Trade War and Foreign Direct Investment in China:

Situation related to the U.S inflows

Javier Fernandez 19021936

Cui Huijie
Economy, IB Master
January 2020
 Summary

1. Introduction

2. Definition of Foreign Direct Investment

a. Types
b. Effects

3. Foreign Direct Investment in China

a. Regulations
b. Evolution
c. Principal Sectors

4. How is the Foreign Direct Investment of U.S in China

a. Trade War Consecuences on FDI What areas have been affected como ha bajado
tanto la inversión y la forma de hacer negocio con china y comparar con el
crecimiento del mismo sector en china(petróleo, telecomunicaciones….
b. Trade Balance and how it is influenced by the Foreign Direct Investment

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 1. Introduction

This paper reviews academic literature according to the question: What is and how does FDI
affects economic development, the situation of this investment in China, how has been
affected by the Trade War between U.S and China.

I first will give a definition of FDI, explaining the types and effects on the economic system,
and how is connected to the nowadays situation of Chinese economy. I will focus on the
consecuences of the Trade War in this investment, and what sectors have been more affected
by this dispute

Finally, with all the information I will give some key factors and what can be the future of
FDI in China.

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 2. Definition of Foreign Direct Investment

Foreign Direct Investment (FDI) is a category of cross-border investment in which an

investor resdient in one economy establishes a lasting interest in and a significant degree of
influence overa n Enterprise resident in another economy. Ownership of 10% or more of the
voting power in an enterprise in one economy by an investor in another economy is evidence
of such a relationship. FDI is a key element in a transfer technology between countries,
promotes international trade through access to foreign markets, and can be an important
vehicle for economic development. The indicators covered in this group are inward and
outward values for stocks, flows and income, by partner country and by industry and FDI
restrictiveness. (OECD iLibrary)

a) Types

As mentioned above, an investor can make a foreign direct investment by expanding its
business in a foreign country. For example: Tesla opening its Gigafactory in Shanghai.
Reinvesting profits from overseas operations, is also considered as foreign direct investment.
There are different methods for a domestic investor to acquire voting power in a foreign
company:
 Acquiring voting stock in a foreign company
 M&A
 Joint ventures with foreign corporations
 Starting subsidiary firm of a domestic firm in a foreign country

Tipically there are two types of FDI: Horizontal, when a business expands it domestic
operations to a foreign country. In this case the business conducts same activities but in a
foreign country. For example: Starbucks in China.
The other type is vertical, is when a business expands into a foreign country by moving to a
different level of the supply chain. For example, if Starbucks uses a coffee-farm in Colombia
to roast its coffee there.

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 b) Effects

When a country makes a direct investment in another country, there is an addition to the
physical capital of country, and new production capacity is created. If the output is tradable,
some production that now takes place in the country will replace production that took place in
the country of the investor, so the production capacity will be reduce in the home country.
Another possibility is that the investment is made in the country, but the stock of the physical
country and the level of production are unchanged in both countries.

The capital flows story depends on the andvantages of countries as locations for production,
and the changes in those advantages. These capital flows produce changes in the industry 1
and employment in the home and host countries.

3. Foreign Direct Investment in China

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In industries produce tradables, they imply shifts in the composition of import and exports.

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According to the 2018 World Investment Report published by the CNUCYD, China was
rankes as the second largest recipient of FDI after the U.S. The country’s economy ranked
second among the most attractive multinational companies for the 2017-2019 period, only
behind the U.S. With steady growth over several years, FDI flows continued to increase
between 2016 and 2017, from USD 133.000 to USD 136.000 million. This growth is favored
by liberalization plans, the rapid development of the high technology sector and the
establishment of free trade areas. The absortion od FDI is part of China’s policy of opening
up to the outside world, with the aim of create a better business enviroment, structure and
distribution of investment. The goverment’s efforts to achieve a better geographic distribution
of investments have allowed China to see FDI increase.

a. Evolution

Foreign Direct Investment policies in China have envolved alongside economic development
and strengthened institutional capacity. Since the 80s the country started a liberalization
process, China experimented a opening to foreign investments in selected coastal and
industrial/economical zones. China with it’s accession to the WTO made an important
commitment to liberalization services. In the period 2000-2010 the country increased 3 times
its FDI services, while manufacturing increased 81%(World Bank). The results of this
opening have been incredible. Since then, thousands of multinational corporations have
invested in China.

The changes in China’s policies to inward FDI are due to important political changes.
Everything started in 1975 when Deng Xiaoping started some economic developments to
achieve modernisations. Some of the initiatives were published in a document, “Some
Questions on Accelerating Industrial Development”2, there are three main points in this
document. First, China needed to adopt advanced technology from foreign countries and
expand international trade. Second, the country must introduce and improve modern

2
This document was drafted by the State Planning Comission and highlighted by Deng Xiaoping at a State
Council meeting in 1975

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industrial management methods. And third, the country should import technology and
equipment for natural reosurce exploitation by paying coal and petrolum.
These ideas were developed to allow inward FDI into China’s domestic economy. Base on
the experience of other developed countries, attracting and using FDI is an effective way to
acquire and master advanced technology and equipment from foreign countries. FDI also
means of better using of China’s resources in absence of domestic capital. Furthermore,
provides China modern economic management skills.

Following this open economy policy, China established four Special Economic Zones,
Shenzen, Zhuhai, Xiamen and Shantou, located in Guangdong and Fujian Provinces. The
main objective of these zones was to attract FDI by offering favourable terms and good
business enviroment. It was a market-oriented economic reform, the SEZ offered freedoms to
operate their economy on a market basis and were allowed to give concessionary tax policies
to foreign investors. For example, “all FDI firms were granted 15% reduction of income tax
and engaged in production and scheduled to operate for a period of ten years and allowed a
50% reduce of income tax in the following three years”. (Chen, 1997)
In addition, Guangdong and Fujian provinces, offered financial subsidies in the form of fiscal
and foreign exchange revenue contracts. In the 1980s, both awarded five year fiscal contracts
permitting them to retain almost all the taxes and industrial profits generated in their
jurisdiction. The economic success of these SEZ increased Chinese Goverment confidence.

With this favorable situation, in 1984 the Chinese Goverment announced the opening and
extensión to another coastal cities and Hainan Island. These new open cities were allowed to
offer tax incentives for FDI firms similar to the SEZ, they were established as Economic and
Technological Development Zones (ETDZs), that could offered more favorable terms than
SEZs. First, they were encouraged to build infrastructure and provide energy,
communications and other public facilities necessary for production and development.
Second, foreign investors were provided more location opportunities to locate their ventures
where the transaction cost was lower. And third, the Goverment primary objective was to
concéntrate on the establishment of more technology productive projects through FDI.

The implementation of the open strategy to FDI from the SEZs, gave to these cities more
benefits than other regions, not only in fiscal and foreign exchange earnings, also in
acquisition of capital, technology and the access to international market. These economic

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development zone policy was extremely popular thoughout China, and since then, there has
been a constant expansion of the effects of FDI through the industrial activities to more
regions of the country.

b. Regulations

The FDI can have three forms: equity joint venture, cooperative joint venture and wholly
foreign owned venture. In the China’s approach to these types of enterprises, we can
diferenciate three phases.

The first phase, 1979-1986, was the time for the adoption of the “Law of the People’s
Republic of China on Joint Ventures Using Chinese and Foreign Investment”. This law was
issued in 1989, it was the first allowing operations of foreign economic entities in the
territory since 1949. The main point of this law is the establishment of a joint venture must be
“on the principle of equality and mutual benefit”. Also, it provides a fundamental guideline
for operations, management and termination of joint ventures. The adoption of the
implementing regulations improved the investment climate and increased the confidence of
foreign investors.

The second phase, from 1986-1990, is important due to two legal documents issued by the
Chinese Goverment. “The Law of the People’s Republic of China Enterprises Operated
Exclusively with Foreign Capital” and “Provisions of the State Council of the People’s
Republic of China for the Encouragement of the Foreign Investment”, the law specifies that
“China allows foreign firms, to set up enterprises exclusively with foreign capital in China
and protects the interests of wholly foreign-funded enterprises”. (Chen, 1997)
For foreign investors this is important for two reasons. First, because the keep the operating
independence over financing, marketing, pricing, production… and the second, to protect
their technologies. For the Chinese perspective, this is positive for: increase the
competitiveness by providing more facilities to investors and the second, because accelerate
the introduction of new technology products, and is part of China’s development strategy.
This phase provide the country an important growing conditions of FDI laws and
improvement of the FDI regulations.

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The third phase, 1990-present, in this period the Chinese goverment liberalised FDI policies
and developed laws and regulations to achieve a quicker and healthy development of FDI in
China. In 1994, the Goverment implemented measures to reduce to problems: over-valuation
and round-tripping. The aim of this reform is to equalise the treatment of foreign and
domestic capital due to the ongoing reduction of tax incentives for FDI. In 1995, The Chinese
Goverment lanched the “Provisional Regulations on Guiding Foreign Investment”. The aim
was to provide guidance for FDI investors among sectors which suits with the Chinese
economic and social plan. This phase has been marked by que quick development of thr FDi
regulations, we can resume it in three key points:
 creation and development of a better regulatory framework
 efforts to create a legislation for the protection of the intellectual property rights
 coordinate and accept international rules and requirements for FDI.

c. Principal Sectors

According to the “Global Foreign Direct Investment Review and Outlook 2018”, China with
USD 144 billion is the second-largest recipient in the world.
The National Bureau of Statistics of China published that manufacturing, real estate, leasing
and business services, wholesale and retail, information transmission, computer services and
software and finance were most favored by foreign investors, getting nearly of the 80% of the
FDI flows in the last three years.
The distribution of these investments are: Jiangsu, Guangdong, Shanghai, Zhejiang, Henan,
Shandong, Anhui, Beijing, Hunan and Chongqing

Figure 1: FDI breakdown by industries

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 Source: National Bureau of Statistics of China

Nowadays the technology, the media and telecom sectors are more active than ever. The
technology sector is expected to have a high growth. The principal areas of this sector will
be: robotics, this market is expanding very fast, China is the largest market in the world. The
plan “Made in China 2025” is improving the development in high-tech and will push this
market. The AI market is also very important, in the last years the industry received
important quantities of flow and by 2030 will become the largest market with a value of USD
150 billion.
Related to the media, the film market thanks to the positive policies, the capital flow and the
supply development, has continue to grow. With the revenue generated, is expected to
surpass the North America market, becoming the first market in the world.
Last, the telecomunication is an industry upgrading every year. The development of the 5G
improve the competitiviness of the China’s manufacturing industry.

4. How is the Foreign Direct Investment of U.S in China

According to Financial Times the investments by U.S. companies in China grew in 2019
despite the trade war between both countries. The U.S. companies invested $6.8 billion into

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China in the first half of the year, 1.5% more than the same period one year before. Most of
these investments are related to greenfield areas, like the Tesla factory in Shanghai or the US
fund Bain Capital’s $570 million investment in data center provider Beijing Qinhuai.

a. Trade War Consecuences on FDI: What areas have been affected

The imposed of US tariffs on Chinese goods has affected to indusries in both countries.

One of the biggest areas affected by this trade war, has been the US automotive industry. In
response to the US, China increased tariffs on US made automobiles, from 15% to 40%.
China is in a complicated situation in the global automotive supply chain, what means that
the US producers spend more in China when they are taxed, so these tariffs won’t make the
US economy more strength, the prices rised for the US costumers, due to the share of
imported parts used in US production.
The chip makers and electronic manufacturers that depends on China sales, were the principal
sectors affected by a trade conflict. China imports form the US weren’t enough large to match
the Trump’s tariffs.
The Chinese agricultural sector, is the fourth largest export market to the US. According to
the Trade Office of the US, are around $9 billion. In 2018, China imposed tariffs to US
soybeans.

A report from UN shows that consumers in the US are suffering the worst part of the tariffs
on China. Also shows that Chinese companies absorbed part of those tariffs cost by reducing
the prices in their exports. The tariffs caused a 25% of losses to the chinese exports in the US
markets during the first part of 2019. The competitiviness of those companies kept th 75% of
their exports to the US. The sectors like chemicals, furniture and electrical machinery
dropped importantly.
The restrictions of US companies investment in Chinese companies would not only affect
China. This restrictions can look like the US is not as open as we thought. More than 200
chinese companies like Alibaba, have raised tens of billions of dollars on US capital markets.
The Chinese government would also like to keep its largest companies at home, and launched
a new stock board to built a better enviroment for technology companies to go public.

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Foreign investment in Mainland is being opened by the goverment to attract more overseas
inflows from investors. If the US investments were banned, the american investors would
missed many invest opportunities in the long term. Also, China is trying to increase foreign
Access to its financial services industry, allowing foreign Banks to take majoriy ownership of
its local securities joint venture.

b. Trade Balance and how it is influenced by the Foreign Direct Investment

The issue of FDI and Trade Balance has been concerning policy makers for a long time. The
relation between FDI and exports can be substitutes, if the exports of final goods form the
home nation are displaced by local production, there will be a net of export value.

Figure 2: China Trade Balance

Source: TradingEconomics

As we can see in Figure 2, China’s trade balance was at the end of 2019, about 46 billion,
lower than a year before when was around 57 billion. Due to the Phase 1 of the agreement
between US and China the exports increase to 7.6% and also the imports to a 16.3%.
Despite the growth of Chinese trade, there were very favorable data observed for exports of
unsual ítems, such as coal and oil, pointing that these sales target the economies that

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participate in the Road Initiative, which could be a new trend for chinese exports. (Pang, Iris
2019)

Figure 3: US Trade Balance

Source: TradingEconomics

The US trade deficit decreased to $43 billion in November 2019, in comparision to 47 in the
previous month. The exports increased 0.7%, the goods to China went to 15.7%, with imports
dropping and exports jumping.

Stabilizing the foreign investment would help to stabilize the economy, and will impact to the
exchange rate. Global investors has become a priority for China, in particular US companies.
Higher taxes and more protectionism mean that China will get less dollars from trade.
Become an importer of capital will help China to reduce it economic reliance on exports and
consume more

Conclusion

The global raising protectionism is another key factor for the FDI trends. Chinese economy
depends importantly of these investments. Thanks to these inflows, many companies were

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allowed to grew and developed important industries such as AI or communications. Also the
country developed faster since the open economical policies since 1975.

The tariffs imposed to China, had an inflationary impact in rents, prices… The Trade War is
affecting private investment and making investors risk-averse.
To fight the situation Chinese Goverment is giving new and more facilities to attract
investment and be able to continue its great economic development.

Sources

 Baldwin, Robert E. and L. Alan Winters (eds) “Challenges to Globalization”. Chicago:

Universityof Chicago Press, 2004
 Chunlai, Chen (NO. 97/15) “The evolution and main features of China’s foreign direct
investment policies” Chinese Economies Research Centre, 1997
 Nicita, Alessandro “Trade and trade diversion effects of US tariffs on China” UNCTAD
Research Paper No. 37, 2019
 Shen, Samuel and Yao, Kevin “As trade war pinches China, it opens doors wide for
foreign money”. Shanghai/Beijing Reuters, September 11, 2019
 Cheng, Evelyn “Constricting investments into chinese companies could hit the US as
hard as it hits China”. CNBC, September 29, 2019
 Davies, K. (2013) “Chinese Investment Policy: An update”, OECD Working Papers on
International Investment, 2013/01, OECD Publishing
 Alfaro, Laura and Chauvin, Jasmina “Foreign Direct Investment, Finance and Economic
Development”, September, 2017
 “China Factors: A guide for investing in China”. Global Chinese Services Group,
Deloitte, October 2018

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