate Sector,' INT Working Paper, The Copenhagen Business School. - (1997): 'Market Reforms and Institutions', Economic and Political Weekly, May, 17.
Patibandla, M and B Petersen (2002): 'Role of MNCs in the Evolution of a High-Tech Industry: The Case of India's Software Industry', World Development, 30 (9), 1561-1577.
Patibandla, M and S Rosario (2002): 'The Pattern of Foreign Direct Investment in Developing Economies: An Exploration' forthcoming in The Journal of Development Studies.
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