Since China returned to the world economy in the late 1970s, its economy has undergone multiple transformations. The latest one is perhaps the most challenging and most important, especially in order to define China’s future role in the world’s economy.

Its importance stems not only from the magnitude of the transition-related challenges facing China’s political economy, but also because the transformation is a consequence of the current worldwide economic climate. The downturn, some would say crisis, currently being faced by the world’s major economies has been a catalyst for the changes that needed to be experienced in China’s economic base.

The consequence has been slowed economic growth in China. In the first quarter of 2009, China’s economic growth stood at about 6 percent, as compared to the same quarter in 2008. This rate was still strong, but below the 8 percent annual target the central government had set, and barely greater than half the rate that had been averaged for the past two decades.

Even with this slowdown, many analysts and policy makers still see China as a strong market for domestic and foreign investment. The drop-off has been attributed by some to a lack of confidence in the short-term in China’s economy. Others state that the potential for continued GDP growth, the base population of 1.3 billion people, and the huge market continue to make China the most promising market among all the world’s emerging economies.

While there is truth in the above statements, some of them need to be qualified, as is evident from recent trends in Guangdong province. This southern province, which has long enjoyed its favorable geographic position of being adjacent to Hong Kong, saw foreign companies contribute nearly 60 percent of its output in 2008. Clearly foreign investment is important to this province, but instead of investing further, foreign investors have been divesting.

China, as a whole, has been experiencing declining foreign direct investment (FDI) since late 2008. Year-on-year, FDI was down 37 percent in January 2009, 16 percent in February 2009, and nearly 10 percent in March 2009. More importantly, provinces like Guangdong have been experiencing divestment. In 2008, 4000 Chinese toy companies closed shop. Toy exporting businesses owned by foreign firms, including those owned by Hong Kong businesspeople, have been closing or going bankrupt because of financial problems or drastically smaller orders. As a consequence, the number of toy-exporting businesses in Guangdong stood at 1404 companies; more than 3,500 companies have withdrawn from the export market.

These numbers do not lie. China is undergoing a transformation, moving from being the world’s manufacturing base to become a more integrated economy with a wider variety of value-added capabilities. These changes are occurring because China’s cost-based advantages are being eroded through economic growth – just as has happened in other economies in the region, such as South Korea, Singapore, Taiwan and Hong Kong.

The shift from being a manufacturing and export-oriented economy to a more integrated one is well recognized by policy makers in China. As reported by Xinhua (http://news.xinhuanet.com/english/2009-04/15/content_11191566.htm), Guangdong’s vice Governor, Wan Qingliang stated: “More efforts will be paid to enhance capital inflow from developed countries and regions, especially those from top-500 multinational companies in the world, to build regional headquarters, research and development centers, purchasing centers and training bases in Guangdong,” At the national level, according to President Hu Jintao, the government has been paying more attention to environmental issues for the purpose of sustainable development.

These are laudable and necessary goals for China’s FDI. But are they achievable? Or, put another way, what does China need to do to meet these new goals? The answer, as before, lies in infrastructure development – on the physical, fiscal and regulatory fronts – in order to extend the current set of manufacturing activities to more sophistication, higher-value-added activities.

The present

Like domestic companies, foreign companies in China concentrated on manufacturing in 2009. This does not mean that services, distribution, research and development, and finance and banking activities did not take place. Rather, it simply means that China has a higher proportion of assembly, basic manufacturing and exporting activities in its economy than most other economies worldwide.

With the high levels of domestic and foreign investment in manufacturing, vast, integrated production networks have been developed in China over the past 15 to 20 years. The result is an efficient, low-cost base for manufacturing, as has been well recognized by the media, businesspeople, and policy makers and academics.

Yet this set of activities represents just a subset of the productive activities required to produce any product, be it an automobile, an air conditioner, a computer or a television. As shown in the figure, a variety of activities go into the development, manufacture and sale of any product. Products need to be researched, designed and engineered. The manufacturing is often distributed in a series of discrete stages. The sale of a product is undertaken through a local market initiative in branding and distribution. The core functions of research, design and engineering, alongside local market sales and distribution are the high-value added activities. Distributed manufacturing tends to be low-margin and low value-added.

The distributed manufacturing of multinational firms has been transferred to China in large volumes of FDI. The high-value-added activities, particularly at the core function stage, have yet to move to China.

Figure 1: A Multinational Firm’s Operations

(Source. Peter Buckley. 2007. Keynote speech – Lessons from Japanese MNEs? Cross-cultural Management practices in East Asia Conference. Leeds, United Kingdom).

While the shift of distributed manufacturing activities to China is a success story on one front, it represents a challenge to China on another front. The challenge has arisen because of changes that have created new incentives for the establishment of foreign subsidiaries in China in the later part of this decade.

These changes relate primarily to the substantial escalations in costs for skilled labor, land, property and other factors of production. Coupled with a rise in the value of the RMB, especially relative to other major Asian currencies not pegged to the U.S. dollar, these cost increases have eroded the magnitude of China’s cost advantages and made it difficult for certain types of subsidiaries to operate profitably in China. As if these changes were not enough, in early 2008, China’s new labor contract law took effect. The institution of this law substantially increased the cost of manufacturing in China. This process of factor-price escalation has also been exacerbated by the emergence of strong domestic competitors that have increased competitive pressures and decreased margins for multinationals focusing on domestic market sales in China.

These changes in the external environment influence the comparative advantage of the value-added activities of a foreign subsidiary. A subsidiary performs an activity or activities that augment the value of the products and services produced by a multinational firm, and heighten a multinational firm’s competitiveness. A subsidiary can fulfill this role in a multinational firm by conducting a single activity, such as manufacturing, or a full range of value-added activities – research and product design, input sourcing, manufacturing, distribution and marketing. The types of value-added activities a subsidiary performs can be called its “role” in the multinational firm; more formally, we can call a subsidiary’s set of activities its “charter” (see Birkinshaw & Hood, 1998). A subsidiary’s charter captures the products it produces, the technology it houses, the markets it serves and the functional areas in its operations.

The consequence of external environmental change in China has been a change in subsidiary charters. Subsidiaries with a manufacturing, cost-center charter have been moved inland, and also outside of China, to other countries such as Vietnam or Bangladesh. If a subsidiary’s core activity has been relocated to another subsidiary inside or outside of China, the subsidiary must either secure a new charter — which can be done if the external environment in China is suited to conducting high-value-added activities — or the subsidiary will be closed.

Physical, fiscal and regulatory infrastructure

Foreign investors locate subsidiaries in economies that can either support sales or production activities. If increasing sales is a goal, a foreign investor looks to market size, market growth and other similar measures of market attractiveness. If becoming more efficient and competitive in production is a goal, investors seek a competitive operating environment, where costs are low, the domestic physical infrastructure is well-developed and the fiscal infrastructure is favorable for investment, typified by a regime of low cost, transparent taxes and tariffs.

As far as higher-value-added activities are concerned, foreign investors seek a strong regulatory infrastructure. This regulatory infrastructure facilitates the negotiation and security of contracts by establishing transparency, fairness and independence in the courts of law in a country. The regulatory infrastructure helps to mitigate risks of the dissemination or outright theft of intellectual property. Such infrastructure also helps to reduce concerns about uncertainty in the policies in the regulatory environment, because such laws define the extent and types of taxes and tariffs faced by domestic and foreign companies. Essentially, the strength of the regulatory infrastructure can be determined by identifying the policy-making process in national and provincial governments, the extent of transparency in government and competitive regulations, the degree of intellectual property protection, the rule of law and the degree of equity in competitive environments between foreign and domestic companies.

Physical and fiscal infrastructure

With regards to physical and fiscal infrastructures, China has made tremendous strides since opening its economy 30 years ago. Since the early 1980s, it has placed a high priority on seeking investment from foreign companies. Such investment has brought needed employment, alongside a transfer of managerial skills and technology to state-owned enterprises and private firms. Further, the recently completed 2008 Beijing Olympics, and the upcoming 2010 Shanghai EXPO have triggered a new round of infrastructure-improvement campaigns. As a result, these two cities and the areas adjacent to them have state-of-the-art, world-class facilities and physical infrastructure.

The strong flow of FDI into China was not an accident or a simple consequence of the huge market and strong economic growth. Policy makers took deliberate action to heighten the attractiveness of China through clear and rapid improvements in physical and fiscal infrastructure.

The steps taken to date to facilitate foreign investment in China mostly relate to reducing the difficulty of manufacturing in China. These steps led to substantial improvements in the transportation, financing and communications infrastructure, as well as the development of economic zones that provided tax and tariff-based cost concessions to foreign investors. Since China joined the WTO in 2001, there has been an additional round of country-wide improvements in the fiscal infrastructure in the form of tariff reductions, equal tax treatments, and the continued opening of new sectors to foreign competition. For example, China recently introduced a new corporate income tax. Before January 1, 2008, domestic firms faced a corporate tax rate of 33 percent and foreign-invested were taxed at 15 to 24 percent After January 1, 2008, domestic and foreign firms faced a unified tax rate of 25 percent.

These recent changes are in line with policy makers’ creation of four distinct regimes of FDI in China. The early regime, 1979-83, began with the establishment of the Joint Venture Law in 1979 and the creation of four SEZs in 1980 (Special Economic Zone). The next regime, 1984-91, saw 14 coastal cities and the island of Hainan opened to FDI, with foreign investment further encouraged by the passing of the Law on Wholly-Foreign Owned enterprises in 1986. The third regime, 1992-94, was the one which FDI into China escalated most dramatically (Figure 2 and 3).

Figure 2: Number of Fortune 500 firms Operating in China

Figure 3: Number of Subsidiaries of Fortune 500 Firms in China

In this regime, the local municipal governments increased incentives for FDI, and new industries such as finance, real estate, tourism, shipping and wholesale and retailing were opened to FDI. The most recent regime, 1995 to the present, has seen increased competition for FDI arise from other countries in Asia, South America, and the transition economies of Eastern Europe. The State Council in China has continued to review which sectors can receive investment, while re-imposing duties on imported machinery, equipment parts and other materials used in foreign-invested joint ventures. But, the State Council has avoided making substantial changes in the regulatory infrastructure.

Regulatory infrastructure

Without substantial changes in the institutions available for investment, the results in the most recent regime of FDI have been lackluster. The policy steps taken in the prior three regimes have provided part, but not all, of what needs to be done to attract and retain FDI. Improvements in the fiscal infrastructure, for example, reduce costs so that the baseline for achieving profitable operations is lower. But fiscal incentives stemming from government policies only camouflage systemic problems and can easily be revoked, given the lack of constraints on policy makers in China. Physical infrastructure improvements do not provide an advantage that is flows to the bottom line on a comparative basis across nations. Instead, physical infrastructure improvements have ameliorated the disadvantages of operating a subsidiary in China, such that China’s physical infrastructure in the eastern provinces is on par with other locations worldwide.

Foreign investors looking to establish high-value-added activities in China necessarily look beyond these improvements in the fiscal and physical infrastructure, for signs that substantive steps, not increased rhetoric, are being taken to enhance China’s regulatory infrastructure. Fundamental institutional change would be one of these signs.

In the case where there has been change, it has not always benefited foreign firms. For example, on August 30, 2008, China’s National People’s Congress passed an anti-monopoly law, which is largely modeled on U.S. and European Union antitrust legislation, though the Chinese version uses a less sophisticated method to determine market domination. Under the law, competition between and among local or overseas companies has faced an increased level of scrutiny by the Chinese government. The recent Coca-Cola-Huiyuan case was the first case in which this law affected competition, blocking Coca-Cola’s bid to acquire a domestic company in China, Huiyuan.

Even with changes such as these, the institutions for governing competition in China are not yet well-established. Recent efforts by the Communist Party of China to demonstrate a stronger resolution to fight corruption is one positive sign. Yet, observers remain highly concerned about the extent of intellectual property protection, stating that enforcement remains a serious problem, despite the Chinese government’s efforts to implement legal reforms in accordance with the WTO Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS Agreement).

This problem does not exist only in the eyes of foreign firms. Domestic consumers in China are well aware of the problems with intellectual property protection in China. China’s most savvy new consumers have documented this copy-cat phenomenon in the new lexicon. Chinese netizens describe the current copy-cat situation in China as ShanZhai, which literally means “mountain stronghold.” However, the word is currently widely used as a noun, adjective or verb, to mean or indicate a cloned product. There is a line of ShanZhai products, ranging from cell phones, TVs to laptop computers. ShanZhai are not strictly speaking knock-offs of branded goods; they simply do not use branded names. But they are, still, essentially copies.

In this sense, the comparatively easy part of the transition in the external environmental has taken place. Numerous sectors have been opened to competition, governments in China have worked tirelessly to correct infrastructure deficiencies and have offered fiscal incentives to draw FDI. But these changes just bring the country up to speed. With increased cost pressures and fewer cost advantages faced in the East, mid-south and northern provinces, manufacturing oriented FDI is exiting to move either inland or overseas. To continue to retain FDI and secure the positioning of high-value added activities in China, more difficult changes need to be made. Institutions need to be developed, the policy environment needs to be made more transparent, and formal and informal rules of competition need to promote a greater level of equality between domestic and foreign firms.

BACK TO GUANGDONG

Guangdong has been the major export base of China, and perhaps the world. The small and medium-sized enterprises (SMEs) that fueled up to 40 percent of China’s exports were a major part of China’s economic success. These SMEs were largely owned by Hong Kong and Taiwanese business people, and they represented the transfer of such labor-intensive production from Taiwan, Hong Kong and other formerly low-cost locales to China. Yet, just as the cost competitiveness of each of these locations was eroded by economic progress, Guangdong based-SMEs have lost their competitiveness from cost increases, the rising RMB and the emergence of new low-cost locales.

Guangdong now finds itself again at the forefront of an economic transition in China. In the coming decade, low-cost, low-tech, labor-intensive manufacturing has to give way to high value-added, high-tech industries. But this process is not as simple as emptying the cage of near extinct enterprises. The cage also has to be re-gilded with the infrastructure needed to support the competitiveness of its new high-value added tenants.