Foreign direct investment (FDI) has played a pivotal role in promoting China's economic growth. As China's economic structure evolves, China needs to upgrade its institutional environment and phase out misleading preferential treatments in the effort to attract more FDI.

By doing so, China can leverage FDI for sustained economic growth while maintaining its leading position in attracting global investment.

Because domestic private firms have been largely discriminated against, foreign invested enterprises (FIEs) have played a role in China as an alternative to private entrepreneurship. Over the past 20 years, FIEs have contributed greatly to the Chinese economy. In 2002, even though FDI accounted for only one tenth of the gross fixed capital formation, FIEs contributed to one third of the industrial output, one fourth of the value added, more than half of the exports - and nearly three quarters of the foreign exchange balances held in the Chinese banks by corporations.

Moreover, FIEs generated nearly one fifth of the total tax revenues and 23.5 million job opportunities, employing about one tenth of urban workers. These numbers reveal FIEs are highly efficient and contribute greatly to the Chinese economy.

Econometric studies pinpoint these numbers as they suggest FDI has contributed to nearly one third to one fourth of China's gross domestic product (GDP) growth.

Despite all of these positives, the facts also indicate there have been some distortions generated by FDI. The efficiency of domestic capital has been low. State-owned enterprises (SOEs) and private firms cannot compete with FIEs in many manufacturing industries.

As entry barriers are further broken down in services, FIEs will play a more dominant role in an array of industries.

Although they are like domestic firms in that FIEs generate income, tax and jobs, a nation's long-term competitiveness arguably depends on its own entrepreneurship and the capabilities of enterprises built up by its citizens to compete in the world market.

In this sense, China needs to narrow the preferential treatments granted to foreign firms. It is necessary to gradually adopt an "FDI shift strategy," meaning steadily removing the distortions created by FDI and alleviating the reliance of China's GDP growth on the FIEs.

Meanwhile, China needs to complement the "FDI shift strategy" with an active "domestic investment promotion strategy," meaning effectively broadening the market entries of domestic non-SOEs and improving their competition environment so that domestic entrepreneurship can grow faster.

If the goal is to attract FDI so as to introduce advanced technology, improve management and expand markets, a direct indication of its success would be the following - more and more private Chinese owned spin-offs of FIEs are capable of competing with these FIEs in China as well as in global markets.

As to the impacts of preferential treatments, some studies show tax incentives play a role in FDI distribution among different regions in China.

However, most studies on global FDI flows in general, and those to China in particular have demonstrated preferential treatments only play a minor role in multinational companies' location decisions of their overseas investment.

In a survey conducted by the World Economic Forum in 2001, 1,200 companies in 76 countries with overseas direct investment were asked to rank the most important factors for their investment decisions.

The first result was that firms tend to invest in open competitive markets. Having a highly competitive domestic market does not prevent potential multinational companies from entering. Instead, most foreign investors prefer to invest in such an environment where more free entry and competition signals more market access and sound market infrastructure.

The major determinants are:

an ability to repatriate capital and remit profits;

predictability and reliability of government policies;

access to local markets;

ability to enforce contracts; and

size of local market.

Therefore, companies pay special attention to sound legal and policy environments and access to a sizable market.

The other important factors include good employment policies and productivity, proximity to target markets, and high quality transport and communications infrastructure.

These mainly relate to physical infrastructure and production input. Human resources normally have a higher rating compared to other areas.

Traditional measures for attracting foreign investment have become much less important. Tax holidays and other incentives, low labour cost, investment incentives like grants, cheap credits or government-sponsored training or presence of export zone and export incentives, have ranked at the bottom of the list. These areas are often the focus of governmental FDI promotion policies, and once were treated as critical components to attract foreign investment.

Interestingly, multinational companies have gradually shifted their attention to market access and market supporting legal/policy environment instead of external incentives provided by the local governments. These findings should remind us to re-evaluate FDI promotion policies.

To many market-seeking foreign investors, preferential treatments are not the dominant factor for their investment, anyway. They are not a sustainable winning strategy for attracting efficiency-seeking FDI as well.

It is imperative for China to create an open and fair competition environment for all firms, domestic and foreign alike, in order to cultivate the growth of its own versions of GE, SONY, Giorgio Armani, McDonalds or Goldman Sachs - not necessarily those providing the same goods or services, but brands with unique market niches.

As China strives to build up a rule-based market economy that respects policy transparency, protects intellectual property rights and upholds fair competition, it will thus upgrade its advantages in attracting FDI.

FDI structures will be shaped by the new instruments and round-tripping FDIs is apt to decline and disappear eventually, reducing China's FDI figures statistically. That in itself may relieve other countries' concerns though the magnitude may be hard to detect in the short term.

Finally, a word of caution has to be placed on striking a balance between phasing in new institutions and phasing out distorted preferential treatments. Both measures must be pursued with the same strength in order to avoid dislocation of policy space.

(China Daily September 29, 2004)