FDI - India vs. China

With the rapidly changing world economy, every country around the globe is trying to integrate its economy with rest of the world. This process is known as globalization. Globalization, as a process of integration of economies around the globe, usually goes through various ways and one such visible way is the inflow of Foreign Direct Investment (FDI). In recent times, FDI has emerged as a buzzword in international business and has received substantial consideration in the policy analysis circles. It represents long-term movement of capital in and out of a country with the purpose of buying physical assets to start a business. It specifies the transfer of a package of resources across the countries, which not only includes capital, but also technology, management, and marketing expertise. Although the process of FDI is a universal phenomenon, the developing countries, however, have strived hard to attract more of it to fill the resource gaps for their economic development.

The global FDI inflows have been on an increasing trend and have increased from a low of US$ 209 bn in 1995 to US$ 612 bn in 2005. Though the major share of FDI inflows was always into developed countries, but an important feature was that all developing regions including Africa lately saw an increase in inflows. Among the individual countries, China has been particularly active and successful in attracting large FDI inflows since the beginning of its economic reforms in 1979. On the contrary, India has been successful in attracting large inflows of FDI, though at a slower rate in comparison to China, since the reforms that began in 1990. One of the most visible reasons for China having an upper hand in attracting FDI is that the country started its reform process much earlier than India. During the beginning of 1990s, India had only US$0.097 bn FDI inflows while China had US$3.5 bn and the ratio of FDI inflows between the two countries was about 36:1. Both the Asian neighbors were progressing at a faster rate during the 1990s for attracting more and more FDI inflows into the economy. In the turn of the century, China attracted an amount of US$40.7 bn FDI, while India attracted US$2.3 bn only but substantially high in comparison to its earlier period. The increase in the FDI inflows led to the decline of FDI ratio between the countries to about 17:4. At present, China's FDI inflows have increased to US$62 bn, while India's FDI inflows are in the region of US$6 bn and have, in the process, contributed to the decline of the ratio between the two countries to 10:3. It is predicted that if this declining ratio continues, India can level its FDI inflows with China within a couple of years. But the question is why is China very successful in attracting FDI inflows and how can India level its position with China?

There are large numbers of factors that affect the substantial inflows of FDI into Chinese economy and can be roughly grouped under three broad heads: Economic structure, open economic policies and cultural and legal environment. Under economic structure, China is very successful for its market potentiality. As we know, market size is considerably an important factor in attracting more FDI from Europe and USA. In fact, many MNCs of USA and Europe have been India can attract more FDI and can compete with China, if it can create a favorable environment similar to that of China. – Rudra Prakash Pradhan Faculty, Economics and Finance Group, Birla Institute of Technology and Science (BITS), Pilani, Rajasthan. Chartered Financial Analyst
December 2005
13 The FDI Inflows: China vs. India setting up their factories in China with the aim of producing goods for domestic market. Another factor that is favorable for China's FDI inflows is its cheap, skilled labor force. The low wage costs appear to have played a significant role in attracting export-oriented FDI to China and in the distribution of FDI flows across its provinces. This has contributed to China's rapid emergence as an important global competitor in laborintensive manufacturing. Empirical studies have already confirmed that a region with more developed infrastructure tends to receive more FDI. China is no exception to it and is successfully attracting more FDI inflows because of its excellent infrastructure. If we look into the Chinese economy, the FDI inflows are substantially high in eastern coastal-China because of this region's superior infrastructure and transport links to external markets. Taking the advantage of positive impact of infrastructure on FDI inflows, China classified its economy into certain special economic zones as per the availability of infrastructure and made the local governments to put an effort to upgrade the infrastructure in order to attract more FDI. China is substantially advanced in transport, electricity, gas, water, posts and telecommunication, which all have a positive impact on FDI inflows.

China has strong scale effects. It suggests that once a province has attracted a critical mass of FDI, it finds easier to attract more. This is because foreign investors perceive the presence of other foreign investors as a positive signal. Additionally, economies of scale make it more efficient for MNCs to locate in the same area, allowing them to share information and facilities (like education and health) for expatriate workers. The coastal provinces of China particularly the southern provinces of Guangdong and Fujian, which are close to Hong Kong SAR and Taiwan, have been the largest recipient of FDI and have acquired an important advantage over the inland provinces in attracting FDI over the past two decades.

The open door policies of China towards attracting FDI are very encouraging. Since the beginning of reform process, Chinese government fixed the goal of attracting FDI inflows into its economy, expecting that it would introduce new technologies and capital that would be helpful to develop its export sector. China's open door policy for attracting FDI follows relaxation in governmental controls and provides practical assistance along with political and legal assurances. It also follows with tax concessions and special privileges for foreign investors and the establishment of Open Economic Zones (OEZs). The tax incentives for Foreign- Found Enterprises (FFEs) are mostly in the form of reduced enterprise income tax rates and tax holidays. These are available to all FFEs as well as domestic firms in the OEZs and to export-oriented and advanced-technology FFEs outside the OEZs. The firms in the OEZs enjoy great autonomy in managing their operations. They face minimal controls on the movements of goods and are allowed to export and import almost freely. These firms also benefit from more flexible labor relations and more land use rights. For export- oriented and advanced-technology FFEs, there is tax exemption on profit remittances and additional tax benefits for reinvested profits and larger reductions in land use fees. OEZs have played a central role in the gradual opening of economy to foreign investors. The local authorities in the OEZs are solely responsible for infrastructural development and other investment as long as they could raise the funds from taxation, from profits of the enterprise they wholly or partly own, or from banks in the zones. The foreign enterprises are allowed to access foreign exchange and domestics market.

The inflow of FDI is also significantly affected by culture, corruption, and legal environment. It is often argued that the unique phenomenon of a large Chinese Diaspora has been the key to China's success in attracting FDI. The fact that Hong Kong SAR, Singapore and Taiwan Province of China together account for more than half of FDI inflows into China is usually used to support this argument. Simultaneously, it is also indicated that the large share of non-resident Chinese in FDI flows into China is a reflection of distortions rather than a unique advantage. Cultural barriers such as language that deter foreign investors from entering China could be a sign that the investment climate is difficult for outsiders, which implies a cost, not an advantage. Also, Chinese law is ambiguous and legal disputes are often settled through personal contracts rather than formal contracts enforceable in the courts. The ambiguity in the law has, in turn, contributed to corruption. China scores relatively poor on corruption and governance indicators in international comparisons, which is measured through Transparency International Corruption Perceptions Index.

In brief, the Chinese success in attracting FDI inflows has been primarily due to its large special economic zones as well as the availability of adequate infrastructure, highly streamlined administration, cheap yet skilled labor force, flexible labor laws, low corruption, strong legal environment, better bureaucratic delivery system, and favorable regulatory and tax treatment to foreign firms. In this range, the position of India is comparatively low and that leads to low FDI inflows into the Indian economy. India can attract more FDI and can compete with China, if it can create a favorable environment similar to that of China. Institutional reforms in a more accountable and transparent way, are imperative for the country. It calls for the creation of special economic zones, improvement in infrastructure, policy stability, introduction of labor reforms, establishment of a strong legal environment, streamlining of the bureaucracy, and the elimination of corruption. It should not be a daunting task, if there is adequate political will with respect to the economy.