UK Firm Investing in China's Textile Sector: FDI Analysis

Introduction

This report assesses the scope for business development in China's textile sector by a UK-based multinational firm. The analysis examines the current state of the Chinese economy, infrastructure, and rules and regulations governing foreign direct investment (FDI), as well as the cultural and economic conditions relevant to deciding whether a UK multinational should export its products or establish operations in China.

In addition, the report explores the potential for investment in the garment sector, assessing the applicable investment laws, the availability of infrastructure, and the labor supply. Potential risks associated with establishing a business in China are also described.

Investment in China and the FDI Landscape

Foreign direct investment (FDI) is defined as investment made to acquire a lasting interest in enterprises operating outside of the investor's home economy. In today's highly interconnected and globalized world economy, FDI plays an essential role in international business — it is the largest source of external finance for developing countries, where FDI inward stock has amounted to approximately one third of their gross domestic product (GDP) (UNCTAD, 2011).

Among the many developing countries seeking economic growth through FDI, China is undoubtedly the most successful. It has been the largest developing host country in the world since 1993 and is widely regarded as the most attractive FDI destination (WTO, 2011).

Since Deng Xiaoping announced economic reform and the "Open Door" policy to attract foreign investment in 1979, FDI has enjoyed unprecedented growth in China. Many multinational enterprises (MNEs) benefited from preferential treatment offered by central and local governments. Others, however, encountered foreseen and hidden difficulties stemming from ideological, cultural, political, and economic differences (Luo, 2000).

After decades of foreign invasion and civil war, Communist Party of China (CPC) leader Mao Zedong proclaimed the establishment of the People's Republic of China (PRC) in 1949. China subsequently underwent a series of dramatic social and political changes, including land reform, the Great Leap Forward (1958–1960), the "Three Years of Natural Disasters" (1959–1961), and the Great Proletarian Cultural Revolution (1966–1976), followed by a period of recovery (1976–1978) (Bailey, 2001).

Major hurdles and hidden problems accompanied the country's rising growth rates. The unemployment rate, after a major decrease in the 1980s, rose continuously through the 1990s, worsening a shrinking domestic market. Almost half of state-owned enterprises (SOEs) were reporting losses and carrying large amounts of bad loans, burdening an already strained banking system. To alleviate these problems, Premier Zhu Rongji proposed a dramatic reform plan in 1997 to privatize SOEs through selling, merging, and closing the vast majority of them. By 2000, China claimed success in its three-year effort to make the majority of large SOEs profitable, though at the expense of millions of workers who lost their SOE jobs. Despite efforts to provide financial safety nets for unemployed workers, social instability and frustration among laid-off workers cast a shadow over the claimed success of the SOE reform.

In line with fast economic growth, living standards continued to improve. Between 1990 and 2000, household income and expenditure per capita increased 4.1-fold and 3.7-fold respectively, while savings grew more than eightfold. Other indices also improved, including housing, public transportation, education, healthcare, and pension insurance. Consumer goods once considered rare — such as motorcycles and cellular phones — became common items. The "three durable goods" dream of the late 1980s and early 1990s (color televisions, washing machines, and refrigerators) came true for most urban Chinese within just a few years, with many also acquiring DVD players, cellular phones, and computers. Between 1990 and 2001, the number of refrigerators, color TVs, and cameras owned per 100 urban households doubled; one third of the urban population owned air conditioners and cellular phones. Living conditions in rural areas improved even more dramatically, with refrigerator and color TV ownership increasing more than tenfold and washing machine ownership more than threefold. By 2001, one quarter of rural households owned a motorcycle. Nevertheless, compared with the urban population, rural Chinese still faced considerable hardship.

FDI also boomed during this period. Following Deng's 1992 Southern Tour and subsequent improvements to the investment environment — including FDI-friendly laws and regulations — there was a 150% increase in FDI flows in 1993, making China the largest developing host country for FDI and representing a qualitative shift from years of accumulated quantitative change since 1979. Five consecutive years of double-digit growth followed, leading to an overall FDI stock in 2000 that was three times greater than in 1993. In 1998, authorities significantly streamlined FDI approval procedures by removing the requirement that projects exceeding $30 million be reviewed by the central government (Huang, 2003). FDI significantly enhanced China's export capacity, with an annual growth rate of 15% between 1990 and 2001, and changed the previously negative trade balance, bringing in substantial foreign exchange reserves.

Dunning (1977) proposed three preconditions for a firm to become a multinational enterprise, known as the OLI framework — covering ownership, location, and internalization advantages. An ownership advantage refers to an intrinsic characteristic of a firm that leverages its investment abroad, such as a patent, trademark, or managerial expertise. A location advantage — also known as the "proximity-concentration hypothesis" (Brainard, 1997) — concerns the decision between FDI and exports: directly investing and producing in a host country is preferable to producing domestically and exporting when trade barriers and trade costs are high or when factor prices in the host country are low. An internalization advantage concerns the trade-off between FDI and licensing arrangements. Even if producing abroad is more profitable than exporting, a firm must still choose between FDI and licensing foreign firms in the host country; a firm internalizes its foreign production and becomes an MNE when FDI is more advantageous than licensing. Most subsequent theoretical and empirical studies on MNEs are grounded in Dunning's framework.

President Hu Jintao's political agenda sought to maintain social stability in order to further economic development and to sustain Chinese culture as an expression of national sovereignty. The Hu-Wen administration aimed to reduce inequality and move away from the previous "pursuit of GDP at all costs" policy (Kimber and Lipton, 2005). The administration focused on the gap between rich and poor and on uneven development between interior and coastal regions, and it committed to robust development of the welfare and social insurance systems. It embraced a sustainable model of growth, envisioning China's future through a "Scientific Development Perspective."

Hu called for the modernization of the Party and greater government transparency and openness. He ordered publication of details from many Party meetings and cancelled a number of traditional Communist extravagances. His emphasis on democracy and political reform was unprecedented in Party history. Hu also provided moral guidance to the Chinese public by promoting "eight honors and disgraces," stressing traditional values and selflessness in an attempt to correct the erosion of morality that had accompanied two decades of single-minded pursuit of monetary gain. These actions contributed to an unprecedented rise in Chinese nationalist sentiment, which at times proved more challenging than the government had anticipated.

Internationally, Hu actively advocated China's "peaceful development" and strongly opposed the "China Threat" narrative. He also aimed to form more diverse international alliances, in contrast to his predecessor Jiang's U.S.-centered foreign policy. China took on greater responsibilities in international matters, including the "North Korea" talks, anti-terrorism efforts, and globalization initiatives.

Since the "rule of law" was written into the Constitution in 1999, China's legal system has made substantial progress. China's accession to the WTO greatly enhanced the sophistication of that system. New laws and revisions of existing laws and regulations multiplied in accordance with WTO legal requirements. Most significantly, the Constitution was amended in 2004 to guarantee private property and human rights — widely regarded as a sign of growing Chinese democracy. The Property Law was also promulgated in 2007, further safeguarding private property. A number of other laws were published during this period (Clarke, 2007). China now has a functioning civil legal system, and the Party has taken a step back to allow judicial mechanisms to regulate social activities. Notably, the government has begun soliciting opinions from legal academics, interest groups, and the general public when drafting major legislation, in order to achieve more democratic lawmaking and advance compliance with the law (Lo, 2007).

The most important economic event of this period — and arguably of the entire post-1978 reform era — was China's accession to the World Trade Organization (WTO) at the end of 2001. Following 15 years of negotiations and policy adjustments, China entered the mainstream world economy and began both enjoying the benefits and facing the challenges of WTO membership.

In response to WTO requirements, China undertook a wide-ranging transformation across many areas. According to the WTO agreement, China was subject to reviews during the eight years following accession. The most recent review, announced in May 2008, acknowledged China's significant efforts and commended its integration into the world economy. The OECD also concluded that China had made significant progress in providing a business environment conducive to FDI (Halverson, 2004).

China's growth since 2001 has largely confirmed the optimistic projections made prior to WTO accession. GDP growth increased from an average of approximately 8% in the late 1990s to more than 10% annually from 2002 onward, with scholars estimating that roughly 1% of that growth was attributable to WTO entry (Chow, 2001). Export growth reached 30% — double the 15% rate of the previous stage — while imports also grew at approximately 20% per year. In 2006, China surpassed Japan as the holder of the world's largest foreign exchange reserves, which reached $1.8 trillion by 2008. Meanwhile, inflation remained steady at approximately 1.5%.

China's Favorable Environment for Investment

Economic growth continued to improve daily life. Ownership of consumer durable goods kept rising: one in every two urban households owned a computer, each household had an average of one and a half mobile phones, and one in twenty households owned a car, with some purchasing their second. Both urban and rural incomes increased by 150% between 2001 and 2006, and per capita savings doubled within the same period. The number of students enrolled in higher education institutions in 2006 was 2.5 times the figure recorded in 2001.

FDI continued to increase and was undoubtedly one of the biggest beneficiaries of China's WTO accession. More stimulating policies were implemented to retain profitable MNEs and encourage reinvestment of FDI profits: foreign investors became eligible for a full refund of enterprise income tax paid on reinvested portions of profit (Tuan and Ng, 2004). The Chinese Commerce Minister pledged that "China will modify the administration and strengthen protection of intellectual property rights to create a better investment environment" (Xinhua, 2007). By that time, 450 of the world's 500 largest multinational corporations had already invested in China. Decision-making authority over attracting FDI was also partly transferred to local governments; in 2004, provincial governments were permitted to approve "encouraged" or "permitted" projects worth under $100 million — $70 million higher than the previous limit (Ming, 2004).

WTO accession provided China with its most promising opportunity yet to sustain legendary economic growth and continue its reform process. At the same time, a new trend in Chinese consumer behavior emerged. Fueled by President Hu's encouragement of Confucian thinking and traditional values, many Chinese demonstrated rising patriotism and nationalism not seen since the end of the Cultural Revolution. In terms of consumer behavior, many Chinese abandoned the notion that Western brands were inherently superior and began purchasing domestic products instead. The government strongly encouraged the development of world-famous Chinese brand names such as Haier and Lenovo. As the quality of Chinese products improved while prices remained competitive, "buying Chinese" became the latest trend, particularly among younger consumers.

An unexpected consequence of this renewed patriotism was a series of anti-Western boycotts. Chinese hostility toward the West and Japan re-emerged at the turn of the century. When political conflicts arose between China and developed countries, Chinese consumers directed their frustrations at foreign commercial businesses. For example, following the "Toshiba Incident" in 2000, another wave of boycotts of Japanese products broke out in 2005, organized via the internet and mobile phones. New websites were set up to quantify how much each renminbi spent on Japanese products contributed to anti-Chinese activities. General avoidance of Japanese cars significantly benefited the American automotive industry's growth in China. The most prominent demonstration of Chinese nationalism at that time was the boycott of French products in response to the Olympic Torch Relay disruptions in Paris and alleged French connections to the Tibet Liberalization Movement. Protests were organized online, and on May 1st, 2008, thousands rallied in front of French supermarket Carrefour, whose sales were reported to have declined thereafter (Zhong, 2008).

Although such nationalist boycotts harm both foreign investors and the Chinese economy, it is unlikely that Chinese consumers will quickly moderate these sensitivities in favor of more rational purchasing behavior. With consumer goods retail sales growing at a year-over-year rate of 12.2% in 2006, businesses are nonetheless eager to participate in the massive Chinese market. Foreign investors need to handle Chinese consumers' sensitivities with greater care and develop a deeper understanding of Chinese cultural and traditional norms (Lin and Stoianoff, 2004).

China's economic growth has created investment opportunities across virtually every sector. In the textile and garment industry in particular, there has been large-scale production relocation from Hong Kong to mainland China since the 1980s, especially to the neighboring province of Guangdong (Lau and Chan). In addition to national and local policy preferences, Hong Kong entrepreneurs were attracted to Guangdong by its convenient transportation links and shared Cantonese dialect. Following Hong Kong entrepreneurs, business people from Taiwan, Japan, South Korea, and the United States also invested in and relocated garment production to Guangdong.

China's accession to the WTO contributed to the expansion of export-oriented garment production in Guangdong during the 2000s. With the phasing out of the quota system, restrictions previously placed on garment exports were loosened. Statistical data show that the value of China's exports of textiles and apparel exceeded $180 billion USD in 2008 — nearly four times the figure recorded in 1995.

Conclusion

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Yang, D. L. (2005). China's looming labor shortage. Far Eastern Economic Review.

Zhong, W. (2008). Time to outgrow boycott calls. Asia Times.