Efficiency, Productivity, and China FDI

A common stereotype concerning China is: “It is all about cheapness. Let’s go there and save money.” This may be true however it is increasingly becoming the case that this is not the only reason to do business in and with this country. Not anymore, at least. Not anymore is this the only reason to exploit its potential; not anymore is it the only reason to source Chinese products. It is quite revealing to now look at how the nation is becoming truly competitive and not just from the pure cost side of the equation but in terms of quality well. And even though labor in China is becoming more expensive relative to it’s original “Open-Door” era levels, labor productivity has been similarly rising. “China’s industrial labor productivity growth exploded at a 17% annual rate between 1995 and 2002. As in the more developed countries, this rise in productivity comes from improved technologies and the reallocation of resources from lower to higher value activities. And Chinese labor is now producing 3 times as much as it did a mere 9 years ago (From NYT: U.S. Leads Productivity Ranking; China Gains). This is remarkable, even for a BRIC country.

One should also appreciate that there has also been a noticeable capital restructuring commitment. Before the 1978 Open Door Policy, China put its primary efforts in the heavy industry sector, which has historically been a mainly state-run sector.

Graph FDI in China

Source “Foreign Direct Investment and Manufacturing Productivity in China” Yu CHEN – Université d’Auvergne Sylvie DÉMURGER CNRS, 2002

Once the borders of the country were opened and restrictions began to loosen, capital inflow started to be aimed at the Chinese market. Foreign capital is the manna of an economic system. Luigi Zingales in his book “Save Capitalism from Capitalists” explains this phenomenon very clearly. Foreign direct investment (FDI) strengthens a system, both economically and institutionally speaking. In order to obtain such an ambitious goal a stock market (for example, but not exclusively) must fulfill certain requirements: transparency, disclosure of information, strict rules and creation of new regulators (Such as the U.S. SEC). These strict goals, generally speaking enhance both effectiveness and efficiency. A positive loop starts as institutions are spurred to increase the overall quality of their economic framework in order to attract investors from all over the world. Firms and companies thus have the right opportunity and incentives to achieve higher levels of efficiency, for this same reason.

So it happened in China, every year more and more after the opening up of trade. Even MNEs (multinational enterprises) have enjoyed these benefits. With friendly regulations and reliable regulators, the whole economic environment, down the economic pyramid, improves as there is an increase of technologically skilled actors the skills of whom spread throughout Chinese human capital. Spillovers will also occur as knowledge transfers, especially in as populated a country as China. This population density furthermore creates an atmosphere of fierce competition where it is constantly a struggle to maintain any sort of competitive advantage. This enables the capabilities of the population to continuously grow and improve. Of course, the productivity growth has only helped to increase FDI growth.

The above table displays how FDI spread in China during the 80s and 90s. There are some interesting features worth noting from this graph.

Such rapid growth of FDI inflows in China is mainly attributable to the following factors:

  • China’s rapid economic growth during the reform period onwards.
  • The abundance of labor and its low costs in China.
  • The immense size and the rapid expansion of China’s domestic markets. This is also thanks to the role of the overseas Chinese investors from Hong Kong, Taiwan and Macao.
  • China’s increasing integration with the world economy and its willingness and efforts to attract FDI as embodied in its preferential policies offered to foreign investors. Innovation policies matter, especially when the technological gap remains so wide with the west.

On the other hand, after the peak in the mid 90’s there were decreases in FDI. The latter phenomenon may be due to the following factors:

  • A slowdown of China’s economic growth, as FDI tends to be positively related to GDP growth.
  • Excess capacity in a number of industries such as certain consumer electric and electronic products, textile and clothing, and other light industrial products. This would have been as a result of the massive -foreign and domestic- investment of the recent past. A 1998 study by the United Nations showed that the capacity of these industries to absorb FDI is limited.
  • Wage increases, especially in coastal provinces, have been eroding incentives to foreign investors. Path dependency matters in order to evaluate performances and their track record.
  • Reduced investment by Asian neighbors whose economies were severely affected by the Asian financial crisis in 1997. At the same time, the international competitiveness of some of China’s exports was reduced as these countries devalued their currencies. Externalities matter.
  • The introduction of World Trade Organization (WTO) agreements in 2001. China had entered into certain Intellectual Property Right (IPR) agreements previously. So, some basic economic requirements had to be set up then out of necessity. This may have severely limited the ability to exploit certain apparent competitive advantages of the Chinese, in conjunction with WTO IPR and law minimum standards being introduced. This, in my opinion, is certainly one of the more interesting phenomenons.

After spillovers and knowledge transfers from abroad, what China learned from outside investors and entrepreneurs now seems to be ready to be implemented domestically. Domestic patenting activity is the area where this is most apparent. As the below graph shows, China entered the World Intellectual Property Organization (WIPO) in 1980, but signed the Patent Cooperation Treaty (PCT) in 1994. The effects of these agreements are represented graphically below.

Resident Patent Activity in China

Resident Patent Activity in China. Source: WIPO

Issues regarding the effectiveness of the Chinese market remains open-ended however. For example, there are still very apparent regional disparities. Furthermore, FDI inflows are heterogeneous, largely attributable to both the geographical advantage of the coastal provinces and preferential policies by the central government implemented in favor of these areas. However, the low cost of labor and the potential of the Chinese market keep on motivating the inflows of FDI into China.

Learning capabilities, organizational routines and other aspects related to the implementation of a new industrial/economic system are crucial for boosting productivity. After a sector and industrial reassessment, learning curves steepen. Some new features of the new economic system may adversely affect the shape of these curves as exogenous factors. Efficiency and effectiveness pass through a hierarchy regarding intra-organizational capabilities and other previously mentioned aspects of the microeconomics of technical and industrial change.

China however is walking its path, as GPD growth figures in these past few years have shown. There seems to be a worldwide consensus on this fact as well. The Japanese electronics maker Fujitsu for example is starting to look at the Chinese market as a major part of its expansion plans From the China Daily quoting Chen Linya, corporate vice-president of Alcoa and president of Alcoa Asia-Pacific: “In China there are millions of opportunities. No one can get everything. The best way to win in China is to cooperate with good companies.” We can also see foreign packaged food provider Nestlè seeking to buy Chinese candy makers. It is clear that FDI is continuing to flow into the Chinese economy. Is China efficient? Yes. Is China continuing to improve? The global consensus seems to also be yes. Thus, though it may not be possible to predict what may happen with any certainty, at least into the foreseeable future, it seems as if with continued productivity growth and a domestic market with massive untapped potential, there is still good reason for FDI into China to remain at its current high levels.

-Marco Tommaso Rossini, CPG Marketing Intern

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