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Proceedings of the 15th Annual Conference of the Association for Chinese Economics Studies Australia (ACESA)

FDI in China: Institutional Evolution and its Impact on

Different Sources

Chen Jing1

Yuhua Song2

Zhejiang University, P.R.China

Abstract The institutional infrastructure towards FDI in China has experienced a fundamental

change attributing to the economic reform since 1979. It plays an important role in

establishing a business-friendly environment for further FDI promotion.

From 1979, China has devoted arduous efforts in earning strict confidence from

foreign investors due to the foregone socialist planning economic system. At the early

stage, Hong Kong (including Macao) dominated the FDI inflows to China. From

1987, Hong Kong reached its turning point and changed its invest patterns. The

confirmation of economic reform and policies has updated the institutional

infrastructure since 1992 and brought huge FDI inflows both in kinds and volume.

The proportion of the different sources was changing. China entered WTO began a

new era for China’s FDI inflow.

This paper intends to examine such an argument via the following focuses: (1) to

trace the legal opening up and FDI specific policies in four stages, (2) to study the 1 Correspondence to: Chen Jing

Chukechen Honors College

Zhejiang University

P.O.Box 1312, Zhejiang University, 310027

P.R. China

Email: [email protected]

Ph: 86-571-87933865 2 Professor Yuhua Song

Department of Economics

Zhejiang University, 310027

P.R. China

Email: [email protected] Ph: 86-571-87968695

Chen, J., & Song, Y., ‘FDI in China: Institutional Evolution and its Impact on Different Sources’. - 1 -

mailto:[email protected]


different patterns of different FDI sources in the different stages, (3) to analyze the

institutional impact on the patterns and behavior of different FDI sources from formal

and informal institution, and build up a model based on Neo-Classical growth model.

Results of the study demonstrate that the changing proportion of the different FDI

sources in the different stages is correlated with the institutional evolution. And

certain institution variables play a significant role in affecting the proportions of FDI

from different sources.

I. Introduction

Since 1979, China has begun to open its front door to the foreign investors. Through

the two decades, the institutional infrastructure towards FDI in China has experienced

a fundamental change and China has become one of the most important destinations

for foreign direct investment in the world. In 2002, China’s FDI inflows even

surpassed that of the United States and became the biggest host country for FDI in the

world. Comparing with an inflow of $US 30 billion into United States, FDI into China

amounted to $US 53 billion in 2002.

The institution towards FDI in China is composed of formal and informal institution.

The formal institution can be divided into direct and indirect institution. The direct

institution is China’s FDI policy, which will directly influence the behavior of foreign

investors. The indirect institution is the pertinent policy towards State Owned

Enterprises, qua the institutional foundation of FDI, which has an indirect impact on

foreign direct investment. The informal institution is the marketization of the

investment environment of China’s inward FDI, which is mainly represented by the

significance of culture and hometown connection to the different investment sources.

The institutional evolution towards China’s inward FDI has a great influence upon the

proportions of FDI inflows from different source countries. Figure 1 shows the

percentages of actually used FDI inflows into China by developing and developed



source countries from 1984 to 2001. (According to Appendix 1) We can clearly

observe that the proportions of FDI from different sources greatly changed through

years. Therefore, we divide the institutional evolution towards China’s inward FDI

into four stages according to the data. The first stage is from 1979 to 1986. During

this stage, investment from developing countries, especially from Hong Kong

(including Macao) dominated the FDI inflows to China. From 1987 to 1991 is the

second stage. In this stage, the proportion of developing countries greatly increased

comparing to that of the first stage, Hong Kong even reached its turning point and the

proportion of developed countries decreased at the mean time. The third stage is

from 1992 to 2000. During this stage, FDI from developing countries shrunk from

81.55% to 53.56%, while FDI from developed countries greatly expanded from

13.55% to 26.64%. The gap of the proportion between developing countries and

developed countries gradually decreased. The fourth stage is from 2001 to present, in

which period several institutional transformations occurred after China entered WTO

and a distinct change of the proportions of different source countries can be

anticipated.

Figure 1, Actually Used FDI inflows into China by Developing and Developed

Source Countries, 1983-2001 (Percentage )

Source: Appendix 1

This paper tries to validate that the institutional evolution towards China’s inward FDI

has a great impact on the proportions of FDI inflows from different source countries



and some institutional factors have different significance to the source counties. In the

second section, we study the different patterns of different FDI sources. In the third

section, we build up a model based on the neo-classical growth model and induce 5

institutional variables. In the fourth section, we explore China’s FDI policy evolution

in 4 stages and its impact on different source countries. We then analyze the pertinent

institutional evolution towards SOEs, who serve as the institutional foundation for

FDI, and its contribution to the structural changes of China’s FDI. At last, we work

over the marketization of investment environment and research on the role of culture

and hometown connection in investment decisions. We hope our research can not only

reveal the significance of certain factors in attracting certain kind of FDI, but also

forecast the further trend of the changes of China’s FDI inflows by analyzing the

institutional evolution towards China’s inward FDI. We hope we can contribute to the

further studies of China’s FDI inflows to some extent.

II. Comparisons of invest patterns of different Sources

i. FDI from Developing Countries

FDI from developing countries mainly include FDI from Hong Kong, Taiwan, Macao,

Singapore and Republic of Korea. From Table 1, we can clearly observe that the FDI

from developing countries is more than half of the total inflow, which is the most

dominant force of China’s inward FDI.

FDI from developing countries aim to fully utilize the cheap labor costs in Mainland

China to develop the traditional labor-intensive industry, in which China has

comparative advantages, just like assembly and processing operations.

The comparative advantages of the investment from developing countries can be seen

in various aspects. First, most of the FDI from developing countries are vertical3

(export-oriented) FDI (Markusen,1995; Zhang and Markusen,1999), which highly 3 The vertical FDI, motivated by foreign cheap labor, fragments the production process across countries by production stages based on labor intensities.



matched the “export-promotion” FDI regime in the early stages of China. Second,

most of the FDI from developing countries are small and medium sized business that

are involved in industries which China has comparative advantage. It makes FDI from

developing countries easy to operate and flexible to retreat from such an uncertain

environment in the early times. Third, in China, a nation emphasizes the role of

relationship and network in business, developing countries appear to own much

superiority in information collection. They are much more familiar with the market

than the developed countries and it can greatly help them to avoid the informal

barriers in China.

As FDI from developing countries can always find informal channels to solve

problems, such as friction and complex procedure, they do not have the strict request

for institution infrastructure in the investment environment. It seems that the

competitive edge of developing countries rests primarily on managerial and marketing

advantages in entering, marketing and selling light consumer goods (USCBC, 1991).

Fourth, a large portion of FDI from developing countries is provided by oversea

Chinese. They prefer to invest in coastal areas which they have “hometown

connection”, such as Guangzhou, Fujian. The cultural and language advantage play an

important role in investment decision. Therefore, most of the FDI from developing

countries prefer to build up equity joint venture and cooperative joint venture, as the

transaction cost for them is much less than that of developed countries when building

up the same enterprise. At last, about 50% of the Hong Kong FDI represented a

recycling of capital from Mainland China, called “ Round-Tripping FDI”, which

sought to take the advantage of preferential treatment given to foreign investment.

(Lardy, 1996). Furthermore, domestic capital tends to be relatively immobile between

regions, some “Round-tripping FDI” can be seen as a result of the intra-regional

barriers to capital flows within China. Comparing with the FDI from developed

countries, who aimed to the huge market size, “Round-Tripping FDI” is superior in

profiting from the preferential policies than developed countries to some extent.



The comparative disadvantages of FDI from developing countries are obvious. They

appear to lack ownership advantages such as advanced proprietary technology and

established brand name. The “spillover” effect of the FDI from developing countries

is much less than that of developed countries. Besides, the small and medium size

firm benefits less from economies of scale.

ii. FDI from developed countries

FDI from developed countries mainly include FDI from United States, Japan, United

Kingdom, Federal Republic of Germany, France, Italy, and Canada. From table 1, we

can clearly see that the FDI from developed countries is about 1/3 of the total amount.

And since 1992, FDI from developed countries has gradually increased and become

one of the major sources of China’s FDI inflows.

The target of the FDI from developed countries is the huge market size of China. And

this kind of FDI is called horizontal 4(market-oriented) FDI (Markusen, 1995; Zhang

and Markusen, 1999). FDI from the US, EU and Japan have been focused on large

import substituting areas such as automobiles and off-shore petroleum and other

natural resource sectors, in which China does not have comparative advantage.

The comparative advantages of FDI from developed countries appear in following

aspects. First, FDI from developed countries usually prefer to build up larger

enterprise size and the larger market size in China offers greater opportunities to

realize effectively economies of scale (Zhang, 2000b). Second, in contrast to FDI

from developing countries, FDI from developed countries hold advantages of

ownership, such as advanced proprietary technology and established brand names.

They are perfectly matched with the technology-promotion FDI regime of China in

the latter stages. And the “spillover effect” of management and technology is much

greater than that of developing countries.

4 Horizontal FDI are induced by foreign market access build plants in multiple countries to serve local markets. (Zhang, 2000b)



The comparative disadvantages of FDI from developed countries are as follows. First,

the foreign investors from developed countries are not quite familiar with the

investment environment due to the cultural and customary barriers. They lack

advantages of collecting information, entering and marketing comparing with FDI

from developing countries. Second, FDI from developed countries have higher

requirement for human capital and infrastructure in the host country. They strictly

require intellectual property protection and prefer to use the formal channel, just like

judiciary and administration, to solve problems. They apt to invest in Shanghai,

Jiangsu etc, where has better market infrastructure and labor quality. Third, in order to

protect the advanced technology, FDI from developed countries usually prefer to

adopt Wholly-Owned Subsidiaries or have better asset control, thus the transaction

cost is much greater than FDI from developing countries.

iii. Comparison of FDI from different sources.

Table 1 gives out a direct comparison of FDI from developing countries and

developed countries. Thus we can get a thorough understanding of the invest patterns

of FDI sources.



Table 1. Comparison of FDI sources

LDCs DCs

Target Low labor cost Huge market size

Advantages ·Export-oriented

·Small and medium size

· Managerial and

marketing advantages

· Cultural and language

advantage

· Enjoy preferential

policies

·Larger enterprise size

·Advantages of ownership

Disadvantages · Lack ownership

advantage

· Benefits less from

economies of scale

·Cultural and customary

barriers

·Higher requirement for

human capital and

infrastructure

·Higher transaction cost

Source: The Study

III. Institutional Model of FDI

(1) Variables

i. Preferential Policy (T): The Preferential Policy is measured by the tax,

and its expected impact should be negative.

ii. The Degree of Openness (DTD): The Degree of Openness is measured by

the degree of trade dependence, and its expected impact should be

positive.

iii. The Market Entry (CIR): The Market Entry is measured by the control of

industrial and region, and its expected impact should be negative.



iv. The Steadiness of Institutions (PCI): The Steadiness of Institutions can be

measured by the persistence and continuance of institutions, and its

expected impact should be positive.

v. Market Perfecting (MSM): The Market Perfecting can be measured by the

market size and marketization. Marketization includes the relationship

between government and market, development of Non-state economy,

maturity of product market, maturity of factor market, maturity of market

agency and the environment of juristic institution5. Its expected impact

should be positive.

(2) Model

(1) ( , )Q AF K L=

(2) 1(1 ) tK K I Fδ −= − + + ∆ DI

(3) ( , , , , )FDI T DTD CIR PCI MSMφ=

(4) 1(1 ) ( , , , , )tK K I T DTD CIR PCI MSδ Mφ−= − + + ∆

(5) ( , , ) ( , )B CIR PCI MSM G T DTDφ = ⋅∑

(6) DC LDCφ φ φ= +

(7) ( , , ) ( , ) ( , , ) ( , )DC DC LDC LDCB CIR PCI MSM G T DTD B CIR PCI MSM G T DTDφ = ⋅ + ⋅

(8) ( ) ,DCG T DTDα βλ α β= ⋅ ⋅ + <1

(9) ( ) ,LDCG T DTDχ γµ χ γ= ⋅ ⋅ + <1

(10) ( , , ) ( ) ( , , ) ( )DC LDCB CIR PCI MSM T DTD B CIR PCI MSM T DTDα β χ γφ λ µ= ⋅ ⋅ ⋅ + ⋅ ⋅ ⋅

α β+ <1, χ γ+ <1

Hypothesis 1: As FDI from developing countries is superior in profiting from the

5 According to “NERI Index of Marketization of China’s Provinces”(2000), Fan Gang, Wang Xiaolu, National Economic Research Institute, China reform Foundation.



preferential policies than developed countries, the marginal revenue of tax is negative,

and the marginal revenue of developing countries is lower than that of developed

countries. Therefore:

LDCdGdT

< DCdGdT

<0

Hypothesis 2:As most of the FDI from developing countries are export-oriented; a

higher degree of trade dependence of the host country would provide larger market for

the FDI from developing countries. Thus the marginal revenue of the Degree of Trade

Dependence is positive, and the marginal revenue of the Degree of Trade Dependence

of developing countries is higher than that of developed countries:

( )

LDCdGd DTD

>( )

DCdGd DTD

>0

Hypothesis 3: As FDI from developing countries have managerial and marketing

advantages, in contrast, FDI from developed countries have higher transaction cost,

the Control of Industry and Region have higher negative effect on FDI from

developed countries:

( )DC DC

DC

dBB d CIRφ∂ ⋅

∂<

( )LDC LDC

LDC

dBB d CIRφ∂ ⋅

∂<0

Hypothesis 4: The cultural and language advantages of FDI from developing

countries can usually help the investors to avoid the institutional risk, therefore the

marginal revenue of the persistence and continuance of institution is higher for the

FDI from developed countries, who usually have cultural and language barriers:

( )DC DC

DC

dBB d PCIφ∂ ⋅

∂>

( )LDC LDC

LDC

dBB d PCIφ∂ ⋅

∂>0

Hypothesis 5: As FDI from developed countries aim to the huge market size in China,

and they usually have larger enterprise size and advantage of ownership, their higher



requirement for human capital and infrastructure also make them more benefit from

the Market Size and Marketization, therefore:

( )

DC DC

DC

dBB d MSMφ∂ ⋅

∂>

( )LDC LDC

LDC

dBB d MSMφ∂ ⋅

∂>0

IV. Policy Evolution towards FDI in China.

Since China’s economic opening in 1978, law making, reform in institutional

infrastructure and regional opening FDI specific policy adopted can be represented by

a four-stage evolution process.

(1) The first stage (1979-1986)

The promulgation of Equity Joint Venture Law in 1979 is the milestone of China’s

opening up in FDI specific area. During this period, law making to provide legal

status for FDI related activities in socialist economy were pursued (Chyau Tuan and

Linda F.Y.Ng, 2002). A checklist of the land-marked legislation for the four stages is

given in Appendix 1. During this stage, law making was focused on Equity Joint

Venture. Several specific laws and regulations about Equity Joint Venture were

promulgated, including registration, labor management, accounting system, foreign

exchange and etc. Equity Joint Venture served as an example for FDI in other

organizational forms. And Wholly Owned Subsidiaries was still a concept in law, but

seldom in practice.

In this period, regional opening was launched on leaning by doing basis. (Chyau

Tuan and Linda F.Y.Ng, 2002). First, four special economic zones (SEZs) were set up

for accommodating FDI inflows in 1979. Preferential policy towards foreign capital

was implemented on a trial basis. Five years later, 14 coastal port cities including

Shanghai & Guangzhou were opened for FDI. Economic open regions were

announced for Yangtze River Delta, Pearl River Delta (PRD) and



Xiamen-Zhanzou-Chunzou Triangle in 1985.

This period, the policy towards FDI was still on trial, thus there were great

restrictions on FDI activities, such as restrictions on foreign exchange, domestic

market entering and equipment purchase, etc. Thus the accumulated amount of FDI

inflow (1979-1986) was still small, about US$7.5 billion or US$0.9 billion per year

on average. Investment from Hong Kong (including Macao) dominated the FDI

inflows to China. Most of the Hong Kong investment projects were in form of

cross-border (SEZ’s and proximate cities in Guangdong) manufacturing/processing

of labor-intensive products, real estate development, and hospitality business. By

utilizing the advantage of familiarity of the market and investing in the industry

which China has comparative advantage, FDI from Hong Kong (including Macao)

was much easier to operate, thus Hong Kong served as a pioneer in China’s FDI

inflow.

(2) The second stage (1987-1991)

This stage was mainly represented by enlargement or fine-tunes of FDI specific

legislation and allowance of more open areas (Chyau Tuan and Linda F.Y.Ng, 2002).

During this stage, several laws and rules were enacted and improved, including the

laws of Joint Venture and Wholly Owned Subsidiaries and the critical mass in terms

of legal, institutional and physical infrastructing might be also formulated around

1991/1992 in some early opened areas. More coastal areas such as Shandong and

Liaodong peninsulas, and Hainan (SEE) were opened in 1988. Pudong New Area of

Shanghai was also established in 1990. During this period (1987-1991), FDI inflows

increased by almost 4 times than the first stage to account for US$ 16.68 billion, or

an annual average of 3.34 billion.

In addition to the export-promotion regime in this period, State Government

promulgated Provisions of the State Council Concerning the Encouragement of

Investment by Compatriots from Taiwan in 1988 and Regulations for Encouraging



Investment from Overseas Chinese and Compatriots from Hong Kong and Macao in

1990, which was a great encouragement for the FDI from Hong Kong, Taiwan and

oversea Chinese. FDI from developing countries, especially from Hong Kong,

Taiwan and Macao drastically increased and the proportion of developing countries

in FDI inflows also gradually increased to 68.40% in 1991. From the fourth quarter

of 1987 and thereafter, the volume of the re-exports from Hong Kong exceeded her

domestic exports. The accumulated effects of cross-border processing from 1979 to

1986 finally pushed Hong Kong’s manufacturing reach the turning point by moving

toward a more complete division of labor between regions (Tuan and Ng, 1995b).

Hong Kong’s successful experience in Guangdong helped China to earn international

confidence finally by build-up of her track record in its policy consistency. But as the

restriction of foreign exchange in China, it’s still hard for investors from developed

countries to retract capital. Contrarily, most of the investments from developing

source are export-oriented, which will avoid the foreign exchange restriction. Besides,

FDI from developing sources can always find the informal channels to solve the

problems, such as entering and complex procedure, which made much contribution to

the surge of FDI from developing countries. But it worth to mention that maybe the

huge amount of actual FDI from Hong Kong is overestimated due to the

“Round-Tripping FDI”, which is the capital flight flow out of China and then flow

back into China as the foreign capital in order to enjoy the preferential policy and

avoid the immobility of domestic capital.

(3) The Third Stage (1992-2000)

Mr. Deng’s speech in October 1992 began a new era for FDI inflow in China. China’s

determination in establishing a “Socialist Market Economy” as a national policy gave

foreign investors great confidence in investing in China. FDI inflows increased by

almost 19.5 times than the second stage to account for US$ 324.70 billion, or an

annual average of 36.08 billion. FDI regime in China turned administrative-oriented

into market-oriented. The extended openness can be seen not only in the open area,



but also in the national institution. Six riverside port cities, 13 inland border cities and

18 provincial capitals were opened and delegation of FDI approval was granted in

1992. Opening has been continued and in fact expanded to cover all mainland areas.

And cities like Shanghai, Suzhou, which has better institutional infrastructure and

purchase power, became the hottest destination for FDI, especially FDI from

developed countries. The institutional infrastructure has been much more systematic

and standard. The government tried to attract part of the investment from eastern

coastal cities to western cities. In this period, the amount of FDI has increased rapidly

and its contend also altered. USA, Japan and European Union gradually expanded

their share of FDI inflows to achieve nearly 30% of FDI in China. FDI from

developing countries decreased its share from 81.55% in 1992 to 53.56% in 2000.

The institutional infrastructure towards China’s FDI has been much improved since

1992. Several specific laws have been announced, not only to protect the legal status

of foreign investors, but also to meet the higher institutional needs of the western

investors, including simplify the procedures, specify the rules and standardize the

regulations. Thus the FDI from developed countries greatly increased during this

period.

As the foreign exchange controls in this period has been much released, investors

from developed countries no longer worried too much about retracting capital. It

would boost up the confidence of FDI from developed countries and it must be one of

the major reasons for the expansion of the share from developed countries.

Since the Ninth Five-Year Plan (1996-2000), attraction of technology intensive FDI

has become the priority of many local governments in China, more pro-active FDI

policies has enabled the participation of FDI to extended from labor-intensive

manufacturing to capital/knowledge-intensive manufacturing and services and from

public to private ownerships (Chyau Tuan and Linda F.Y.Ng, 2002). China used some

policy tools to attract Hi-Tech FDI. With Pudong as an example, the major policy

tools, on top of the other FDI “preferentials”, including financial measures as follows



(Lin, et.al, 2000): (1) full (100%) return of value-added tax and business income tax

for three years for computer hi-tech, medical and material industries; (2) full tax

return for two years for other recognized hi-tech industries; (3) full or partial tax

concessions in new technology importations, transfer of technology, and new

technology exhibitions; and (4) government express services in taxation, registration,

various purchasing assessments, and permissions, etc. Further, areas such as Suzhou

Industrial Park, Suzhou New Zone, Shengzhen SEZ, and Zuihai SEZ had been

provided with similar attraction in the past few years. FDI from developed countries

exactly met the need of China’s national policy. The revision of Guideline for FDI in

1997 clearly indicates the transference from export-promotion FDI regime into

technology-promotion FDI regime. Hi-tech industries have been much increased in

catalogue of hortative industries, at mean time been much decreased in catalogue of

restrictive industries.

(4) The Fourth Stage (2001-present)

In order to meet the criteria of WTO, China has begun another institutional reform

since 2001. A series of laws and regulations has been revised and several new rules

have been promulgated. The investment market of FDI in China has been more open,

systematic and technology-oriented.

The extended openness of China’s FDI market in this period can be seen in two

aspects. The first one is the market which permits foreign investors entering has been

expanded. According to the Catalogue for the Guidance of Foreign Investment

Industries, the hortative industries have been much increased, at same time, restrictive

industries and inhibitive industries have been much reduced. It is worth to mention

that the financial sectors and service sectors have been opened to a much better extent.

And foreign investors are permitted to sell products in domestic market more freely.

The second aspect is represented by the looseness of restriction, including the

restrictions of foreign exchange control, employment requirement, distribution and etc.



The competition between foreign capital and domestic capital is fairer.

In order to meet the standards of WTO accession, China has promulgated series of

specific laws and regulations. The accounting system, instauration procedure and

operation measures have become more systemic and normative, which would highly

meet the criteria of developed countries. Although we do not know much about the

share of China’s FDI inflows by different sources in this period, another surge of FDI

from developed source can be anticipated.

Keeping on the technology-promotion FDI regime, China gives more privilege to

Hi-Tech industries, which can be observed in series laws. It can be also seen in the

Catalogue for the Guidance of Foreign Investment Industries, more Hi-Tech industries

are in catalogue of hortative industries.

V. Pertinent institutional evolution towards State Owned

Enterprises

Because of the policy and legal restriction in the early period, most of the FIEs in

China took the form of joint ventures with Chinese shareholding firms and most of the

Chinese shareholding firms were SOEs. After 1990s, state assets have become more

acquirable; some FDI inflows take the form of acquisition of existing assets rather

than green-field investment, especially state assets. Thus, institutional evolution

towards SOEs, which serves as the institutional foundation of FDI in China have great

impact on FDI inflows. Some findings suggest that the debt obligations on the part of

the SOEs and the local control of the SOEs promote the growth of FIEs and that some

of the foreign direct investment (FDI) inflows result in acquisition of existing assets

and shift assets control from SOEs to FIEs. (Yasheng Huang, 1999)



In the early stages (Before 1990)

In the early stages of China’s FDI inflows, vast majority of the FIEs were joint

ventures between Chinese firms and MNEs, which were mainly formed by developing

countries, vast majority of the Chinese shareholding firms were SOEs.

In these stages, SOEs were protected by government and all the profit and loss were

balanced by the state budget. The SOEs could hardly realize the low efficiency and

high waste and didn’t highly require for changes. They took the alliance with MNEs

as “strategy alliance” and asset of the SOEs were not easily acquirable, SOEs sought

to ally with MNEs with high asset control. From table 3, we can clearly conclude that

MNEs who took the alliance with SOEs with low asset control in this period were

FDI from developing countries.

In this period, SOEs may view alliances with MNEs as an access to the deep financial

and technological base of the MNEs, either to launch new products or to gain markets

as the Chinese competitive landscape intensifies. Another related motives is to raise

cash quickly to service the onerous social and policy burdens placed on the SOEs,

such as funding pensions of retirees, medical expenses and unemployment

contributions. Shares in FIEs may yield dividend payments that match better with

SOEs’ liabilities than their operations. (Yasheng Huang, 1999). Chinese SOEs are

divided into “central” and “local” enterprise. Local governments plan a prominent

supervisory and financing role in economy.6 As of 1995, according to the 1995

Industry Census, there were 87,905 SOEs, of which 83,167 of them were local SOEs.

Local SOEs accounted for 54 percent of the industrial value added and 65 percent of

the assets in the state sector. Local governments are extremely motivated to seek

foreign alliance in the early years. Because FDI can not only help to solve the

problem of unemployment, but also has advantage of mobility comparing to the

domestic capital, local governments compete with each other to capture a bigger share

6 See [Montinola, Forthcoming #1225]



of the capital inflows. Capital competition often prompts local governments to grant

generous tax concessions, subsidized bank credits, and undervalue Chinese equity

contributions (often in the form of heavily subsidized land usage charges.)

In the late Stages (After 1990)

After 1990, majority of FIEs are still Joint Venture, but the number of Wholly Owned

Subsidiaries and Joint Ventures with higher foreign control are increasing due to the

boom of FDI from developed countries in the 1990s. Merger and Acquisition of state

assets become a prevalent form of establishing FIEs in China.

In the later stages, as more SOEs faltered, more of their assets were acquirable. SOEs

no longer create Joint Venture with MNEs as “strategy alliance”, but more as the

result of financial distress. SOEs gradually lost the assets control to their foreign

copartners in order to raise liquidity, and it would just match the need of high assets

control of FDI from developed countries (Table 2). Besides, after China entered WTO,

encouraging foreign investors to join the reform of SOEs by means of transitional

M&A is a major breakthrough for China’s FDI regime. Some findings suggest that

some of the FDI inflows take the form of acquisition of existing assets rather than

green-field investments in 1990s.Thus acquisition of existing assets, especially state

assets was a prevalent way and will be a more prevalent way for investors from

developed countries to build Wholly Owned Subsidiaries and Joint Venture with high

assets control.



Table 2 Equity Shares of the developing and developed source countries (based

on the approvals of 1994)

Equity Share of FFEs Developing country FFEs(100%) Developed country

FFEs(100%)

Under 25% 0.92 0.00

25-<50% 33.80 24.64

50-<75% 39.84 42.32

75-<100% 12.23 15.36

100% 13.21 17.68

Total 100 100

Source: Calculated from the Editorial Board of the Almanac of China’s Foreign

Economic Relations and Trade (1995), Zhangguo Duiwai Jingji Maoyi Nianjian

1995/1996 [Almanac of China’s Foreign Economic Relation and Trade1995/96],

Zhongguo Shehui Chubanshe, Beijing

VI. Marketization of investment environment

The marketization of China can be evaluated by the NERI Index of marketization,

including the relationship between government and market, development of Non-state

economy, maturity of product market, maturity of factor market, maturity of market

agency and the environment of juristic institution7.

Before 1992, low level of the institutional infrastructure, low government efficiency

and lack of market transparence directly halted the confidence of FDI from developed

countries. But FDI from developing countries, just like Hong Kong, Taiwan,

Singapore can utilize the cultural ties to solve the institutional barriers, including

collecting informal information and averting complex procedures. Information on

labor and material costs, suppliers, distributions, and other market conditions is often

7 According to “NERI Index of Marketization of China’s Provinces”(2000), Fan Gang, Wang Xiaolu, National Economic Research Institute, China reform Foundation.



necessary to assess the future profitability of an investment project. The network and

personal relationship deeply embed into every Chinese’s ethic, so the role of

connections is particularly important. Thus FDI before 1992 were mainly FDI from

developing countries with cultural ties, invested in Guangzhou, Fujian, where oversea

Chinese have better hometown relationship. Some findings suggest that cultural ties

with Hong Kong, Taiwan and Singapore alone would be responsible for 60% of total

FDI. (Ting Gao, 2002)

After 1992, the fast growing marketization of eastern coastal cities, just like Shanghai,

Suzhou, attracts large amount of FDI from developed countries. The risen efficiency

of government and better market transparence provide a much better investment

environment for FDI from developed countries. Besides, the modern concepts of

profit, justice and efficiency began to instill into modern Chinese, especially people

living in open areas. Thus, FDI from developed countries, which invested in Shanghai,

Jiangsu become conspicuous land scenery in China’s opening process.

VII. Conclusion

After more than two decades of openness, the institutional infrastructure towards FDI

has experienced a fundamental change in China. The institution is much more formal,

systematic, open and improved in order to meet the high requirement of the fast

growing development of “Socialist Market Economy”.

The institutional evolution towards FDI has a far-reaching impact on different source

countries. With the preferential policies and export promotion regime in the early

stages, FDI from developing countries had better return and saved as the dominant

force. With the improving law making, loosening restriction and opening competition,

continuous institution and better market infrastructure in these 24 years, the share of

FDI is diverting to the developed countries. FIEs with high foreign controls, which



are formed by developed countries has become a prevalent organization form in

current years and would be more prevalent in the future. Cities with better market

infrastructure, like Shanghai, Jiangzhou, have be the hottest destinations for the

increasing FDI from developed countries and the role of cultural ties would be a much

less consideration in the future, marketization of the investment environment would

be an important factor in investment decision. We can speculate that FDI from

developed countries would play a more significant role in contributing to the national

economic growth in the near future.

Further research can be done to quantify some of the institution indexes and revise the

FDI model.



APPENDIX 1

Actually Used FDI inflows into China by Developing and Developed Source

Countries, 1984-2001 (Percentage)

1984 1985 1986 1987 1988 1989 1990 1991 1992

LDCs8 52.77 49.37 59.83 69.08 66.48 63.72 56.32 68.40 81.55

DCs9 43.48 42.38 31.97 23.01 26.89 23.65 30.69 25.80 13.55

1993 1994 1995 1996 1997 1998 1999 2000 2001

LDCs 79.38 75.50 70.62 68.09 64.22 59.50 57.51 53.56 51.87

DCs 14.73 17.81 22.26 18.64 25.30 23.13 27.26 26.64 26.11

Source: Various issues of China Statistical Yearbook, National Bureau of

Statistics of China, China Statistics Press.

APPENDIX 2

A checklist of landmark Legislation of FDI policy in China

Stage 1(1979-1986)

·Equity Joint Venture Law (1979)

· Regulation for the implementation of the law of the People’s Republic of China on

Chinese-foreign Equity Joint Ventures.(1983)

·Wholly Owned Subsidiaries (WOS) Law.(1986)

·Provision for the FDI Encouragement (1986)

·Constitutional Status of Foreign Invested Enterprises in Chinese Civil Law (1986)

Stage 2(1987-1991)

·Interim Provisions on Guiding FDI (1987)

·Delegation on Approval of selected FDI Projects to more Local Governments (1988)

·Laws of Cooperative Joint Ventures (1988)

8 LDCs include Hong Kong, Taiwan, Macao, Singapore, and Republic of Korea. 9 DCs include United States, Japan, United Kingdom, Federal Republic of Germany, France, Italy, and Canada.



·Revision of Equity Joint Venture Law (1990)

·Rules for Implementation of WOS Law(1990)

·Income Tax Law and its Rules for Implementation(1991)

Stage 3(1992-2000)

·Trade Union Law (1992)

·Company Law (1993)

·Provisions Regulations of Value-added Tax, Consumption Tax, Business Tax and

Enterprise Income Tax (1993)

·Law on Certified Public Accountants (1994)

·Law of the People's Republic of China on Protection of Taiwan Compatriots'

Investment(1994)

·Provisions for Foreign Exchange Controls(1994,1997)

·Insurance Law(1995)

·Law of Commercial Bank(1995)

·Detailed rules for implementation of Cooperative Joint Venture Law.(1995)

·Provisions on Guiding Foreign Investment Direction (1995,1997)

·Further delegation For Approving FDI to Local Government(1996)

· Industrial Catalogue for Foreign Investment in the Central and Western

Regions.(2000)

Stage 4(2001-present)

·Revision of Equity Joint Venture Law (2001)

·Revision of regulation for the implementation of the law of the People’s Republic of

China on Chinese-foreign Equity Joint Ventures (2001)

·Rules for Implementation of WOS Law (2001)

·Provisions on Guiding Foreign Investment Direction (2002)

Source: “FDI in China and the Regional Development: From Institutional Reform to

agglomeration Economics Perspectives” Chyau Tuan and Linda F.Y.Ng, 2002,

Revised by the study.



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