China FDI

Better FDI? The Shanghai Pilot Free Trade Zone is not the answer

December 20, 2014 by Ken Davies

The Shanghai Pilot Free Trade Zone has not so far succeeded in driving innovation in government policy towards foreign investment. What is now needed are bold further reforms across the whole country. Look elsewhere — for example, in China’s foreign investment regulations and diplomacy — to see where this may occur next.

Having attracted massive amounts of foreign direct investment (FDI) over the past three decades, in recent years China has been trying to cope with over-investment and the need to innovate and move up the technology ladder to capture more of the value-added earned by its exports. This means attracting more capital-intensive, high-tech FDI, including R&D centres, as the country moves away from increasingly expensive labour-intensive export manufacturing. It also needs to encourage inward investment in services to help its economic re-balancing effort.

How can the Shanghai Pilot Free Trade Zone help? Will it pioneer a more effective approach to attracting high-quality FDI? The tentative measures taken so far have manifestly failed to do so.

At the heart of foreign investment policy are sectoral restrictions in the Catalogues for Guiding Foreign Investment Industries. Replacing this four-fold behemoth of prohibited, restricted, permitted and encouraged categories with a simple closed list that would leave all other sectors unconditionally open to foreign investment was heralded as the big policy breakthrough the Shanghai FTZ would achieve.

But instead of a short closed list, the initial negative list unveiled on 29 September 2013 was extensive. In fact, it merely reproduced existing restrictions in the Catalogues. This was a disappointment to foreign investors. Nonetheless, it did represent a reasonable starting point for liberalisation, as the list could then be trimmed in future annual reviews, as the authorities promised at the start of the exercise.

The first such revision was on 30 June 2014, when the list was cut from 190 industries and activities to 139. This was a fairly modest liberalisation measure, as only 13 restrictions on the original list were removed; the rest of the reduction resulted from reclassification and the elimination of duplicate items.

Some of the manufacturing and processing sectors opened up are unlikely to attract investors because of inadequate space in the zone (as it now stands). More significant was the opening of services sectors, including trade certification, shipping and cargo handling, internet cafés, oil and sugar trading, automotive electronics R&D and some real estate project areas.

The real test of the negative list will be how far and how fast it is reduced in future annual revisions. The slow pace of change so far may indicate opposition from government agencies and domestic firms that stand to lose from it.

This gradual streamlining, though, is essentially the same outdated approach as that embodied in the Catalogues. The latest of these, published on 4 November 2014, embodies a much greater degree of liberalisation than the Shanghai negative list reduction, as it reduces the number of restricted areas to only 35.

Foreign investment is now allowed nationwide in several sectors which have been closed for years, including traditional Chinese medicine, oilfield exploration and development, automobile parts, aircraft and ship engines and components, accounting and auditing. (I remember as far back as 2003 telling the Chinese government that it didn’t make sense for them to refuse foreign money to help them develop industries, including herbal medicines and green tea, where they have a historical advantage. It seems they have now got the message.)

While services sectors have been further opened to foreign investment, some additional restrictions have been added (in automobile production and education) and several new areas closed off, not all of them for internationally acceptable reasons such as the protection of public health or national security.

What is needed to meet the needs of a modern economy is a radical simplification of the foreign investment regime, starting with the repeal of all laws defining foreign investment vehicles such as joint ventures and wholly-foreign-owned enterprises, in other words, the withdrawal of the concept of “foreign-invested enterprise” in favour of an approach that treats foreign and domestic investors alike, except for reasonable and transparently-explained prohibitions on foreign investment in sectors that are explicitly closed to protect national security, public order or public health. This is a logical extension of the policy of treating foreign and domestic enterprises alike for tax purposes since the abolition of fiscal incentives to foreign-invested enterprises at the beginning of 2008.

An example near to hand is available in Hong Kong, where foreign investment is treated the same as domestic investment for all practical purposes, and there is no complex categorisation of different types of “foreign-invested enterprise” in Hong Kong law.

It is possible that this real “closed list” approach may replace the current “negative list” before too long, as a result of China’s renewed activity in negotiating investment agreements. Discussions with the United States on a Bilateral Investment Treaty are due to be revived in 2015, and the Chinese authorities have already indicated that they are now prepared to accept pre-entry national treatment, which would almost certainly entail the abandonment of the Catalogue regime.

Officials at the National Development and Reform Commission (NDRC) said on 21 November 2014 that China will develop a plan to give pre-entry national treatment to foreign investors and explore a negative list approach.

If this happens, it will be a major step forward. Only five years ago, the policy (as vociferously expressed to me by a Ministry of Commerce official at the margins of a meeting at the OECD in Paris) was: “Pre-entry national treatment? China says: no way, José!”

I confess to feeling some personal satisfaction in seeing the Chinese government edge its way towards putting into effect the recommendations for liberalising its policies towards foreign investment (and investment in general) that I put forward in the three Investment Policy Reviews of China that I wrote for the OECD between 2003 and 2008. But that is not why policy has changed. China’s perspective has now been reversed by the country’s new role as a major exporter of capital: Chinese multinationals will now be beneficiaries of a more open global FDI regime.

Tags: OECD, Shanghai FTZ,

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