Foreign Investment in China
Foreign Investment in China

Yun-Wing Sung
Departamento de Economía
Chinese University of
Hong Kong
Shatin, Hong Kong, SAR, Porcelana
ywsung@cuhk.edu.hk

Made in China: From World Sweatshop
to a Global Manufacturing Center?*

Abstracto
This paper argues that foreign investment is a second-best instru-
ment that helps China to succeed in export-led growth by cir-
cumventing the many distortions that discriminate against domes-
tic private enterprises. China’s dependence on foreign investment
for exports should decline as China builds up its market economy,
but its generous preferences for foreign investors may unduly pro-
long its dependence. It is found that China’s exports are increas-
ingly dominated by the low value-added processing exports of
foreign affiliates. In the case of Hong Kong investment in export
processing on the Chinese mainland, the value-added in the Main-
land is often less than that of re-exporting the output in Hong
kong. Desde 2004, China has amended its treatment of foreign in-
vestments to attract higher-quality foreign investment and up-
grade processing exports in order to transform itself from a
world sweatshop to a global manufacturing center. The policies
appear to have the intended effects.

1. Introducción

China’s economic reform and opening since 1979 have led
to rapid growth in foreign trade and investment that is
widely regarded as a miracle. China’s rank as an exporter
rose from 24th in 1978 to 3rd in 2004. China surpassed the
United States to become the world’s number one recipient
of Foreign Direct Investment (FDI) en 2002. The labor-
intensive, export-oriented industries from Hong Kong
(HK), Taiwán, South Korea, and elsewhere relocate to

* This is a revised version of a paper prepared for the Asian Eco-
nomic Panel Meeting in Keio University, Tokio, 29–30 Septem-
ber 2006. The author thanks Fukunari Kimura and Wing Thye
Woo for helpful comments, and Wing Tse for research assis-
tance.

Asian Economic Papers 6:3

© 2007 The Earth Institute at Columbia University and the Massachusetts

Institute of Technology

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Foreign Investment in China

China in droves, and China has often been described as a “world factory.” The ex-
ports and inward FDI of the ASEAN and even Mexico have suffered from competi-
tion with China.

Although China’s export drive and economic development have been highly suc-
cessful, and the contribution of foreign investment is undoubtedly substantial,
Huang (2003) and Sung (2000, 2001) argued that China is unduly dependent on for-
eign investment for exports due to misconceived policies and market distortions in
China’s transitional economy. Por ejemplo, foreign afªliates have an advantage over
domestic ªrms because China’s administrative planning favored the least efªcient
ªrms, eso es, state-owned enterprises (SOEs), and discriminated against efªcient
private enterprises. Foreign investment accounted for a high and rising share of
China’s exports, rising to a record of 64 por ciento en 2005. Además, Sung (2000, 2001)
showed that exports related to foreign investment tend to have a low domestic
value-added content of 30 percent or so, because of transfer pricing, and also be-
cause foreign afªliates tend to source globally or from their overseas parents rather
than locally.

It is well known that it is difªcult for centrally planned economies to participate in
world trade because of the many market distortions that can only be rectiªed gradu-
ally. This paper argues that, given such institutional distortions, foreign investment
represents a second-best solution that allows China to participate in international
specialization despite the many rigidities of China’s economy. Por ejemplo, China’s
private enterprises can circumvent the systemic constraint in credit rationing
through forming joint ventures with foreign partners.

Because the many distortions in China’s economy are transitional, the high depend-
ence of China on foreign investment for exports should also be transitional. Como
China moves toward a market economy, the value of foreign investment as a sec-
ond-best instrument to circumvent distortions would decline, and China should
phase out the preferences given to foreign investors. This paper argues that the gen-
erous preferences China gives to foreign investors, especially those given by local
governments in their intense competition for foreign investment, may unnecessarily
prolong China’s dependence on foreign investment. En efecto, undue dependence on
foreign investment has been a focus of national debate in China since 2005. Porcelana
has taken signiªcant policy changes to phase out preferences for foreign investment
and also to foster indigenous innovation and technological capacity. From an analy-
sis of 2006 datos, the policy changes appear to be having the intended effect in lower-
ing China’s dependence on foreign investment for exports.

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Foreign Investment in China

The rest of the paper is organized as follows. Sección 2 summarizes the arguments of
Huang (2003) and Sung (2000, 2001) that China is unduly dependent on foreign in-
vestment. Sección 3 describes China’s export regime, especially the institutional fea-
tures of processing exports. Sección 4 focuses on the likely beneªts and costs of ex-
port-oriented investment for China. Sección 5 computes the rate of gross margin of
export processing as a proxy for the rate of value-added. Sección 6 compares the di-
vision of value-added between the Mainland (host of FDI) and HK (source of FDI)
in splitting the supply chain in processing exports between the two. Sección 7 ana-
lyzes the change in the rates of value-added in the Mainland and in Hong Kong.
Sección 8 examines the recent policy switch in China’s regime of foreign trade and
investment. Sección 9 presents the conclusions of the analysis.

2. China’s dependence on foreign investment

There have been increasing doubts on the economic efªciency and beneªts of
China’s foreign trade and investment both in academic and policy circles. Yasheng
Huang (2003) argued convincingly that China’s inward FDI was unduly large due to
two major weaknesses of the Chinese economy that constrained domestic ªrms
rather than foreign ªrms. Primero, China’s administrative planning favored the least
efªcient ªrms, eso es, state-owned enterprises (SOEs), and discriminated against
efªcient private enterprises. Chinese ªrms were thus not competitive. Segundo,
China’s system led to a fragmentation of the national economy that constrained the
growth of domestic ªrms rather than foreign ªrms. Through FDI, foreign ªrms
could take advantage of business opportunities in China that were denied to domes-
tic ªrms.

Sung (2000, 2001) showed that the rate of total value-added of China’s processing
exports, which were mostly related to foreign investment and also constituted the
bulk of China’s exports, was low (solo 30 percent or so). Processing exports refer to
schemes in China that that allow the duty-free import of components and raw mate-
rials for use in export manufacturing. Such schemes were introduced formally in
1984 to offset the distortion on the cost of imported inputs due to China’s high
tariffs.

As HK accounted for the bulk of the foreign investment in export-processing in the
Chinese mainland, Sung compared the income generated by such investment in HK
with that generated in the Chinese mainland, and found that the former often ex-
ceeded the latter. From the point of view of the rate of value-added, a lot of what is
classiªed as Mainland exports in international trade statistics should really be HK

45

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Foreign Investment in China

exports. Sin embargo, HK takes the lion’s share of value-added while the Mainland
takes the heat of U.S. protectionism.

Both Huang and Sung noted that Taiwan, HK, and South Korea had been able to de-
velop labor-intensive exports through subcontracting arrangements without much
need for inward FDI, unlike the case of the Chinese mainland (Huang 2003, pag. 11;
Sung 2000, pag. 56). Both argued that, as a result of China’s rigid system that hampers
the operation of domestic enterprises, China was unduly dependent on foreign
ªrms for investment in developing labor-intensive exports. Both noted that China’s
system of credit rationing, which discriminated against efªcient private enterprises,
exacerbated China’s dependence on foreign investors (Huang 2003, pag. 81; Sung
2000, pag. 68).

Recientemente, the Chinese press and policymakers have been awakening to the short-
comings of China’s foreign trade and investment regime. During the meeting of the
National People’s Congress (NPC) held in March 2005, China’s undue dependency
on foreign investment and technology was repeatedly discussed, and the case of
DVD manufacturing was widely cited in the press. In the Chinese press, China is of-
ten depicted as a world sweatshop rather than a global manufacturing center.

Liu Chingfeng, a representative to the NPC, warned against China’s dependency on
FDI (Beijing Daily, 11 Marzo 2005). He noted that although China produced 70 por-
cent of the world’s DVDs, a DVD set selling for US$ 32 has to pay US$ 18 in patent
fees and US$ 13 in costs, leaving only US$ 1 as proªt. Many Chinese DVD manufac-
turers have gone out of business, leaving an industry dominated by foreign inves-
tores. An MP3 set selling for US$ 79 has to pay patent fees of US$ 45 and costs of
US$ 32.50, leaving only US$ 1.50 as proªts. Liu concluded that Chinese manufactur-
En g, which utilized the world’s cheapest labor, was under “foreign technological ex-
ploitation.” It was characterized by low efªciency and high levels of inputs, wast-
edad, and pollution.

3. China’s export regime

Many tariff-ridden less-developed countries (LDCs) embarked on the path of export
promotion by allowing the duty-free import of inputs used in export manufacturing
to offset the distortion on the cost of imported inputs. En 1984, China instituted two
such schemes, a saber, “processing and assembling” (PAG&A), and “processing with
imported materials” (PIM), which allowed the duty-free import of components and
raw materials for use in export industries (Lardy 1994, pag. 112). Exports under the
two schemes are called processing exports. Detailed statistics on processing exports

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Foreign Investment in China

and their imported inputs are available from China’s Customs Statistics because
their imported inputs are entitled to tariff exemption.

In P&A, a ªrm in China (which may be an indigenous ªrm or a foreign afªliate) pro-
cesses raw materials or components supplied by a partner outside China for a pro-
cessing fee. The outside partner owns the raw materials and processing outputs,
and exports the outputs. PIM also involves the processing of imported materials
and components for export. Sin embargo, unlike P&A, ªrms in China (which may be
indigenous ªrms or foreign afªliates) rather than those outside own the outputs and
imported inputs. Instead of earning a processing fee, as they do in P&A, the ªrms
involved sell the processing exports for a proªt. In comparison with P&A, the ªrms
undertaking PIM assume more risks as they own the outputs and imported inputs.
Sin embargo, as these ªrms are often foreign afªliates, the prices of inputs and outputs
and the sourcing and marketing channels are frequently determined by the foreign
padres. The distinction between the two schemes may be largely legal rather than
substantive.

PAG&A represents an extreme form of dependence on foreign partners as most of the
risks are on foreign investors. A diferencia de, ªrms in East Asian newly industrializing
economías (NIEs) that undertake export processing bear more risks even at the early
stage of export-oriented industrialization as they usually own their raw materials
and outputs as in PIM.

In comparison with the usual case of subcontracting output to ªrms in East Asian
NIEs, foreign partners in P&A usually undertake more tasks in the supply chain,
leaving fewer tasks for the Chinese partners. Por ejemplo, besides providing the
product design and marketing the output, which is common in subcontracting ar-
rangements, the foreign partners in P&A usually have to provide the required mate-
rials, machinery, and technical assistance to their partners in China. The enhanced
role of the foreign partner is attributable to the rigidity of China’s system. Para en-
postura, China’s state monopoly on imports and exports was only gradually decen-
tralized in the reform era. It is still cumbersome for ªrms in China to import materi-
als and machinery on their own. This implies a greater role for foreign partners, y
a smaller role for Chinese ªrms. It is no accident that P&A exports have low value-
added.

The foreign funds involved in P&A are classiªed as other foreign investment (OFI)
rather than FDI. Unlike FDI, OFI does not confer legal control of the enterprise to
the foreign investor. The Chinese partner legally controls the operation and usually
pays for foreign machinery and technical assistance with labor services used in

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Foreign Investment in China

making goods for the foreign partner. Sin embargo, the distinction between the two
types of investment is not sharp, because the foreign partner in P&A often has
de facto (though not de jure) control.

The share of P&A exports in China’s total exports rose rapidly from a base of zero in
1978 (inauguration of China’s open policy) to a peak of 18 por ciento en 1992. The share
declined to 14 por ciento en 1995, but rebounded to another peak of 18.4 por ciento en
1999, before declining to 9.7 por ciento en 2006.

National data on PIM exports were not released until 1992. Sin embargo, it is known
eso, in the late 1980s in Guangdong, which accounted for the bulk of China’s pro-
cessing exports, PAG&A exports vastly exceeded PIM exports (Sung 2001, pag. 214). Es
thus safe to conclude that P&A exports were the dominant form of processing ex-
ports in China in the 1980s. Sin embargo, since the late 1980s, PIM exports have grown
much faster than P&A exports in Guangdong. The same should be true for China as
un todo. Por 1992, when national data on PIM exports were ªrst released, they were
already 28.6 percent of national exports, exceeding the share of P&A exports by 10.6
puntos de porcentaje. The rise of PIM exports relative to P&A exports probably reºects
eso, by the early 1990s, the development of China’s market economy had gone far
enough for ªrms in China to bear more risks. The share of PIM exports in China’s
exports rose to a peak of 43.7 por ciento en 2004, and declined marginally to 42.9 por-
cent in 2006.

As will be seen subsequently, the value-added content of PIM exports are higher
than those of P&A exports. Sin embargo, the rise of PIM exports relative to P&A exports
does not imply China is becoming less dependent on foreign investors in exports.
On the contrary, the share of processing exports produced by foreign-invested enter-
tomado (FIEs, or foreign afªliates) is high and rising. Cifra 1 shows that, de 1994
a 2006, the share of P&A exports produced by FIEs rose from 10 por ciento a 56 por-
centavo, and the share of PIM exports produced by FIEs rose from 74 a 91 por ciento. Para
processing exports as a whole, the share produced by FIEs has risen from 54 por ciento
a 85 percent during this period.

Processing exports have accounted for over half of China’s total exports since 1996.
This paper focuses on processing exports related to foreign investment (PERFI),
which is deªned to be PIM exports produced by FIEs plus all P&A exports (regard-
less of whether they are produced by FIEs or by domestic enterprises). This is be-
cause P&A represents an extreme form of dependence on foreign partners, who pro-
vide equipment and technical assistance in addition to raw materials and design

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Foreign Investment in China

Cifra 1. China’s processed exports and that generated from foreign investments
(% of China’s total exports)

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speciªcations. PERFI have accounted for over half of China’s exports since 1998
(Cifra 1).

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Cifra 2 shows the share of China’s exports produced by FIEs. The share has risen
de 1 por ciento en 1985 to a peak of 58 por ciento en 2005. Although the bulk of exports
of FIEs are processing exports, the share of processing exports in exports of FIEs has
declined from 88 por ciento en 1994 a 78 por ciento en 2005. With the development of
China’s market economy, there is less need to rely on tariff-exempt schemes for two
razones. Primero, China’s tariffs have been gradually slashed. Segundo, FIEs may have
been able to source more inputs locally.

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Cifra 2 also shows the share of China’s exports related to foreign investment,
which includes exports of FIEs, and also P&A exports by domestic enterprises
(PAG&A exports by FIEs are already included in exports of FIEs). The share of China’s
exports related to foreign investment rose from 42 por ciento en 1994 to a peak of
64 por ciento en 2005.

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Foreign Investment in China

Cifra 2. Share of China’s exports related to foreign investment

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4. Beneªts and costs of export-oriented foreign investment

Export-oriented FDI has received considerable attention in the trade and develop-
ment literature as it has been important in the growth of many LDCs. Helleiner’s
(1973) classic article distinguished between short-run allocative effects and long-run
growth effects of export-oriented FDI.

Despite low value-added, the short-run allocative effects of export-oriented FDI for
China have usually been positive as such FDI has created millions of jobs for sur-
plus labor that have a low opportunity cost. The long run growth effects are mixed.
Helleiner discussed “linkage,” “learning,” and “dependence” effects. Linkage and
learning effects are normally positive, but dependence effects can be worrisome, como
China’s emerging private enterprises have to face an arena dominated by large FIEs.
The beneªts and costs of export-oriented FDI are discussed in detail herein.

4.1 Beneªts of export-oriented foreign investment in a transitional economy
It must be stressed that, en si mismo, the surprisingly large share of China’s exports aris-
ing from foreign investment may not imply that China is over-dependent on FDI, o
that China’s foreign investment regime is inefªcient. Due to globalization, the global

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Foreign Investment in China

Mesa 1. Share of foreign afªliates in total exports of East Asian host countries (por ciento)

Host country

Hong Kong (1984)
South Korea (1978)
Taiwán (1986)
Singapur (1988)
Malasia (1986)
Philippines (1983)
Tailandia (1980)

Secondary sector

Primary
sector

Electrical/electronic
products

Chemical
products

Motor
vehicles

—
—
18.5
—
32.6
—
—

—
—
43.6
—
—
—
—

—
—
30.8
—
—
—
—

—
—
—
—
—
—
—

Total

16.5
24.6
18.5
86.0
51.2
51.5
37.3

Tertiary
sector

—
—
3.6
—
15.9
—
—

Fuente: UNTCMD (1992), Table Annex 9.

Nota: Year in parentheses refers to year of data.

coordination of the supply chain in low-tech, labor-intensive products often requires
specialized skills in supply chain management. The development of globalized pro-
duction implies that “late industrializers” would be more dependent on foreign in-
vestment than “early industrializers” such as HK and Taiwan. Mesa 1 shows the
share of foreign afªliates in the total exports in selected East Asian economies. El
“late industrializers” (Malasia, Philippines, y Tailandia) were more dependent
on foreign investment than the “early industrializers” (HK, Taiwán, and South
Korea). As China’s open-door policy came only in 1978, the high share of FIEs in
China’s exports seems to ªt the East Asian pattern.

Besides the late opening of the Chinese economy, China’s dependence on foreign in-
vestment can be seen as a temporary second best means to enable China to circum-
vent the many rigidities of its transitional economy in order to reap the beneªts of
export-oriented growth. Por ejemplo, even though the state monopoly in foreign
trade has been gradually diluted and the power to trade has also been gradually de-
centralized, getting approval can still be cumbersome. Restrictions on foreign travel
and red-tape in obtaining a passport hamper the chance of indigenous entrepre-
neurs to obtain orders from foreign buyers. China’s foreign exchange control also
acts as a barrier to organizing overseas road shows and exhibitions.

Although an FIE can get around the above institutional constraints, foreign owner-
ship was still ideologically suspect in the early days of the reform era; Por ejemplo,
wholly foreign-owned enterprises were seldom approved before 1987 (Naughton
1997, páginas. 91–92). Given such considerations, the popularity of P&A in the early stage
of the reform era is understandable. Under P&A, it is possible to avoid foreign own-
ership.1 The foreign partner bears most of the risks and performs most of the value-

1 In the early reform era, PAG&A arrangements mostly involved foreign partners subcontracting

output to indigenous Chinese enterprises instead of FIEs in China.

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Foreign Investment in China

adding activities in the production chain while leaving the labor-intensive process-
ing to the Chinese enterprise. As mentioned before, PAG&A represents an extreme
form of dependence on the foreign investor.

With China’s liberalization on FDI in 1987, especially on wholly foreign-owned en-
terprises, FDI rose rapidly,2 and dominated both P&A exports and PIM exports. PIM
exports also grew faster than P&A exports, and exceeded the latter by 1991 o 1992.
Foreign investment has helped China to reap the beneªts of export-oriented growth
despite the rigidities of its transitional economy. Though China’s processing exports
related to foreign investment have low value-added, FIEs can be highly competitive
as they have access to global export and sourcing networks. Whereas domestic ªrms
have better access to domestic suppliers, they tend to be inefªcient due to protec-
ción. De hecho, globalized, cross-border production implies that the rate of value-
added in any one country would tend to be low as the production chain is shared
among many countries. With the help of an efªcient, globalized production network
of foreign investors, China’s exports have grown at astounding rates, and the total
value-added generated can be large despite a low rate of value-added.

In comparison with India, China is more open to foreign investment, and there is
strong evidence that foreign investors have helped China greatly in the competition
with India for export markets. Por ejemplo, a principios de los años 1980, India and China had
identical shares of world exports of clothing, en 3.95 por ciento. By the end of the 1990s,
China’s share soared to 20.5 por ciento, whereas that of India was only 5.3 por ciento.

With the help of foreign investors, China has surpassed India in exporting jewelry,
in which India has world-renowned craftsmanship. By the end of the 1990s, China’s
share of world jewelry exports rose to 9.48 por ciento, whereas India’s was only
4.61 por ciento. The relocation of HK’s jewelry industry to Guangdong has been a
decisive factor.

En 1978, the inaugural year of China’s open-door policy, China’s export–GDP ratio
was only 4.6 por ciento, which was less than India’s 5.6 por ciento. Por 2005, China’s ratio
soared to 34 por ciento, vastly exceeding India’s 12 por ciento. Though the rate of value-
added of China’s processing exports is low, the scale of these exports means that the
total value-added and employment generated is substantial. At the end of 2001, HK
investors reportedly employed over 10 million workers in Guangdong (Sung 2005,

2 There was slow growth from 1989–1991 due to the 1989 Tiananmen Incident. Sin embargo, el
Tiananmen Incident affected mostly FDI from the West geared toward the domestic market
rather than the labor-intensive, export-oriented projects from HK and Taiwan.

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Foreign Investment in China

pag. 9). As China has huge reserves of surplus labor with little opportunity costs, el
allocative effect of export-oriented investment in China should be highly positive in
most cases.

4.2 Costs of export-oriented FDI
Although import-substituting FDI may lead to immiserization due to tariff protec-
ción, export-oriented FDI seldom results in value subtraction, a saber, negative value-
added (at international prices) as the outputs are sold in the world market and most
of the inputs are imported at international prices (Helleiner 1973, pag. 14). Sin embargo,
Helleiner cautioned that it is possible for the costs of government-provided infra-
structure to exceed the beneªts in the competition for “foot-loose” industries among
host countries, which have little bargaining power.

For the Chinese case, value subtraction is possible. China’s special economic zones
have ªnancial assistance from the state for infrastructure, often in the form of low-
interest loans. Energy prices are still artiªcially low in China. Además, in addition
to the international competition for foreign investment mentioned by Helleiner,
China’s local governments also compete ªercely for foreign investment because lo-
cal ofªcials are promoted on their performance in attracting foreign investment. No
surprisingly, local ofªcials have given concessions to foreign investors exceeding the
limits allowed by national policy. Some of these concessions (sometimes called
“super-national treatment”) can lead to substantial social losses. Por ejemplo, local
ofªcials in the Yangzi Delta have granted large tracts of free land to foreign inves-
tores. As the Yangzi Delta is a densely populated region, the opportunity cost of land
can be extremely high.

Export-oriented foreign investment can generate substantial negative externalities.
China’s local governments have often violated national environmental standards in
their ªerce competition for foreign investment. Environmental degradation is a se-
vere problem in the Pearl River Delta, which is the cradle of China’s export drive.
Although Guangdong has lately banned high polluting industries, it should be
noted that most manufacturing activities have some negative environmental effects
in terms of noise and emissions generation. If the rate of value-added is low, as is
the case in processing exports, the negative externality does not have to be large to
lead to welfare loss.

The rapid growth of China’s exports has triggered protectionism in overseas mar-
kets. This can also be regarded as a negative externality. Although this negative
externality applies to all Chinese exports, it is of particular concern for low value-
added processing exports for two reasons. Primero, trade ºows are measured in terms

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Foreign Investment in China

of gross value rather than value-added. The low value-added exports of China exag-
gerate the magnitude of China’s bilateral trade imbalances, which drive protection-
ist sentiments against China. Por ejemplo, mientras que la 2005 U.S.–China bilateral trade
deªcit in U.S. Estadísticas (measured in gross value of trade) was US$ 201.6 billion, the deªcit measured in domestic value-added would only be US$ 30.6 billion (Lau et al.
2006). Protectionist sentiments have led to trade barriers against China’s processing
exports as well as non-processing exports, which have higher value-added.

Segundo, in the case of HK’s investment in processing exports in the mainland, el
rate of value-added in HK is often higher than that in the mainland. The higher
“take” of HK relative to the mainland implies that much of what are regarded as the
mainland’s exports are in fact HK exports, if value-added rather than assembling or
fabrication is used to determine country of origin. The mainland takes the heat of
A NOSOTROS. trade protectionism, while HK captures the lion’s share of the beneªts. China’s
low value-added processing exports have generated a signiªcant negative extern-
ality for China in its relationship with the United States.

Besides these considerations on allocative effects, there are also causes for concern in
long-run growth. As China’s institutional rigidities are transitional, its high depend-
ence on foreign investment for exports should also be transitional. Sin embargo, hay
the danger that the dominating position of FIEs may be entrenched, and China’s
emerging private enterprises may face an arena dominated by FIEs. The transitional
nature of China’s economy also implies that China should phase out its many pref-
erences for foreign investors during its transition to a market economy. A pesar de
China has phased out some preferences for foreign investors, the existing prefer-
ences are still strong.

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China’s preferential treatment of foreign investors (and discrimination against do-
mestic enterprises) is so strong that many Chinese enterprises take advantage of the
preferential treatment by disguising themselves as foreign investors: they establish
overseas subsidiaries to invest back in China. The World Bank estimated that this
“round-tripping” of Chinese capital is substantial, accounting for 25 por ciento de la
total inward FDI in China in 1992 (Huang 2003, pag. 38).

Although the magnitude of round-tripping is difªcult to estimate, there is no sign
that the activity has dampened in recent years. One proxy of round-tripping is the
share of the “tax haven economies” (Bermuda, British Virgin Islands, etc.) in China’s
outward/inward FDI. The share in China’s outward FDI has risen from 31 por ciento
en 2004 a 53 por ciento en 2005. For inward FDI, the share has risen from 0.2 por ciento en
1991 to over 20 por ciento en 2005.

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Foreign Investment in China

Round-tripping of Chinese capital neither brings new technology nor additional
capital to China. It may beneªt China as it enables domestic capital to circumvent
institutional constraints. Sin embargo, the beneªts must be weighed against losses in
tax revenue and other distortions that round-tripping may generate.

Undue dependence on foreign investment may have hampered the development of
indigenous ªrms. In the Forbes list of “exciting new ªrms” in 2002, Había 13
from India but none from the Chinese mainland. En el 2003 lista, Había 13 de
India but only 1 from the Chinese mainland.

5. The rate of value-added of processing exports related to foreign
investment

This paper focuses on the analysis of rate of value-added of processing exports to
examine the economic beneªts for China of export-oriented foreign investment. Como
mentioned before, a low rate of value-added may not imply that the activity in-
volved is economically inefªcient. In the age of globalization, fragmentation of the
production process across national borders is efªcient, and often implies a low rate
of value-added in any one country.

Although the rate of value-added (or change in the rate over time) is a crude indica-
tor of economic beneªts, there are many advantages of focusing on the rate of value-
added. Primero, in the case of China’s processing exports, value-added is a good proxy
of net beneªts because such exports usually employ surplus labor with little alterna-
tive use. Segundo, a low rate of value-added implies that the gross value of exports
would vastly overstate the size of beneªts to China. Tercero, a rise in the rate of value-
added over time usually indicates increasing forward and backward linkages,
whereas stagnation of the rate over a long period may be a cause of concern.

Finalmente, given fragmentation of the production process, focusing on the rate of
value-added in a particular step in the production chain (for processing exports, este
is usually the assembly stage) is often more revealing than looking at the technology
content of the ªnal product. Quite a few studies have shown that the commodity
composition of China’s exports has shifted from simple products such as clothing to
high-tech products such as DVDs, and concluded that China has been successful in
climbing up the technological ladder.3 These studies are misleading. A pesar de
DVDs are indeed a high-tech product, the assembly of DVD sets from imported

3 Por ejemplo, see Zhang (2006), which is a study of the Development Research Center of

China’s State Council.

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Foreign Investment in China

components is a low-tech activity, which is reºected in the low rate of value-added
of these processing exports.

As a measure of economic beneªts, total value-added is better than direct value-
added. Increasing forward or backward linkage would show up in total value-
added instead of direct value-added. Desafortunadamente, the computation of total
value-added requires an input–output table, which is very data intensive. The anal-
ysis of change in the rate of total value-added over time would involve the use of
many input–output tables.

Fortunately, the rate of gross margin (RGM) of export processing (the percentage by
which the value of processing exports exceeds the value of imported inputs, usando
the former as the base)4 is a good proxy for the rate of total value-added. As China
Customs Statistics contain data on imports of raw materials and components used in
processing exports, the computation of the RGM of processing exports is straightfor-
ward.

Our computation assumes that imported inputs in a given year are all used to pro-
duce goods exported in that year. In actual fact, processing takes time, and there is
some lag time between imports and exports. When export processing is growing
rapidly, the above method of computation will understate the gross margin, como el
value of imported inputs in a given year will overstate the amount of inputs actu-
ally used to produce exports in that year. Sin embargo, the problem is not very serious,
as the production cycle for labor-intensive processing is quite short (a couple of
months or so).

Conceptually, the gross margin of PERFI overstates total value-added or income
generated in the Mainland for two reasons. Primero, besides importing raw materials,
processing operations may import services (often from HK). Segundo, the domesti-
cally produced inputs used in export processing may also use imported inputs (p.ej.,
the electricity used in export processing may need imported oil), and the indirect
use of imported inputs represent a leakage that should be deducted. Deducting

4 RGM (cid:2) (X (cid:3) METRO)/X , where X and M represent values of exports and imported inputs used in
export production, respectivamente. It is possible to use M (instead of X) as the base, and the rate
thus deªned would be monotonic with ours (except when X is negative, which is not empiri-
cally relevant), giving similar results. We choose X as the base in order to compare the value-
added generated per dollar of processing exports, X, in the mainland (host of FDI) with that
in HK (source of FDI). It will be seen later that, in the deªnition of rate of value-added for
Hong Kong, X is also used as the base to facilitate comparison.

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Foreign Investment in China

Mesa 2. Rate of gross margin of China’s processing exports (por ciento)

Processing exports

Processing with imported materials

Processing and assembly

Domestic
enterprises

FIEs

Todo
enterprises

Domestic
enterprises

FIEs

Todo
enterprises

Related to
foreign
investment

En general

1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Average

38.9
44.2
41.6
48.5
53.4
56.6
54.3
57.0
55.1
55.7
52.3
52.7
55.9
51.2

8.4
12.2
22.3
25.6
30.3
29.4
30.0
35.5
30.9
31.6
33.6
36.3
38.9
28.1

16.4
20.6
26.0
29.7
34.0
33.4
33.1
38.1
33.5
34.0
35.2
37.7
40.5
31.7

18.1
23.8
28.8
30.9
36.9
36.3
34.5
35.1
30.1
30.7
29.9
28.5
26.8
30.0

4.6
7.2
16.7
22.1
30.2
28.8
26.5
25.0
24.1
23.7
11.1
12.5
18.0
19.3

16.7
21.5
26.6
29.1
35.3
34.1
32.0
31.7
28.0
28.0
21.7
20.2
21.9
26.7

11.6
15.4
23.7
26.8
31.9
31.1
30.6
34.3
30.1
30.7
30.9
32.8
35.5
28.1

Fuentes: China Customs Statistics, China Customs Administration various issues.

16.5
20.8
26.2
29.5
34.4
33.6
32.8
36.3
32.1
32.6
32.4
34.2
37.0
30.6

these two items would give domestic value added or GDP generated. To obtain
GNP generated for the Mainland, we need to deduct a third item, a saber, the proªts
of PERFI that belong to the foreign investor. The gross margin of PERFI thus gives
an upper bound of the GNP generated for the Mainland.

5.1 RGM of export processing
Mesa 2 shows the RGM of China’s processing exports since 1994. Two observations
are in order. Primero, the rates of gross margin of domestic enterprises in both PIM and
PAG&A are substantially higher than those of FIEs. This is expected because domestic
enterprises tend to source locally whereas FIEs tend to source globally. Segundo, el
rates of gross margin of PIM for both domestic enterprises and FIEs are higher than
those of P&A. This is again expected because ªrms involved in PIM owned their in-
puts and outputs and bear more risks. The rates shows an increasing trend, especialmente-
cially in the late 1990s. The changes in the rates will be analyzed later.

There have been two input–output studies of the rate of value-added of China’s ex-
ports that distinguished between processing and non-processing exports. Mesa 3
compares the RGM of processing exports with the rate of total value-added in 1995
y 2005, the base year of the two studies. Four observations are in order. Primero, el
RGM of processing exports overstates the rate of value-added slightly by around
3 percentage points in both 1995 y 2005. This shows that RGM is a good proxy for
the rate of total value-added. Segundo, the rates of value-added for non-processing
exports are much higher than those of processing exports. Tercero, the rates of value-

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Mesa 3. Rates of gross margin / value-added of China’s processing and non-processing
exports (por ciento)

Processing exports

Other exports

All exports

1995
2005

DVA

15.3
16.6

TVA

17.6
28.7

RGM

20.8
32.1

DVA

32.9
24.0

TVA

92.5
63.3

DVA

24.0
20.4

TVA

54.5
46.6

Fuentes: 1995 y 2005 data are taken from Chen et al. (2005) and Lau et al. (in press), respectivamente.

Notas: DVD Rate of direct value-added; TVA Rate of total value-added; RGM Rate of gross margin.

Mesa 4. Processed exports by FIEs and domestic enterprises (US$ million)

Domestic enterprises

1994

2006

FIEs

30,598
(53.7)

431,159
(84.5)
(cid:4)24.7(cid:5)

Subtotal

26,373
(46.3)

79,216
(15.5)
(cid:4)9.6(cid:5)

SOEs

25,886
(45.4)

51,424
(10.0)
(cid:4)5.9(cid:5)

CE

560
(1.0)

10,092
(2.0)
(cid:4)27.3(cid:5)

Otro

12
(0.02)

17,670
(3.5)
(cid:4)83.7(cid:5)

Total

56,980
(100)

510,375
(100)
(cid:4)20.1(cid:5)

Fuentes: China Customs Statistics, various issues.

Notas: Figures in parentheses represent percentage share of total, ªgures in angle brackets represent average annual growth rate from

1994 a 2006.

added of the two groups of exports have partially converged. This is expected
because China has slashed its tariffs and liberalized imports. Como resultado, non-
processing exports would also use more imported inputs. Cuatro, due to the large
share of processing exports in total exports, the rate of total value-added of China’s
exports is quite low, alrededor 47 por ciento en 2002.

While the RGM of the processing exports of FIEs is much less than that of domestic
enterprises, the processing exports of FIEs have grown much faster than that of do-
mestic enterprises, with the result that China’s processing exports are increasingly
dominated by the low value-added exports of FIEs. Mesa 4 compares processing ex-
ports from FIEs and domestic enterprises. De 1994 a 2006, the average annual
rate of growth of processing exports from FIEs was 24.7 por ciento, whereas that for
domestic enterprises was only 9.6 por ciento. Among domestic enterprises, estado-
owned enterprises (SOEs) have performed badly while collective enterprises and
“other enterprises” (mostly private enterprises) have performed extremely well.
Sin embargo, because SOEs have a dominating position among domestic enterprises,
and the share of private enterprises was negligible, the hyper-growth of exports
from exports from private enterprises (averaging 84 percent a year) was unable to
reverse the weak performance for domestic enterprises as a whole. The share of FIEs

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Foreign Investment in China

Cifra 3. Year-on-year growth rate of processed exports of FIEs and private domestic
enterprises

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in processing exports rose from 54 por ciento en 1994 a 84.5 por ciento en 2006, y el
share of domestic enterprises fell correspondingly.

Though the average rate of growth of processing exports of private enterprises is
much higher than that of FIEs, the picture is misleading because private enterprises
started from a very small base. Además, the growth of exports of private enter-
prises is greatly exaggerated by the conversion of SOEs and collective enterprises
into private enterprises. It is more meaningful to look at the total processing exports
of all domestic enterprises.

Cifra 3 compares the year-on-year (YOY) growth rate of the processing exports of
private enterprises with that of FIEs. The YOY growth of the processed exports of
private enterprises has ºuctuated greatly (de (cid:3)33 percent to over 390 por ciento),
reºecting the small base and the conversion of SOEs to private enterprises. Desde
2004, the YOY growth rate of exports of private enterprises has slowed down
greatly, converging to that of FIEs. Despite many years of hyper-growth, the pro-
cessing exports of private enterprises were only 4 percent of that of FIEs in 2006. Él

59

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Foreign Investment in China

would be difªcult for the emerging private enterprises of China to challenge the
dominance of FIEs, which are established and more technologically advanced.

6. Income generated for HK and for the Mainland

It is well known that HK is the number one investor in the Chinese Mainland. HK
accounted for 41 percent of the cumulative inward FDI in the Mainland from 1979 a
2006. HK’s share in export-oriented FDI is likely to be even higher as HK tends to
invest in labor-intensive export-oriented projects in the Mainland whereas the
United States and Japan have concentrated their investments on large-scale import-
competing projects.

HK’s investment in export-processing activities in the Mainland has generated huge
trade ºows between the Mainland and HK. In such investment, the Mainland part-
ners of HK ªrms process raw materials and semi-manufacturers supplied by the HK
parent, and the processing output is sold via the parent to the world market, usually
in the form of HK imports from the Mainland for re-exports to third economies.
Such trade is called outward-processing (OP) trade in HK. OP accounted for around
80 percent or more of HK’s re-exports of Mainland origin since 1993 (Sung 2005,
páginas. 89–90).

In re-exporting, HK adds value to the goods exported by other economies to HK for
re-export. Mesa 5 shows the RGMs of HK’s re-exports (the percentage by which the
value of HK’s re-exports exceed the value of HK’s imports for re-exports,5 using the
latter as the base). The RGM is much higher for re-exports of Mainland goods than
for re-exports of other goods. This is because the bulk of HK’s re-exports of Main-
land goods involve OP, and HK investors engage in many value-adding activities
in OP.

The RGM of re-exports of Mainland goods rose from 13 por ciento en 1989 to a record
40 por ciento en 2000, but declined to 31 por ciento en 2005. HK’s re-exports of Mainland
goods include products related to OP as well as “pure re-exports” that do not in-
volve OP. The RGM of the former should exceed the latter because OP involves
many value-adding activities provided by the HK investors. The increase in the

5 It should be noted that, in this paper, HK’s imports from the Mainland for re-exports are

taken to be the same as Mainland’s exports to HK because the cost, insurance, freight (c.o.b.)
minus freight on board (f.o.b.) differential is negligible (solo 1 por ciento). We use the value of
Mainland’s exports as the base in the calculation of the RGM of Mainland’s exports and also
the RGM of HK’s re-exports of Mainland goods in order to facilitate comparison of the value-
added generated for the Mainland and for HK.

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Foreign Investment in China

Mesa 5. Rates of gross margin (RGM) of Hong Kong’s re-exports, offshore exports, y
outward-processing in the mainland (por ciento)

HK’s re-exports

HK’s offshore exportsa

HK’s outward processingb

Mainland
origen

Others

Mainland
origen

A
Mainland

Re-exports
via HK

Offshore
exports

Encima
todo

13.0
21.1
25.8
29.7
35.3
33.2
32.8
34.4
34.6
35.1
38.3
39.9
37.0
34.2
31.4
30.7
30.7
31.6

11.5
12.7
10.3
10.3
8.5
6.0
5.9
6.6
7.4
8.6
9.6
10.5
10.6
11.9
9.9
8.8
8.5
9.3

—
—
—
—
—
—
—
—
—
—
—
16.3
12.8
12.1
12.4
12.1
11.3
12.8

—
—
—
—
—
—
—
—
—
—
—
7.9
9.2
9.1
8.3
8.7
7.7
8.5

—
—
30.1
34.0
38.9
35.8
35.6
37.3
37.9
38.8
42.9
45.4
42.6
40.8
37.9
36.8
36.0
38.1

—
—
—
—
—
—
—
—
—
—
—
23.6
19.4
17.9
18.7
17.4
16.3
18.9

—
—
—
—
—
—
—
—
—
—
—
39.9
35.4
32.7
30.9
28.8
28.4
32.7

Año

1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Average

Fuentes: RGM of re-exports are provided by the Census and Statistics Department of the Hong Kong Government. RGM of offshore

exports are taken from Report on Hong Kong Trade in Services Statistics, Census and Statistics Department of Hong Kong, variar-

ous issues.

Notas: a. Offshore export involved goods purchased from the Mainland by an HK ªrm for export to another party outside HK. El

goods involved do not enter and leave HK.

b. HK’s outward processing in the Mainland refers to the provision of raw materials and semi-manufactures by an HK ªrm to a main-

land ªrm for processing with a contractual arrangement for subsequent export of the processed product from the Mainland to HK or to

a party outside HK.

RGM of re-exports of Mainland goods from 1989 a 2000 is largely due to the rise in
the share of products related to OP, which rose from 74.1 por ciento en 1991 a 88.4 por-
cent in 1997 (Sung 2005, Mesa 4.6). The decline in the RGM of re-exports of Main-
land goods after 2000 is largely due to the substitution of local inputs for HK inputs,
as will be detailed later.

We do not have data on the RGMs of the two separate categories re-exports of Main-
land goods (those involving OP and pure re-exports). The gross margin of re-
exports of Mainland goods would understate the gross margin of re-exports involv-
ing OP. In the absence of better data, we take the former as a proxy for the latter. El
bias should not be too serious as the bulk of HK’s re-exports of Mainland goods in-
volves OP.

Before the mid 1990s, encima 80 percent of China’s PERFI were re-exported via HK
(Sung 2000, pag. 213). The share has since declined, a 47 por ciento en 2000, and to only
17 por ciento en 2005. The decline is largely due to two factors. Primero, China’s export-
oriented industrialization, which started in Guangdong with HK investors, spread

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Foreign Investment in China

north along the coast, and PERFI outside of Guangdong are usually not shipped via
HK. Although some HK investors have gone north, most of the export-oriented in-
vestment outside of Guangdong came from other countries such as Taiwan, Japón,
and South Korea. Segundo, China has modernized its port facilities in Guangdong
since the mid 1990s, and the exports of HK ªrms in Guangdong have been increas-
ingly diverted to local ports, though the trade is still handled mostly by HK ªrms. En
HK, this is called offshore trade—that is, trade that bypasses the HK port but is still
handled by HK ªrms. The RGM of HK’s offshore exports is less than that of HK’s
re-exports (Mesa 5). This is expected as offshore trade involves less value-adding ac-
tivities in HK.

It should be stressed that the bulk of Guangdong’s processing exports are still inter-
mediated by HK. En 2005, HK’s OP in the Mainland re-exported via HK and han-
dled as HK’s offshore exports were, respectivamente, 42 percent and 27 por ciento de
Guangdong’s processing exports, or a total of 69 percent of Guangdong’s exports
were intermediated by HK.

With relocation of HK manufacturing to the Mainland, part of the supply chain,
mostly assembly and related operations, are performed in the Mainland, mientras que la
ªnancing and trading operations are usually done in HK. It is instructive to com-
pare the division of value-added between the Mainland (host of FDI) and HK
(source of FDI) in producing processing exports. Para hacer esto, we compare the RGM of
Mainland’s PERFI with the RGM of HK’s OP, which is deªned to be the gross mar-
gin generated in HK per dollar of Mainland’s PERFI.

Although the bulk of HK’s OP in the Mainland is still re-exported through HK, un
increasing portion takes the form of offshore trade. De 2000 a 2005, the share of
HK’s OP taking the form of offshore exports rose from 25 por ciento a 41 por ciento. El
RGM of HK’s OP is a weighted average of the RGMs of OP handled through two al-
ternative channels: as HK’s re-exports, or as HK’s offshore exports. The weights are
the shares of exports through the respective channels.6 The method of estimation is
now detailed.

6 Algebraically,

RgmOp (cid:2) ShOpRe (cid:6) RgmOpRe (cid:7) ShOpOff (cid:6) RgmOpOff,

dónde

ShOpRe is the share of HK’s OP in the Mainland re-exported through HK,
RgmOpRe is the RGM of HK’s OP in the Mainland re-exported through HK,
ShOpOff is the share of HK’s OP in the Mainland handled as HK’s offshore trade, y
RgmOpOff is the RGM of HK’s OP in the Mainland handled as HK’s offshore trade.

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Foreign Investment in China

The RGM of HK’s OP re-exported via HK is the sum of two terms. The ªrst term is
the RGM of re-exports of Mainland goods. The second term arises from re-exports
of non-Mainland goods (materials and semi-manufactures) by HK investors to the
Mainland for OP, as HK investors also earn re-export margin from the activity.
The second term is the product of two factors. The ªrst factor is the RGM of HK’s re-
exports of third-country goods to the Mainland. The second factor is HK’s re-exports
of third-country goods to the Mainland for OP per dollar of Mainland’s processing exports
re-exported by HK involving OP.7 The factor is obtained from HK statistics on re-
exports involving OP (Sung 2005, páginas. 89–90). En 2005, this ratio is 0.62, a saber, uno
dollar of Mainland’s processing exports re-exported by HK involving OP requires
62 cents of HK’s re-exports of third-country goods.

The estimation of the RGM of HK’s OP handled as offshore exports is analogous to
that of OP re-exported via HK.8 The RGM of HK’s OP is computed from the
weighted average of the two RGMs of OP through the two channels (Mesa 5). El
RGM of HK’s OP re-exported via HK rose from 30 por ciento en 1991 to a peak of
45 por ciento en 2000, but then declined to 36 por ciento en 2005. For the RGM of HK’s OP
taking the form of offshore exports, data are only available since 2000. De 2000 a
2005, the overall RGM of HK’s OP has declined sharply in 5 años (de 39.9 por ciento
a 28.4 por ciento), for two reasons. Primero, re-exports via HK are increasingly diverted to
offshore exports bypassing HK, and the latter has a lower RGM. Segundo, the RGMs
of HK’s OP through both channels have declined, reºecting more value-added in
the Mainland and less value-added in HK for each channel.

Before 2000, there are no data to estimate the overall RGM, but we can just use the
RGM of OP re-exported via HK as a proxy. Although the proxy is biased upward,

7 Algebraically,

RgmOpRe (cid:2) RgmReMd (cid:7) RgmReTh (ReThOp/ReMdOp),

dónde

RgmOpRe is the RGM of HK’s OP re-exported via HK,
RgmReMd is the RGM of HK’s re-exports of Mainland goods,
RgmReTh is the RGM of HK’s re-exports of third country goods to the Mainland,
ReThOp is HK’s re-exports of third-country goods to the Mainland for OP, y
ReMdOp is HK’s re-exports of Mainland goods involving OP.

8 The RGM is the sum of two terms. The ªrst term is the RGM of HK’s offshore export of
Mainland goods. The second term, which arises from offshore exports of non-Mainland
goods by HK ªrms to the Mainland for OP, is the product of two factors. The ªrst factor is
the RGM of HK’s offshore export of non-Mainland goods to the Mainland. The second factor
is HK’s offshore export of non-Mainland goods to the Mainland for OP per dollar of HK’s offshore
export of Mainland goods from OP.

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Foreign Investment in China

the bias should not be too serious as offshore exports were less signiªcant before
2000.

Estrictamente hablando, the RGM of HK’s OP should include the proªts of HK’s afªliates
in the Mainland in addition to the RGMs of re-exports and offshore exports. Cómo-
alguna vez, these afªliates do not usually report signiªcant proªts because they book their
proªts in HK through transfer pricing. Though the relevant tax rates in HK and the
Chinese mainland are similar, there is a signiªcant incentive for transfer pricing, como
HK has no foreign exchange controls and has better protection of property rights.
Funds can be used more ºexibly in HK than the Mainland. The standard way of
transfer pricing is to overstate the price of inputs supplied by the parent ªrm to its
subsidiary (which inºates the RGM of HK’s re-exports, or offshore exports, of third-
country goods to the Mainland), and understate the price of outputs sold by the
subsidiary to its parent (which inºates HK’s RGM of re-exports, or offshore exports,
of Mainland goods). The greater part of the proªt should be captured in the RGMs
of re-exports or offshore exports. Our estimation of the RGM of HK’s OP should be
quite accurate.

The RGM of HK’s OP overstates the rate of total value-added generated by OP in
HK slightly because the domestically produced inputs used in re-exporting and off-
shore exports may require imported inputs, and the indirect use of imported inputs
represent a leakage that should be deducted. The rate of leakage for each year from
1991 a 2004 is known from an input–output study of HK trade (Sung 2006), y el
rate was no more than 7 percent because trading services use few intermediate in-
puts. This means that the RGM of OP is a good proxy for the rate of total value-
added as the rate of total value-added is only slightly less than the RGM.

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Although the RGM of HK’s OP in the Mainland is high, it is still less than the in-
come generated for HK per dollar of PERFI for three reasons. Primero, as previously
mentioned, the RGM of HK’s re-exports of Mainland goods understates the RGM of
re-exports that involve OP. The same holds for the RGM of offshore exports. Segundo,
the re-export margin only includes services performed in HK but does not include
export of services, eso es, services performed in the Mainland by HK ªrms for its
OP operations. Tercero, the income generated in HK is less than the income generated
for HK because part of the proªts of the afªliate belongs to the HK investor. Though
the bulk of such proªts is probably included in HK’s margin of re-exports and off-
shore trade due to transfer pricing, not all proªts are transferred. In the absence of
better data, the RGM of HK’s OP in the Mainland is taken as a lower bound of the
income generated for HK per dollar of exports produced by HK’s OP in the Main-
land.

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64

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Cifra 4. Rates of gross margin of Hong Kong’s outward processing in mainland and
mainland’s PERFI

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7. Change in the rates of gross margin in the Mainland and in HK

Cifra 4 shows that HK’s RGM of OP in the Mainland (lower bound of income gen-
erated for HK) was higher than Mainland’s RGM of PERFI (upper bound of income
generated for the Mainland) in the 1994–2005 period of China’s open-door era.
Sin embargo, Mainland’s RGM of PERFI has surpassed HK’s RGM of OP since 2004
due to the rapid decline of the latter and the gradual rise of the former. The substitu-
tion of local inputs for HK inputs (p.ej., using Shenzhen ports rather than the HK
puerto) would account for both trends in Mainland’s and HK’s RGMs.

HK’s relatively high “take” in the 1994–2005 period indicated that HK performed
many value-adding services for processing operations in the Mainland, incluido
product design, production management, marketing, taking orders from ªnal im-
porters, sourcing, quality control, trade ªnancing, coordination of shipping, y entonces
adelante, whereas Mainland’s role was conªned to assembly or fabrication. The fact
that the Mainland was dependent on HK for so many of these services shows the ri-
gidities of Mainland’s transitional economy until 2003, when Mainland’s RGM of
PERFI began to equal or surpass the RGM of HK’s OP, reºecting the rapid develop-
ment of Mainland’s market economy.

65

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Foreign Investment in China

7.1 Trend of RGMs of China’s processing exports
Mesa 2 shows that the changes over time of the RGMs of P&A and PIM are some-
what different. For P&A, the rates for both domestic enterprises and FIEs rose rap-
idly from 1994–98, but peaked in 1998 and declined thereafter. For PIM, the rates for
both domestic enterprises and FIEs also rose rapidly from 1994–98. Después 1998, el
rates hovered around the 1998 niveles (53 percent for domestic enterprises and
30 percent for FIEs) till 2005 without an obvious trend except for a spike in 2001.
Sin embargo, the rates seem to rise again in 2006, though it is difªcult to discern a trend
with only one year’s data. The rates for all processing exports, and for those related
to foreign investment, exhibited a similar pattern: rising rapidly from 1994 a 1998,
hovering around the 1998 levels till 2005 without an obvious trend except for a spike
en 2001, and rising again in 2006. The reasons for change in the rates will be ana-
lyzed subsequently.

The substantial rise in the RGMs of processing exports from 1994 a 1998 es, en parte,
a statistical artifact caused by a decrease in smuggling. Some processing operations
were mere shelters for the illegal sale of tariff-free imported materials in the domes-
tic market, which exaggerates the amount of imported inputs and lowers the pro-
cessing margin. From anecdotal evidence, it would seem that smuggling was ram-
pant until the crackdown in the fall of 1997.

Sin embargo, there is also evidence that the rise in the rate of processing margin is
partly caused by an increase in backward and forward linkages, indicating that eco-
nomic reforms have increased the ºexibility of the Chinese economy. A prominent
example of forward linkage is the development of Mainland ports that compete
with the HK port. Backward linkage has also been important. Initially, China’s FIEs
consisted largely of relocated labor-intensive downstream operations involving pro-
cessing and assembling. This created a demand for intermediate inputs, which was
partly met by the relocation of midstream and upstream operations from elsewhere,
and also by local enterprises (Naughton 1997, pag. 296).9

7.2 Recent stagnation in the RGM of Mainland’s PERFI
Although the rise in the RGM of Mainland’s PERFI from 1994 a 1998 is the ex-
pected result of economic development and economic reforms, it is perplexing that
the rate has hovered at around the 1998 level of approximately 32 percent until
2005 (Mesa 2). This seems to imply that the linkage and learning effects have not

9 It should be noted that the RGM of Mainland’s PERFI and the RGM of HK’s OP are not exact
mirror images due to many reasons. There are statistical quirks such as China’s crackdown
on smuggling. Además, HK’s OP constitutes a falling share of Mainland’s PERFI due to the
entry of other investors.

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Foreign Investment in China

Cifra 5. Unit value index of Hong Kong’s imports from the Chinese mainland

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developed further, and the upgrading of Mainland’s processing exports has
stopped.10

The deªnitive explanation of stagnation in Mainland’s PERFI awaits further study.
China’s WTO entry in 2002 may play a role, as China has to phase out its local con-
tent requirements. The deterioration of Mainland’s terms of trade since 1998 is prob-
ably a more important factor. Price competition in labor-intensive exports has in-
creased sharply after 1997 as a result of the sudden currency depreciations in East
Asia caused by the Asian financial crisis. The unit value index of HK’s imports from
the Mainland, encima 70 percent of which involve OP (Sung 2005, páginas. 88–90), can be
taken as a proxy of the unit value index of Mainland’s PERFI (Cifra 5). The index

10 The spike of the RGMs of PIM in 2001 appears to be a statistical artifact of the sudden slow-
down of China’s processing exports in 2001, the year of the 11 September terrorist attack. Como
mentioned before, our calculation assumes that imported inputs are all used in export pro-
duction in the same year. When exports are growing rapidly, our measure would understate
the true RGM due to time lag in production. A sudden slowdown of exports would lead to a
spike in the computed RGM. The growth of China’s processing exports dropped from
24 por ciento en 2000 a 7 por ciento en 2001, leading to the spikes of the RGMs in 2001. Except for
el 2001 spike, the RGM of Mainland’s PERFI was less than the 1998 RGM of 32 por ciento
de 1999 a 2004 (Mesa 2).

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Foreign Investment in China

rose sharply from 99.8 en 1993 to the peak of 110.6 en 1997. This is consistent with
quality upgrading and the sharp rise in the RGM of Mainland’s PERFI in the period.
Sin embargo, the index peaked in July 1997 and declined sharply thereafter to a low of
98.4 en 2001, falling by 11 por ciento en 4 años. The sharp decline in the index since
Julio 1997 is obviously related to the Asian ªnancial crisis that led to the depreciation
of many East Asian currencies and increased the pressure of price-competition
among Asian exporters.

Export unit values have recovered partially since 2001. Sin embargo, this recovery was
more than offset by the rising import prices of oil, minerals, and raw materials. C.A-
cording to a study of UNCTAD, China’s terms of trade fell by nearly 6 percent from
2001 a 2004 (UNCTAD 2005, pag. 99). In East and South Asia as a whole, terms of
trade fell by 15 percent between 1997 y 2004 (UNCTAD 2005, pag. 92).

As previously mentioned, quite a few studies have concluded China is successful in
climbing the technological ladder because the commodity composition of its exports
has shifted rapidly from low-tech to high-tech products. Por ejemplo, a study of the
Development Research Center of China’s State Council emphasized that, de 2001
a 2005, the share of electrical and electronic products in Mainland’s exports has
risen from 21.9 por ciento a 30.6 por ciento, whereas the share of textiles, clothing and
footwear has fallen from 24.7 por ciento a 7.9 por ciento (zhang 2006). Whereas electrical
products are regarded as high-tech products, the assembling of such products is of-
ten low-tech in the age of globalized production and splitting of the production
chain among many countries. It is more important to examine the rate of value-
added in production, as complaints about DVD and MP3 manufacturing in the Chi-
nese press have revealed.

It can even be argued that the linkage and learning effects of electrical products are
much less than that of traditional labor-intensive exports such as textiles and cloth-
En g. This is because the manufacture of the high-tech components of DVDs, PCs,
and laptop computers involves speciªc proprietary technology that is not easily ac-
quired. For a developing country, it may be easier to achieve upgrading in clothing
exports than in exports of DVDs.

It should be noted that, in the assembling of high-tech electrical machinery, the gross
margin as deªned in this paper (value of exports minus imported inputs) may
vastly overstate the domestic value-added due to the payment of patent fees to for-
eign enterprises. In the processing of traditional goods such as textiles and clothing,
the gross margin is a better proxy for domestic value-added.

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Foreign Investment in China

8. Policy switch in China’s foreign trade and investment regime

Since late 2004, China’s leadership has repeatedly called for a switch from extensive
growth to intensive growth, stressing the importance of quality rather than quantity.
The switch was enshrined in China’s 11th Five-Year Plan (2006 a 2010), which was
announced in 2005. A prominent goal of the plan was the ongoing development of
China’s autonomous technological capacity.

In line with the Plan, China is trying to shift foreign investment from simple pro-
cesando, assembly, and low-end production to high value-added and innovative ac-
tivities (Hong Kong Trade Development Council 2006). en septiembre 2006, Porcelana
announced that the export tax rebates for certain high-pollution and high-resource
consumption products would be removed or reduced, and the export tax rebates for
high-tech and high-value products would be raised. The Ministry of Commerce
would further upgrade the product structure of processing exports by expanding
the list of products in the prohibited and restricted categories. En noviembre 2006,
the National Development and Reform Commission called for a radical change from
“quantity” to “quality” in utilization of foreign investment. The previous emphasis
on volume of investment and preference for export-oriented investment will be
shifted to importing advanced technology, management expertise, and high-caliber
talents (Hong Kong Trade Development Council 2006, pag. 6).

China is also planning to unify the income tax rates for domestic and foreign enter-
prises at 25 por ciento en 2008. The tax breaks for export-oriented FIEs will be re-
scinded, but high-tech enterprises will enjoy a preferential rate of 15 por ciento (hong
Kong Industrialists 2007, pag. 52).

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It is interesting to note that, en 2006, the rising share of FIEs in China’s exports was
invertido: the share of FIEs in China’s exports declined from the peak of 58.3 por ciento
en 2005 a 58.2 por ciento en 2006. The share of China’s exports related to foreign invest-
ment likewise declined from the peak of 63.6 por ciento a 62.5 por ciento (Cifra 2). Alabama-
though the decline is small, this is the ªrst reversal since the inauguration of China’s
open policy in 1978. En 2005 y 2006, there is also an increase in the RGM of
China’s processing exports, de 32.4 por ciento en 2004 a 34.2 por ciento en 2005 y
37 por ciento en 2006 (Mesa 2). As the reversals are very recent, it is too early to tell if
they are the results of the policy switch since late 2004. Sin embargo, the reversals are
certainly consistent with China’s policy switch toward processing exports.

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Foreign Investment in China

9. Conclusión

The share of China’s exports related to foreign investment is high, rising to a record
de 64 por ciento en 2005 (ver figura 2). China’s processing exports are increasingly
dominated by low value-added production of FIEs. Although the rate of value-
added of the processing exports of domestic enterprises is much higher, they have a
dwindling share of the market, partly because there are many rigidities in the
China’s transitional economy that constrain domestic enterprises rather than FIEs.

The many distortions of China’s transitional economy can only be rectiªed gradu-
ally. Given such distortions, foreign investment represents a second-best instrument
that allows China to reap the beneªts of international specialization despite the in-
stitutional rigidities of its economy. Sin embargo, China’s dependence on foreign in-
vestment for exports should be transitional. As China moves toward a market econ-
omy, its undue dependence on foreign investment for exports should diminish.
Though China has moved toward a market economy quite rapidly, the generous
preferences China gives to foreign investors may unnecessarily prolong China’s de-
pendence on foreign investment. The emerging private enterprises of China have to
compete in an arena dominated by FIEs.

Export processing represents the creation of an enclave facing world market prices
within a tariff-ridden economy. With import liberalization and successful economic
reforms, the enclave should eventually merge with the rest of the economy. Allá
are some signs that this is happening. Por ejemplo, the share of processing exports
in total exports peaked at 57 por ciento en 1998, and declined slowly thereafter (Cifra
1). There is partial convergence in the rates of value-added of processing and non-
processing exports from 1995 a 2005, though the gap in the rates remained large
(Mesa 3).

Sin embargo, whereas the FDI-processing exports enclave is weakening in some ways,
it is strengthening in other ways. The share of processing exports produced by FIEs
is high and rising, reaching a record of 84.5 por ciento en 2006 (Mesa 4). Both the shares
of PERFI and FIEs in total exports rose to a peak in 2005. Though the RGM of PERFI
rose rapidly from 1994 a 1998, reºecting increasing backward and forward linkages,
the rate stagnated at around the 1998 level until 2005.

As China’s system rewarded managers and local ofªcials on quantitative targets,
many Mainland analysts have lamented that the drive of local ofªcials to fulªll
quantitative targets has led to neglect of quality and innovation (HK Economic Jour-
nal, 6 Puede 2005). En 2005 China’s 11th Five-Year Plan sought to switch growth from

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Foreign Investment in China

the extensive mode to the intensive mode by restricting low-value-added and high-
pollution exports, and encouraging high-tech and innovative activities. The switch
is in the right direction because although China still has plentiful surplus labor, es
short of land, clean air, and natural resources. In terms of allocative effects, those
PERFI that have low value-added may not be worth the negative externalities in en-
vironmental resources and in protectionist sentiments in overseas markets. In terms
of growth effects, China is trying to build autonomous technological capacity. Es
not satisªed with simply assembling imported components to earn foreign ex-
change as China is no longer short of foreign exchange.

De 2006 datos, the policy switch appears to be having its intended effect of trans-
forming China from the world’s sweatshop to a global manufacturing center. Cómo-
alguna vez, the design of targets that would promote quality instead of quantity is an ar-
duous task because quality is much more difªcult to measure.

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