Reprinted with permission of The Wall Street Journal, © 2002 Dow Jones & Company, Inc.
Foreign direct investment is generally agreed to have been one of the most important contributors to China's rapid economic growth over the past 15 years. China has become the world's second largest recipient of FDI, ranking behind only the United States. The $43 billion it received last year is more than the amount invested in all other Asian economies, excluding Hong Kong which functions as an entrepot for China and Asian nations.
In 1986, China received just $2 billion in FDI. But since then the amount has increased at a compound annual rate of over 18%, steadily rising from 1986 until 1997 with a slight decline since then, when measured using the value of the dollar in 1995.
Most experts expect FDI in China to continue to grow in the coming decade. Of a group of recognized authorities on China whom I surveyed a few months ago, 38% expected it to continue to grow by less than $3 billion a year, a similar percentage expected an annual increase of $4 billion to $8 billion, while 12% expected the increase to exceed $8 billion.
But experts are typically more reliable in interpreting and explaining the past than forecasting the future. That explains their general consensus on the crucial role FDI has played in China's economic growth so far. It also highlights the dangers Beijing faces if FDI begins to fall. According to my initial calculations, China's annual economic growth has been boosted by 0.9% to 1.6% for each $10 billion of FDI. That means if annual FDI falls by $20 billion, China's current 7.3% growth rate could be almost halved.
In forecasting what will happen rather than in explaining what has happened, the experts have frequently gotten it wrong. Consider, for example, their failure to forecast Japan's stagnation in the 1990s against that nation's background of remarkable growth in the 1970s and 1980s; or their failure to predict the plunge in the economies of Korea, Indonesia and Thailand during the Asian financial crisis of 1997-98, or the protracted slow growth of Germany in the 1990s.
Of course, this time the experts might be right, and FDI in China will remain at high levels or even increase in the coming decade. But equally they could be wrong again, and FDI could fall substantially, with serious consequences for China's economic growth.
The difficulty of predicting this with more certainty hinges on the many unanswered questions -- both inside and outside China -- that are likely to affect its attractiveness as an investment destination. These include whether the impending transition from a third-generation to fourth-generation leadership will bring harmony or friction, and whether the present unrest in rural areas spreads to China's cities, affecting political and social stability.
Other unanswered questions include whether China will move towards or away from a rule of law in which property rights are respected, equities markets expand, corporate governance becomes more responsive and transparent and corruption recedes rather than advances. The outlook for FDI in China will also be materially affected by whether the Chinese yuan remains stable while moving toward full convertibility, how far the huge volume of non-performing loans on the balance sheets of China's four state banks continues to grow and whether this triggers a financial crisis.
There is also the uncertainty over how far and how fast China will honor the market-opening commitments it made as part of its entry into the World Trade Organization. Indeed these may affect FDI in more ways than one. While there is disagreement over why FDI has had such a positive impact on China's economic growth, one possible explanation is that the preferential treatment accorded to foreign investors enables FDI to take advantage of opportunities within China that are inaccessible to domestic capital due to the internal trade barriers that currently exist among China's 31 provinces. But many of these may have to be dismantled as part of China's market-opening obligations following WTO entry. In particular, the international trade body's "non-discrimination" rule should end the current discrimination against domestic investors and so lessen the advantages that currently act as an attraction to foreign investors.
With increasing integration and competitiveness in global capital markets, whether FDI in China falls or grows will also depend on the environment in rival destinations for foreign investment, including the emerging markets of Korea, Russia, Eastern Europe, Southeast Asia, Taiwan, South Asia and Latin America, as well as in the capital exporting nations themselves. And, of course, it will also depend on how investment is shared among these destinations.
Hence, China's ability to attract FDI in the future will depend on other countries' political stability, their development and protection of property rights, corporate governance, the rule of law and any discovery of natural resources. It will also depend, in particular, on China's ability to maintain reasonably harmonious relations with its neighbors, including the U.S., Japan, the European Union, Taiwan and Southeast Asia.
In the past, FDI has been lured to China by the attraction of its potentially huge market. But in most instances, that promise has not been matched by results. Thus far, very few foreign investors have made significant profits in China, although the accounting practices followed by their large parent corporations often tend to obscure this.
Nonetheless, this lack of profits means that some of the previous optimism is being replaced by increasingly hardheaded calculations of the costs and prospective returns that come from investing in China. That means the amount of FDI which flows into China in the future will depend to a much greater extent than in the past on the risk-adjusted, after-tax return on investment that China offers, relative to other opportunities available to investors elsewhere in a world of globally-integrated capital markets.
The ensuing stakes for China are immense. If the combination of internal and external factors influencing FDI in China moves in an unfavorable direction, China's currently high level of economic growth will be seriously eroded. This prospect will and should, as Dr. Johnson observed, "concentrate the minds" of China's policy makers.
Mr. Wolf is senior economic adviser and corporate fellow in international economics at RAND Corp., and a senior research fellow at the Hoover Institution in California
This commentary originally appeared in Wall Street Journal on June 24, 2002. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.