China May Need to Open up More aggressively to Foreign Companies

The challenges Western companies encounter when investing in China are well documented. The Chinese legal structure and getting all necessary government approval is, to say the least, difficult, while cultural and social norms can be hard to relate to many foreigners.

Language barriers only accentuate this. Add rising labor costs and it seems to create a perfect storm.

But to conclude that these reasons are behind the 1.9 percent year-on-year decline in foreign direct investment in the first five months of the year would be wrong. These issues have existed for many years and most people will tell you that barriers to investment are declining as approvals are getting easier, and foreign investment is being encouraged in new sectors and regions that were previously off limits. Even rising labor costs, which many cite as a major deterrent, have long been expected.

The real reason for the decline in FDI isn't any of these factors, but rather Europe's debt crisis that is resulting in anemic growth and increased risk aversion.

Overall eurozone FDI into China fell 27.9 percent year-on-year in the first four months of the year to $1.9 billion (1.5 billion euros). As part of this, German FDI fell 26.1 percent, Italian FDI fell 47.4 percent, Luxembourg FDI fell 48.2 percent and UK FDI fell 62.5 percent.

While the debt crisis is affecting many eurozone economies, the 28 percent decline in FDI does not paint the whole picture, however, as other major European countries are actually increasing investment. French FDI was up 12.1 percent year-on-year in the first four months and Netherlands FDI was up 18.4 percent. An often overlooked fact is that Swiss FDI into China is up more than 700 percent year-on-year in the same period.

While the drop in eurozone FDI is highlighted much more frequently, it is the growth in the Swiss investment that is more telling about the future of FDI.

Swiss FDI has been driven by Nestle, the world's largest nutrition, health and wellness company, which is buying into the domestic food and beverage industry. The company purchased a 60 percent stake of Hsu Fu Chi, China's second-largest confectionary company, for about $1.7 billion, and a 60 percent stake in Yinlu, a domestic food and drinks producer, for an estimated $600 million to $1 billion. It also set up a joint venture with Yinlu worth almost $400 million.

Not only is Nestle investing more in China, it is investing for new reasons. Unlike in previous years, when companies were investing to manufacture goods to sell outside of China, companies are now manufacturing goods to sell in China. Nestle's decision to partner with two major Chinese companies is aimed at tapping the growing potential of China's domestic market, a desire in which it is not alone.

Even with the debt crisis unfolding, BMW has announced plans to triple its output in China; Volkswagen's two joint ventures are investing $17.3 billion in China through 2016 to develop their domestic production capacity; and Siemens plans to relocate its global headquarters for Basic Healthcare to China. These are just three examples from a seemingly endless list, of which European companies are only part.

Consistent with this trend, FDI from other major foreign countries is rising, with United States up 15.4 percent over the period, Japan up 15.8 percent, Singapore up 28.3 percent and South Korea up 7.6 percent. While all of this is positive in the long term, the outlook for FDI in the short to medium term will remain clouded as long as problems in Europe persist.

Meanwhile, the weakening European economy is also affecting trade and domestic monetary policy. China's exports to the EU fell 0.8 percent from the previous year in the January-May period, meaning overall exports rose by just 8.7 percent against an annual trade target of 10 percent growth. This, combined with the slowdown in FDI, has meant less new money is flowing into China. When taking into account other domestic factors, China has actually seen sustained capital outflows for the first time in recent history.

To offset this, the People's Bank of China has cut banks' required reserves three times in six months to increase financial market liquidity, while the foreign exchange regulator has approved nearly as much new quota for foreign financial investors under its qualified foreign institutional investor scheme in the first five months of the year as it did in the previous two years combined.

As long as fiscal austerity continues to drag down GDP growth in Europe, China's economy will suffer, meaning further easing of domestic monetary policy and a faster pace in opening up the economy to foreign investment can be expected. And with many predicting that the European crisis will continue for some time, this opening-up may need to be more aggressive than anyone is expecting.

The author is a financial analyst at North Square Blue Oak, a London-based brokerage house.

(China Daily 06/22/2012 page7)