Lecture 5.3 Investment Reform

Question 1

Define Horizontal FDI

Answer 1

An affiliate that REPLICATES the production process of the PARENT FIRM in its own domestic facilities

Question 2

When does a Horizontal FDI normally occur and why

Answer 2

• between developed countries
• parent and affiliate are both in developed countries
• to locate production NEAR customer base

Question 3

Vertical FDI

Answer 3

production chain that is broken up wherein parts of the production is transferred to the location of its affiliate

— FRAGMENTED PRODUCTION

Question 4

What is horizontal intra-industry trade

Answer 4

Kind of trade that occurs between 2 developed countries due to horizontal FDI

Similar to intra-industry trade where the trade occurs within ONE INDUSTRY

Question 5

Why are vertical FDIs in existence

Answer 5

driven by PRODUCTION COST DIFFERENCES between countries

Question 6

FDI and Trade Linkages

Differentiate Substitutes and Complements

Answer 6

• Substitutes - when FDI DISPLACES trade
  - (instead of trading goods and services between countries, companies invest directly in foreign countries to produce and sell their products there)
• Complements - when FDI is a PRE-REQUISITE / FDI INCREASES trade

Question 7

Relate FDI and Trade Linkages

Answer 7

• Substitutes - parent companies DUPLICATE themselves - HORIZONTAL
• Complements - when vertical FDI occurs, it complements trade -> FDI is a prerequisite and an increase in FDI increases trade - VERTICAL

Question 8

3 characteristics of an FDI

Answer 8

1. Dominant form to access global capital
2. Large proportion of FDI inflows from the MANUFACTURING SECTOR
3. Initially from East Asia economies

Question 9

Why is FDI a dominant form to access global capital

Answer 9

1.In an open economy, FDI can be used to finance investment opportunities when you don’t have enough savings

Primarily, it can be compensated by two things: 1) FDIs and 2) Foreign Debt

2.FDI is a channel where Investment can exceed Savings (I > S) in an open economy

Question 10

Where are the proportion of FDI inflows concentrated on?

Answer 10

Manufacturing sectors

• Opposed to services or resource extraction
• Restricted entry into service sector

Question 11

Give me the overall trend of FDI FROM 1949, 1978, 1985, 1986, and 1992 onwards

Answer 11

• 1949 - closed FDI, reopened and accepted foreign investment only in 1978
• 1978 - OPENING UP, trade and investment (1st phase of reform)
• 1985 - Plaza Accord
• 1986 - Coastal Development Strategy
• Experiments in Guangzhou, Guangdong
• 1992 onwards - expansion of acceptable FDI inflows (2nd phase of reform)

Question 12

What happened in the trade reform from 1992 onwards

Answer 12

• flood of FDIs, opening of domestic marketplace to foreign businesses
• confined only to export MANUFACTURING
• concentrated in the COASTAL PROVINCES in Southeast

Question 13

Give me the characteristics of the INVESTMENT REGIME LIBERALIZATION

Answer 13

• Started by SEZs — an important tool in liberalizing investment
• Highly sensitive to foreign dominance due to history of foreign agressors
• Signal of policy commitment to opening up and commitment to external liberalization -> endorsed by Deng
• 3 major waves that were marked by new batches of SEZs
• Granted incentives that reduced FIES over time

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Question 14

REFORMING THE FDI REGIME

What are the important policies that were in place during 1992?

Answer 14

1. Policy pronouncements by Deng to the South of China (Shenzhen) to endorse its operation as a prelude to a further wave of liberalization
2. Removed uncertainty about policy directions -> build credibility
3. DOMESTIC MARKETS WERE OPENED IN 1992 !!!

Question 15

What’s special about domestic markets opening in 1992?

Answer 15

Prior to 1992, FDIs were only confined to SEZs.

Question 16

Differentiate Chinese FDI vs. East Asia FDI

Answer 16

CHINA FDI
1) FDI is 4%-6% of GDP
1a) China’s reliance on FDI is similar to developing SEA countries of Malaysia, Thailand, Philippines, Indonesia: 4%-6% of GDP

2) Despite protective trade regime, FDI is quite OPEN particularly in EXPORT MANUFACTURING

3) Less dependent on FDI relative to other developing countries due to HIGH SAVINGS RATE

4) FDI brings in management experience, marketing channels and technology

EAST ASIA FDI
1) FDI is 2% of GDP
1a) FDI in Japan, Korea, and Taiwan never exceeded 2% of GDP**

Question 17

China SEZs vs. Asia SEZs

Answer 17

China SEZs
1) testing grounds for domestic reforms

2) had high level of autonomy

3) had multiple functions:
absorbed transfer of technology, administration, etc.

Asia SEZs
1) sheltered from global competition by trade and industrial policies
1a) SIMULATED a FREE TRADE regime

Question 18

CHINESE SEZs (Gradual Investment Liberalization) - 4

Answer 18

1. SEZs allowed changes and experiments in a rigid system
2. Allowed 100% foreign ownership
3. Initial 4 SEZs - Overseas Chinese ONLY (HONGKONG and TAIWAN)
   3a. Geographically and historically – maritime China (Guangdong, Fujian)
   3b. Outward oriented to sea-trade
4. Initial SEZs were similar to EPs in Asia
   4a. Lower tax rates
   4b. Simplified procedures
   4c. Simulates a free trade zone

Question 19

CHINESE SEZs (Gradual Investment Liberalization) Timeline

Answer 19

1. 1980s - Proliferation of zones began
2. 1990s - SECOND WAVE of accelerated reforms by the creation of another SEZ -> PUDONG Special Zone in East Shanghai
3. Post 2013 new Free Trade Zones were opened
4. Economic reform of Xi Jinping and Li Keqiang ( then Premier)
5. Launch of Shanghai Pilot Free Trade Zone for testing innovations; 100% foreign ownership in SERVICE sectors!!!!!!!!!

Question 20

Tax rate incentives of FDIs in China

Answer 20

1) Income tax rate is 33% ( 30% national plus 3% local) - ORIGINAL

2) Rates for SEZs and ETDZs – 15%

3) Coastal cities - 24%

4) Reductions in tax for companies that can export 70% of their output

5) Floor rate is 10% — taxes can’t get lower than that

6) Tax holidays are time-bound (there’s a limit)

Question 21

What occurred during the normalization of SEZs in China?

Answer 21

As the potential for special treatment has narrowed, SEZs have become less special.

1) Preferential policies (tax incentives mentioned earlier) granted to initial FIEs were grandfathered

2) Preferences were reduced and/or made uniform

3) By 2012: Uniform corporate tax rates at 25%

4) FIEs were subjected to local taxes

5) SEZs became less important

6) Uniform tax rates are used to attract FDI into inland provinces (since FDIs were concentrated in coastal regions)

Question 22

What are the IMPACTS of FDI?

Answer 22

● Additional source of saving/investment

● Technology transfer (served as vehicles)

● Contribution to trade

● Competition and emulation

● Spillovers and upgrading

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Question 23

Further impacts of FDI (3) — Contributions to Aggregate Saving and Investment

Answer 23

1) In an open economy, new source of investment is FDI in country’s CAPITAL ACCOUNT

2) The aspect of Savings and Investments in FDI is LESS SIGNIFICANT for China due to its HIGH DOMESTIC SAVING and INVESTMENT RATE

3) Foreign Trade (FDI and Trade Linkages)

Question 24

What are the 2 waves of shifting occurrence of FDI from HK and Taiwan to China?

Answer 24

China’s contribution to foreign trade occurred in 2 waves:

1) 1st wave — HK and Taiwan – first movers brought in expertise, built trade infra and EXPORTED LIGHT LABOR-INTENSIVE MANUFACTURED GOODS

2) 2nd wave — ASSEMBLY OF ELECTRONICS ( GVCs) – responsible for quadrupling of exports
between 2002 and 2007

Question 25

What are the countries part of the China Circle?

Answer 25

PRC, HK, Taiwan

Question 26

(1) Why were the 3 countries associated with each other and (2) what is the basis for the emergence of the China circle?

Answer 26

1) Due to close economic associations

2) Success of Taiwan and HK in developing labor-intensive manufactured exports during 1960s and 70s

Question 27

Timeline of occurrences of the China Circle (basically a summary of Lec 5.2 from the POV of HK and Taiwan)

Answer 27

1960s-1970s
- HK and Taiwan – successful in exporting labor-intensive goods
to US (formation of China Circle)

Mid-1980s
Taiwan and HK searching for lower-wage locations because skills and educational levels increased-> higher and more expensive wages

1978
China’s reform started in 1978 that started with EPs

Mid 1980s
The CDS was launched to restructure Asian export production networks ->

HK and Taiwan transferred their labor-intensive export production to China ->

The transfer of HK & Taiwan to China were part of a worldwide trend toward geographical dispersion of production

Question 28

What were the consequences of the opening of China to foreign investment?

Answer 28

Gave opportunity for foreign countries to transfer labor-intensive export production -> this development became PART OF A WORLDWIDE TREND TOWARDS GEOGRAPHICAL DISPERSION OF PRODUCTION CHAINS

• Requires FDI to build networks

Question 29

Why was the dispersion production chains easier for Taiwan and HK to do?

Answer 29

Geographical proximity, cultural affinity, similar language made transaction costs lower

Question 29

What are China’s sources of investment?

Answer 29

1) Major Groups:

1a) HK, Taiwan and Macau +( free ports)

1b) Developed countries: US, Canada, Japan and the EU

1c) Asian investors: Korea and Singapore

2) Hong Kong- source of more than 60% of China’s FDI inflows after 3 waves of liberalization

Question 30

China Circle: FDI and Trade Linkages

Answer 30

• Part of a world wide trend toward geographical dispersion of production chains
• Requires FDI to build networks
• Low transactions costs - geographical proximity, cultural affinity, similar language
• Moved only the most labor-intensive stage of production
• **Restructuring **started in garments and footwear
• IT restructuring began later in 1990s

Question 31

What are the Modes of Capital Inflow

Answer 31

1) Early 1980s – borrowing from governments and international
organizations

2) Since 1993, overshadowed by FDI

3) Financial markets were closed – hence no portfolio investments

4) Little foreign debt – due to concerns that foreign debt may not
be well managed

5) Restrictions on capital account convertibility (but liquid capital inflows were large)

6) Currency convertibility was allowed in the current account of the BOP