China: Boom, Boom, Bust?

CHINA IS RISING. IT’S been happening rapidly and it’s been happening (with the odd hiccup) consistently. For 10 years the PRC has been growing at a break neck pace at something like 10 per cent per annum. Fishing villages like Shenzhen (the closest city in the PRC bordering Hong Kong) have become cities and cities like Shanghai have become mega cities with the immense Pudong financial district rising from paddy fields in a decade. Urban legend? It has been said that at one point half the world’s cranes were to be found in Shanghai.

This article considers how China is managing this growth through its own programme of Foreign Direct Investment (FDI) and the implications of its success or failure in steering the behemoth economy it is creating. We will also look at the frameworks being used for the flow of FDI into China.

In an effort to cool growth and prevent overheating in the economy, The People’s Bank of China had required banks in the PRC to increase funds on reserve to nine per cent by 15 November 2006. This followed two similar orders to increase deposits in June and July 2006. Estimates suggest that each 0.5 per cent rise in the funds banks keep on deposit freezes 150 billion Renminbi.

China’s scrabble for natural resources to fuel its growth is important. Over the past decade China has worked assiduously at building relationships with resource rich countries, particularly those that are nonaligned or have specific anti-US or socialist policies like Venezuela, in keeping with China’s political hue.

Evidence of this can be found at the recent summit of African nations – called the Forum on China-Africa Cooperation – which included 48 African nations devoted to developing increasingly stronger economic relationships. As many as 2,500 deals were on the table at the summit for oil and other resources. Trade with African nations has grown to US$40 billion and Chinese investment has poured into copper mines and oil fields, helping to boost African economies. As the world’s second largest consumer of oil behind the United States, China last year imported 38.4 million tons of oil from Africa.

The World Bank has pledged US$2.3bn to sub-Saharan African nations this year yet this pales in comparison next to the US$8.1bn (according to World Bank figures) Beijing has committed in 2006 to Nigeria, Angola and Mozambique alone. This places China in the position of becoming the number one lender to African nations.

Some in the West have criticised China for pouring money into African treasuries while ignoring human rights and environmental concerns on the continent. China, however, has rejected such criticism, saying it abides by a policy of non-intervention and it makes its loans without restrictions which perturbs many international aid organisations and the World Bank which try to place restrictions on their loans. These restrictions usually involve issues with corruption or the environment.

China places few restrictions on its loans leading agencies like the World Bank to feel their efforts in developing nations are being undermined. Hong Kong’s South China Morning Post quoted Dan Large,a specialist at the Rift Valley Institute (a UNICEF funded think tank) as saying “The Chinese deals...seem often to be long-term mortgages on Africa’s resources or mineral deposits.”

A T Kearney is a global management consultancy firm which, through its Global Business Policy Council, produces an annual FDI Confidence Index. Responses from participating executives about their views of 68 countries, which receive more than 90 per cent of global FDI, reveal likely foreign direct investment flows and point to the factors that drive corporate decisions to invest abroad. Companies included in the survey are responsible for about 70 per cent of global FDI flows and generate more than US$27 trillion in annual revenues. These companies represent all major regions and sectors.

Investor enthusiasm for China and India (noted in the latest (2005) FDI Confidence Index) is at an all-time high, with roughly 45 per cent of global investors more upbeat about China and India compared to last year. China achieved its highest ever score in the latest index and has held top spot since 2002.

The FDI gap is likely to widen as China continues to implement its WTO accession commitments that involve extensive liberalisation of the service sector until the year 2007.

At some point as or after this article goes to press, China will surpass US$1 trillion in reserves. With the immense wealth comes increasing responsibility as China takes on a part in not only steering its own economy but that of the world. Within the next 20 years, China could rival the US as one the world’s economic navigators.

“If our simulations are anywhere close to the mark, the world has a grace period of about five years before it really begins to feel the heat of China’s emergence,” Stephen Roach, global economist at the investment bank Morgan Stanley in New York, wrote in a report earlier this year. “How the world then copes with China may well be the biggest what-if of all.”

The US$1 trillion reserves represent a fivefold increase since 2001 and present great challenges to China whilst simultaneously reflecting the successes of its policies. On the downside China now has an imbalanced economy, driven too much by exports – which keep adding to those reserves – and not enough by domestic consumers.

China is trying to manage the transition to a more consumer-driven economy through policies aimed at stimulating domestic spending which include two, week-long national holidays.

Research presented by academics in a paper at the Sixth Asian Economic Panel Meeting has shown that FDI to China is positively related to levels of FDI that the other main contenders for investment in neighbouring Asian and South East Asian countries receive. However, the increases are not shown to be proportionate.

Representative office

As the name suggests, a representative office is set up for representing the parent company in China. It is an easy and cost effective way of establishing a presence in high profile cities such as Shanghai, Beijing, Shenzhen, Guangzhou, and Tianjin.

Representative offices are only permitted to conduct non-profit making activities in China such as liaison with clients, market research and quality control.

Applicants for setting up a representative office must show a 12-month plus trading record in their home jurisdiction. A set of translated corporate documents has to be notarised, apostilled and authenticated by a China embassy then lodged with authorities.

Depending on the province, city and/or district, taxation of the representative office is assessed on declared expenses at the rate of seven to 10 per cent. The funds for the representative office must be transferred directly from the parent company.

Wholly foreign owned enterprise

A wholly foreign owned enterprise (WFOE) is the most popular choice for the foreign company seeking to do business in the fields of international trading, manufacturing, processing, assembling or other profit making activities.

A WFOE is a Chinese limited liability company which is established with 100 per cent foreign capital and is therefore totally under the foreign investors’ control. The registered capital may be paid up through a combination of equipment and cash. A WFOE’s operations are governed by the articles of association. The minimum registered share capital is normally US$140,000 but the registered share capital can be significantly higher for certain heavily regulated areas of business.

The tax rate for WFOEs varies based largely on where it is registered. Generally,a WFOE is subject to a business tax of five per cent for selling goods or services in China. A rate of between 15–33 per cent on profits tax will be charged by the provincial and city governments.

Many cities in China now offer incentives via special economic and free trade zones to WFOEs primarily engaged in exporting and re-exporting. These zones provide tax breaks for FDI and the rates and terms usually differ according to location. Certain areas of business, such as high technology, manufacturing and agriculture are favoured.

For companies seeking to access the local market it is important to know that the Chinese government defines foreign goods and services under three categories: ‘encouraged’, ‘limited’ and ‘prohibited’. Each has its own requirements and regulations that guide the activities of the WFOE. China’s internal reform of the legal, financial, accounting and tax standards is an ongoing and often confusing process that is evolving to meet World Trade Organisation requirements.

Joint venture

A joint venture is a legal entity in China that is usually composed of foreign investor(s) and Chinese investor(s). This business arrangement is usually set up by equity or co-operative methods. The main difference between equity joint ventures and co-operative joint ventures is the allocation of profits. The co-operative joint venture offers more flexibility than the equity joint venture.The Chinese government favours and encourages this form of arrangement for obtaining advanced technology, modern administration and management skills.

Although China has developed greatly in the past 30 years doing business there can often be confusing, frustrating and damaging to one’s financial well-being should experiences and competent professional advice not be obtained!

While both the level of China’s foreign direct investment and the levels of foreign direct investments of Asian economies are increasing together, an increase in China’s investment is associated with a decline in the shares of foreign direct investment of the Asian economies. The self-perpetuating affect of China’s continued share of FDI growth in Asia is not the most important determinant governing FDI into Asian countries. Policy variables under the control of the nations concerned, such as lower corporate taxes and higher degrees of openness play a larger role in attracting investment. Lower levels of corruption also play a role in leading to higher levels of FDI.

Guangdong is perhaps China’s leading provincial economy in many ways. It has the largest GDP among all provinces and municipalities, accounting for 11.7 per cent of the national total, and the highest industrial output value among all the provinces and municipalities, accounting for about 13 per cent of the national total.

It also has the largest export value among all provinces and municipalities, accounting for 32.3 per cent of the national total and the largest retail sales value of consumer goods which accounted for about 12 per cent of the national total.

It is reasonably complicated for a foreign firm to set up a business in China. The three typical methods of doing so are through representative offices, wholly foreign owned enterprises and joint ventures. The regulations, tax treatment, business categories, and requirements for each type of business are different. These differences are not only limited to the types of business, but are also specific to each province, city and sometimes district.