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FDI with Chinese Characteristics

Posted: 10/12/10 03:51 PM ET

Consistent with so much about China's thrust on to the global stage over the past decade, its outward foreign direct investment (OFDI) has grown far faster than OFDI from other transitional economies. Chinese OFDI is largely politically driven, aimed at achieving specific nationalistic objectives, such as securing natural resources, acquiring strategic assets in key technologies and service industries, and creating national champion companies. China's approach to OFDI -- which is often aggressive and brusque in nature -- is increasingly coloring its relationship with recipient nations at all levels of development and income.

China has tailored its approach to OFDI based on the relative economic and political strength of the recipient country in exchange for specific benefits. For example, in highly indebted poor countries (HIPCs), China tends to offer to build infrastructure in exchange for the right to access to raw materials. In developing countries, China may offer to help develop an indigenous industry; in emerging markets, grant greater access to the Chinese market; and in developed countries, expand reciprocal agreements related to cross-border investment. In each case, China weighs the relative costs and benefits associated with expanding its relationship with a given county vis-à-vis what it will receive in return.

Developed countries have cried foul over the perceived anti-competitive financial support granted by the Chinese government to Chinese multinational enterprises (MNEs) -- most of which are state-owned -- operating in developing countries. Suspicions persist that much Chinese OFDI is driven by political considerations, since state-owned-enterprises (SOEs) are under the direct control of the state. Aggressive merger and acquisition (M&A) activity by Chinese MNEs in high technology and strategic natural resources has further heightened tensions.

At the same time, many developing countries welcome aid with no-strings-attached, which often accompanies Chinese OFDI, particularly in the natural resources sector. Yet some governments remain wary that such investment will lead to the 'development trap': a flood of cash that results in heightened corruption and largesse without building indigenous capacity, knowledge, management skills, or that allows movement up the global economic value chain. This is increasingly becoming an issue as China ramps up its investment presence in the world's poorest countries.

A Government-Led Strategy

China's stock OFDI is still small compared with that of developed countries, and was approximately equal to that of Austria in 2008. That same year Chinese OFDI stock was only 3.4% of GDP compared to 20.3% for East Asia as a whole and a world average of 27.3%. Yet until 2000, OFDI from China was negligible. That year, Premier Zhu Rongji officially announced that overseas investment would be one of the main objectives of the government's Tenth Five Year Plan (2001-05), giving birth to a "go global" strategy. Premier Wen Jiabao reinforced the importance of overseas investment in the Eleventh Five Year Plan (2006-10). The government-led strategy has proven to be effective. In 2006, yearly OFDI flow was
19 times that of 2000, growing at an average rate of 116% per year, far greater than average world OFDI growth of 6% over the same period. Other emerging economies recorded growth of just 31%. According the latest United Nations Conference on Trade and Development figures, OFDI flows more than doubled from 2006 to 2008.12

Until the late 1990s, the Chinese government discouraged OFDI by the private sector. Apart from a few projects run by SOEs, OFDI remained less than a sideshow to China's export led growth. The "go global" strategy radically shifted the government's policy toward the private sector to one of overseas investment promotion, in addition to aggressively pushing strategic investment by SOEs. In other words, the "go global" strategy is essentially two-pronged: in part a strategic decision to maximize China's political and economic power and at the same time a response to macroeconomic and domestic market factors.

The acquisition of strategic natural resources through investment in the primary sector abroad is at the top of the government's agenda. Such investment is designed to provide supply and price security for China's manufacturing-based economy, whose ravenous appetite for oil, metals, construction materials, and other key commodities makes their supply a national security imperative for the government. Not surprisingly, SOEs conduct OFDI in the primary sector, where investments are dominated by a few giant firms such as Baosteel, the China National Offshore Oil Corporation (CNOOC), the China National Petroleum Corporation, Sinochem, and Sinopec.

A second strategic objective is to spur investment that acquires sophisticated, proprietary technology, technical skills, industry best practices, and established brand names and distribution networks. The government hopes strategic asset acquisition can propel its chosen SOEs into industries at the top of the global value added chain, while obtaining the latest technology potentially for government use. Such investment often takes the form of M&A activity. Lenovo's purchase of IBM's computer unit and Huaneng Group's acquisition of InterGen are representative examples.

China's overall strategy for SOEs is to "grasp the large and let go of the small", aiming to create national champions from large SOEs through extensive government support while giving small and medium-sized SOEs greater exposure to the market. The government hopes to establish global, vertically and horizontally diversified MNEs operating with the most advanced technology and business practices as tools to advance its political and economic objectives. In addition to the primary sector, the government seeks to create and support national champions among some manufacturing, shipping, telecommunications, and financial services companies.

Finally, OFDI serves as a strategic objective at the macroeconomic level, relieving some of the imbalances that have been built up by economic policy that distorts the marketplace. Upward pressure on the Yuan can be somewhat mitigated by encouraging greater capital outflows, and OFDI reduces the massive capital stock the government has accumulated. Furthermore, promoting OFDI allows for investment diversification, particularly away from U.S. and other government bonds.

The Private Sector vs. Government Control

Domestic market dynamics have increasingly factored into OFDI growth and would have fueled its growth even without government promotion, given China's low OFDI relative to GDP. The increasing maturity and sophistication of some Chinese industries has oriented them to naturally expand profitably overseas. Fierce domestic competition has also propelled Chinese business in that direction, through organic business development and survival strategies. Establishing overseas production facilities and sales and distribution networks cuts operating costs, permits access to new markets, and provides the ability to avoid tariff barriers. As China's economic growth continues, labor costs, which are already held artificially low, will become more expensive. As domestic investment continues, capital will become cheaper, so firms from low-skilled, labor-intensive industries will increasingly use their domestic knowledge to seek more efficient production markets.

While private sector enterprises exposed to market forces are clearly playing a greater role, SOE's have continued to dominate OFDI, with SOEs holding approximately 84% of OFDI stock, and accounting for approximately the same percentage of OFDI flows from 2004-2006. Nearly all of the 30 largest Chinese MNEs are SOEs, and all large SOEs are under the direct control of the State-owned Assets Supervision and Administration Council (SASAC), which has authority over human resources, budgets, and investment decisions and strategy. Therefore, much of the OFDI can be viewed as an extension of government economic policy.

SOE's receive direct financial support from the government in the form of below market rate loans, direct payments, and other subsidies associated with official aid programs. The China Development Bank (CDB) and China Export and Import Bank (EXIM Bank) are the two primary government organs that provide support, although other state-owned banks and specially created funds also provide backing. Strategic OFDI receives significant political backing (see below), so while private sector enterprises will gradually expand their share of OFDI, the government will maintain strict control of what it views as strategic industries.

Sweeteners in Developing Countries

An increased share of global investment is one consequence of China's economic and political rise. Chinese OFDI has the potential to become a large portion of global cross-border investment, but China's obstreperous use of bargaining power creates political obstacles which may inhibit that growth. The blowback China has recently received from some African countries objecting to its one-size-fits-all approach to OFDI (leaving them with a nice football stadium but no knowledge that will help them grow in the long-term)-- has prompted China to reconsider its approach.

Some African countries are no longer simply rolling out the red carpet. In an increasing number of cases, natural resource export earnings must now be deposited into off-shore escrow accounts, with the value of the exports determined at the time of export, rather than in advance. Angola has required some Chinese companies to subcontract up to 30 percent of the work generated by OFDI to local companies and workers. Angola also began to require that Chinese companies obtain a minimum of three locally-sourced bids for every project. The government of Congo is now requiring that up to 12 percent of any infrastructure project pursued by Chinese companies involve local firms, with no more than 20 percent of workers being Chinese, up to one percent of the costs of each project devoted to worker training programs.3 This is a far cry from how Chinese OFDI started in these countries, when the Chinese simply dictated the terms of engagement.

Developing countries accounted for 95% of Chinese OFDI stock by the end of 2006, with a significant percentage in countries with weak governance and rule of law. Many of these countries have experienced the classic "resource curse" in which valuable reserves of minerals or fossil fuels enhanced corruption and conflict rather than promoting economic development. Chinese SOEs typically step into this environment with the advantages of political backing and government subsidized and insured investment, and China has often used significant sweeteners to win contracts. As part and parcel of negotiating OFDI deals in resource rich poor countries, China usually sends high-ranking officials to negotiate deals alongside official development aid (ODA) programs. In order to secure investment deals, the government offers infrastructure projects, politically important landmarks, soft loans, and grant programs as a package deal with a proposed natural resource investment. With government financing and political support, Chinese SOEs avoid a plethora of risks that often plague investments in resource-rich poor countries. Political and reputational risks are usually mitigated, and financing uncertainty is eliminated.

For several years, the World Bank has ranked Congo last on its list of ease of doing business measurement. Congo has a failed legal system, a kleptocratic bureaucracy, nearly non-existent infrastructure, and is consistently rated as one of the most corrupt countries in the world by Transparency International. Yet in 2008, EXIM Bank and CDB signed investment deals estimated to be worth up to $14 billion with the Congolese government. The banks agreed to build infrastructure and refurbish mines in exchange for 3.5m tons of copper reserves.4

While Freeport McMoRan, a U.S. firm, controls three times as much copper at its Tenke Fungurume mine in Congo, it took years to arrange the investment. Furthermore, the speed with which the Chinese SOEs reached a deal is striking by comparison to a mine in Katanga Province that Freeport recently opened -- Tenke Fungurume Mining Sarl -- which took more than a decade to finance and get off the ground. It has already faced significant obstacles, including unforeseen and possibly illegal taxes, jailed employees, and fines running in the millions of dollars.5 Such risks hinder western MNEs, which must respect the bottom line, but are of little concern to Chinese SOEs.