Chinese Economy: Issues and Policies Essay

Introduction

A country can stimulate its economic growth through different avenues. Some of these avenues include increasing government expenditure, stimulating the level of consumption, and managing its net exports. International trade plays an important role in the growth of a country’s Gross Domestic Product (GDP) for example, by increasing the volume of foreign currency (Wilson & Brennan 2010, p.2).

A country must implement effective trade policies to stimulate foreign trade. For decades, it was very difficult to invest in China because it had adopted a closed system of economy. However, China has undergone significant economic transformations, which have allowed it to become one of the most attractive foreign investment destinations in the world (Lin & Wang 2012, p. 1).

One of the most notable factors that have stimulated the country’s attractiveness to foreign investors relates to the economic reforms that were undertaken (Yao, Wu & Lin 2010, p. 44). In 1978, China’s net exports amounted to $ 20.64 billion. This figure had increased significantly by 2001 to $ 509.8 billion. During this period, foreign trade in China had increased to 9.5 per cent compared to the global average of 15 per cent.

Another reason that has enhanced the country’s economic growth relates to adoption of an open door policy (Lin & Wang 2012, p. 1). Over the years, the country has experienced an exceptional increment in the volume of Foreign Direct Investment (FDI) and GDP (United Nations 2005, p. 24).

According to Wilson and Brennan (2010), the 19th century was UK’s turn to grow while the 20th century was for the US. The 21st century is widely considered as China’s turn to grow. Most economists believe that if the country maintains this rate of economic growth, it will be the largest economy in the world by 2020.

From the above evaluation, it is apparent the economic transformations that China has undergone have played a fundamental role in setting the growth for China’s economic growth hence its attractiveness to FDI.

The high rate of economic growth arising from increased international trade and foreign investment are some of the major factors that have stimulated the country’s economic growth. Additionally, the government’s commitment in attaining and sustaining a high rate of economic growth is a major factor that will stimulate the country’s future economic growth and increased FDI.

Adoption of the open-door policy is one of the factors that will promote the country’s attractiveness to FDI. This paper intends to analyse the extent to which China has become an attractive market for foreign investment coupled with conducting an evaluation of the extent to which the current rapid growth in the Chinese economy is sustainable in the future.

Extent to which China has become an attractive market for foreign investment

In the 21st century, it has become relatively easy to invest in China. This transformation has arisen from an increment in capital availability in the country. Over the past few years, China has undertaken numerous legal reforms that have led to an increment in venture capital funds.

Moreover, to promote capital availability, China has attracted western countries to invest in the country’s financial sector over the past few years (US-China Business Council 2012, p. 2).

China has attained this goal by promoting the use of offshore funding vehicles. According Organisation for Economic Cooperation and Development (2009, p. 74), it has become relatively easy for foreign companies to access financial capital in the country.

Formulating and enacting effective rules and policies have a great effect in a country’s economy. According to Piggot, Malle, Langer, and Blondal (2002, p. 330), a country’s regulatory environment determines the extent to which it attracts FDI. Over the past few decades, China has increasingly been committed towards reducing barriers to FDI (US-China Business Council 2012, p. 1).

The country has also implemented preferential policies to FDI. According to Piggot, et al (2002, p. 334), the Chinese government has implemented a comprehensive industrial policies whose objective is to guide and stimulate increment in the size of foreign direct investment.

The preferential policies formulated by the Chinese government are in accordance with the country’s industrial and economic development strategy. Examples of such regulations relate to tax reduction and exemption and fall under two main regulations that include,

  1. Industrial Catalogue on guidance of Foreign Investment
  2. The Provisional Regulations on Guiding Foreign Investment

The decision to reduce barriers to FDI and implement preferential treatment to foreign investors arose from the fact that China recognised investment, in some economic sectors, as vital in the country’s economic growth. Some of the sectors that were identified as vital in the country’s economic growth relate to introduction of new technologies.

The export sector was also cited as a vital in the country’s economic growth (Tseng & Zebregs 2002, p. 11). Consequently, China identified a number of Special Economic Zones (SEZs) during the 1980s that were intended at promoting the country’s economic growth. China has also formulated a number of tax incentives for investors in a bid to attract FDI in these zones.

These zones have been “economic levers” whose objective is to guide FDI in specific economic sectors, regions, and industries (Piggot, et al. 2002, p. 334). In 1994, China employed a new tax system by harmonising the income tax levied to foreign investors with that of domestic investors.

By 1994, foreign enterprises in China were subject to an enterprise income tax of 33 per cent and an additional value added tax of 17 per cent. In line with its commitment to create a level-playing field, China has continued to eliminate preferential treatment that was given to domestic firms over foreign firms.

Currently, foreign companies that have invested in Economic and Technological Development Zones and the Special Economic Zones enjoy substantial income tax subsidies (Piggot, et al. 2002, p. 334). The tax reductions and exemptions also vary depending on the type of FDI firm and the economic sector within which they invest.

For example, productive foreign companies whose operation period in the host country is more than 10 years enjoy a 2 years tax exemption commencing from the 1st year of profit making and 3 years and a 50 per cent income tax reduction.

Joint venture companies involved in ports construction and whose operational period is 15 years or more enjoy a 5 years tax exemption commencing from the 1st year of profit making and 5 years of 50 per cent income tax reduction. Additionally, tax exemptions and reductions also vary depending on the region where the business is located.

For example, FDI firms situated at Shanghai Pudong’s new ETDZs and are involved in infrastructure construction and their operational period is 15 years more are subject to5 year’s tax exemption commencing from the 1st year of profit making and a 5 years of 50 per cent income tax reduction (Piggot. et al. 2002, p. 334).

The chart below illustrates a summary of the national income tax reduction and exemption provided to FDI firms in China.

FDI firms Income tax exemption and reduction
Production firms whose operation duration in China is 10 years or more 2-years tax exemption and an addition 3 years 50% tax reduction.
Infrastructure construction FDI firms situated at Hainan Special Economic Zones scheduled to operate for15 years 5 years tax exemption and a 5-year 50% tax reduction commencing 1 year after its profit making.
Airport, railway, and power station construction FDI firms located at Shanghai Pudong New Economic Zone with an economic life of 15 years more 5 years tax exemption in addition to a 5-years 50% tax reduction.
New technology joint venture situated at new technology development economic zones planned to operate for 10 years or more. 2 years tax exemption applicable after the first profit-making year.
Export-oriented FDI firms that export 70% or more of their annual production An addition 50% tax reduction after expiry of the initial tax reduction and exemption allowed.
Joint-venture and wholly-owned FDI banks situated at the special economic zones with an investment of US$ 10 million and planned to operate for 10 years and more. 1-year tax exemption commencing from its 1stprofit making year and an additional 2 years tax reduction
FDI firms in the forestry, animal husbandry, and agriculture sectors situated in remote and less developed areas. An additional 10-year 15% to 30% tax reduction applicable after expiry of the initial tax reduction and exemption

The tax incentives have played an important role in attracting foreign investors to different economic sectors. The objective of such regulations is to promote equitable economic growth by ensuring that FDI also occurs in the less developed areas and targeted economic sectors such as export-oriented industries, agriculture, infrastructure, resource exploitation and high technology sectors (Piggot, et al. 2002, p. 334).

China has also included tax holidays within the tax incentives aimed at attracting foreign investors. Trade openness is another factor that has significantly increased the degree of China’s attractiveness to foreign investors. Numerous theoretical growth models reveal that increase in a country’s Total Factor Productivity (TFP) is a major determinant in its economic growth.

Additionally, previous studies conducted on countries’ economic growth also reveal that a country’s level of integration with other economies influences its extent of economic growth. Market openness is vital in attracting FDI.

According to Wei and Balasubraamanyam (2005, p.23), it is paramount for governments to ensure that FDIs firms have an opportunity to market their products and services. Their market scope should not be limited to the local market, but should also include the foreign market. Consequently, it is crucial for governments to implement effective trade policies such as trade liberalisation.

Trade liberalisation is an essential factor in a country’s economic growth because it increases the volume of FDIs. In an effort to stimulate their country’s economic growth, different governments have implemented varying degree of trade liberalisation. This explains why countries have different rates of economic growth.

In line with its open-door policy, the Chinese government transformed its economy into a market-oriented system (Lin & Wang 2012, p. 4). By opening its borders to international trade, FDI firms in China have managed to market their products in the international market.

Availability of labour is another factor that has enhanced the attractiveness of China to foreign investors. The low labour costs in the country position the China at a competitive advantage especially in the manufacturing sector.

Wei and Balasubraamanyam (2005, p.23) emphasise that China’s endowment with a sufficient labour force has played an important role in attracting FDI. The country’s labour force is characterised as being both skilled and unskilled. The low wage rate in the country positions China as a unique investment destination compared to other countries in the region.

The low cost labour in China has made China to emerge as one of the most global competitive country with regard to the labour-intensive manufacturing sector (Tseng & Zebregs 2002, p. 9).

Wei and Balasubraamanyam (2005, p.23) opine that a low wage rate is very effective in attracting FDI given the country’s level of productivity. The country’s human capital is also very qualified, which results in foreign investors developing a perception that their firms will perform better upon venturing the market.

A country’s stability is vital in attracting foreign investors (Wilson & Brennan 2010, p.4). A number of factors influence the stability of a country such as the economic, social, and political environments together with the justice system. Over the past decades, China has managed to maintain a considerable level of political, economic, and political stability hence reducing the degree of country risk significantly.

In making their investment decision, foreign investors evaluate the level of stability prevailing within the identified investment destination. The stability of a country forms the basis upon which companies determine their probability of future success. Prevalence of social unrests such as riots and strikes tends to decline the attractiveness of a country to foreign investors (Ferguson 2007, p. 72).

China has managed to maintain a stable foreign exchange rate regime. This has safeguarded the Remnibi from undergoing intense fluctuation against major foreign currencies.

The total effect is that foreign investors have been protected from losses emanating from foreign exchange rate fluctuations (Lu 2004, p.343). In summary, one can assert that China has a relatively high degree of attractiveness to foreign investors.

Extent to which the current rapid growth in the Chinese economy be sustainable in the future

Sustaining positive economic growth is one of the major considerations by most governments. However, the likelihood of sustaining rapid economic growth is a major challenge to most economies. This arises from the fact that changes in the global macro-environment can adversely affect such rate of economic growth.

The high rate of economic growth that China is currently experiencing has arisen from a number of reasons that include adoption of an open door policy and its ascent to the WTO. Moreover, the country’s competitiveness is also promoted by the labour cost advantages. For example, most manufacturers are increasingly considering China as an optimal investment destination.

However, the country’s comparative advantage arising from low labour cost faces a major challenge with regard to its sustainability. According to Wei and Balasubraamanyam (2005, p.23), China is facing increased competition with regard to labour competitiveness. The competition is emanating from its neighbouring countries such as India, Vietnam, and Laos.

These countries have experienced an increment in the volume of cheap labour. The competitiveness of China’s labour-force market is also limited by the fact that the country is experiencing a reduction in the supply of highly qualified work force (Beiske 2003, p.54). Growth of labour market in emerging economies such as in the Gulf region has lead to a decline in the country’s competitiveness.

Foreign companies are considering venturing in such markets in order to exploit the labour market advantage presented. Additionally, these countries are also reviewing their foreign investment policies in an effort to stimulate FDI (Tseng & Zebregs 2002, p. 9).

Therefore, the probability of China maintaining its comparative advantage with respect to the labour market will be diminished in the future if effective measures to counter occurrence of the same are not implemented.

High levels of corruption, increase in regulatory burden, and an increment in the country’s risk are other factors that will negatively affect sustainability of China’s rapid economic growth (Wedeman 2012, p. 37). Despite stimulating the country’s economic growth, the economic reforms undertaken by China from 1970s led to a surge in the level of corruption.

Therefore, China has for the past few decades continued to experience endemic corruption (Wedeman 2012, p. 111). According to Sinha (2008, p.33) corruption increases the cost of business operation. Previous studies conducted reveal that there is an indirect relationship between FDI and the level of corruption.

To venture in a country characterised by high levels of corruption, foreign investors will be required to collaborate with a local company via joint ventures. Currently, there are numerous joint ventures between Chinese and foreign firms. The objective of these joint ventures is to avoid corruption.

However, this tends to increase the cost of doing business (Whalley & Xin 2009, p. 123). If not addressed urgently, the high level of corruption in China will distort competition and free and fair trade, and thus there will be a reduction in future foreign direct investment thus leading to a decline in the country’s rate of economic growth (Cole 2007, p.2).

Consequently, the sustainability of China’s economic growth is greatly dependent on the effectiveness with which it will address the high levels of corruption.

Over the past one decade, China has continued to experience an increment in the number of social unrests as evidenced by an increment in the number of demonstrations in the country. The high level of corruption amongst the political class is one of the factors that have increasingly stimulated these demonstrations.

Consequently, probably most foreign investors perceiving an increment in the level of country’s risk, and shy away from investing in China, thus reducing the high rate of economic growth that the country is currently experiencing.

Despite the impact of the above factors on the country’s future economic growth, there is still hope that the country’s economic growth is sustainable. One of the factors that will contribute towards sustainability of the country’s economic growth is the large market size. According to (Tseng & Zebregs 2002, p. 9), market size is one of the factors that attract foreign investors.

China has an enormous market potential that is likely to remain sustainable in the future. The large market size has continued to attract numerous foreign investors from Europe and the US. Additionally, the high rate of economic growth being experienced in China has enhanced the citizens’ living standards remarkably.

According to Chen (2007 p.549), improvement in the country’s healthcare and education will also culminate in most foreign investors being attracted to undertake FDI.

The sustainability of China’s future economic growth would also be enhanced by its 2001 ascent to the World Trade Organisation (WTO). The ascent has remarkably improved the country’s level of integration within the global economy (Ianchovichina, Suthiwart-Narueput, & Zhao 2012, p.1). One of the factors that will sustain the country’s growth relates to increment in the volume of exports.

Most developed countries prefer importing from China due to the competitive nature of the imports. Most of the country’s imports are manufactured under favourable economic conditions that include low-wage, and labour-intensive.

These economic conditions position China at a competitive advantage compared to other developing countries. Most Chinese firms will increase their global activities through adoption of various internationalisation strategies such as exportation and cross-border mergers and acquisitions.

Furthermore, Chinese firms will participate in Outward Direct Investment (ODI) hence increasing stimulating growth in the country’s volume of foreign exchange (IBM Business Consulting Services 2006, p.1).

One of the major challenges that limited Chinese companies from ODI relates to existence of tight controls in terms of financial requirements. However, the country’s integration in the global economy opened up opportunities for Chinese firms to enter the market.

In addition to exports, the country ascent to WTO has created an opportunity for most foreign investors to enter into China. Over the past two decades, China has become the largest recipient of FDI. Its annual Gross Domestic Product (GDP) has grown with a margin of over 9.6%. In 2005, its total GDP amounted to US$2.35 trillion.

Because of its ascent to the WTO, China’s economy has grown by seven times compared the economic growth experienced 20 years prior to its ascent. The high rate of economic growth experienced is higher than that experienced by Japan and the US during their early economic development stage.

Economists forecast that the country’s annual GDP will continue on an upward trajectory at an average rate of 7% over the next few decades. Additionally, most economists are of the opinion that China’s economy will exceed that of the US by 2035 (IBM Business Consulting Services 2006, p.1).

The ascent will increase the market scope available to foreign investors. Therefore, FDI firms in China will increase the volume of their exports leading to an increment in the volume of foreign capital inflows, which is a key ingredient in a country’s economic growth.

The high rate at which China is experiencing ODI and FDI has played a phenomenal role in stimulating the country’s economic growth with regard to capital flows into China. The chart below illustrates China’s international capital inflow over the past decade (Wang & Song 2012, p. 519).

Capital inflows in China from 2001-2011

Figure 1: Capital inflows in China from 2001-2011

Source: (Wang & Song 2012, p. 519)

China has been committed towards adhering to requirements of the WTO. For example, the country has continued to implement the non-discriminatory treatment policy to foreign investors. The country is also being committed to reforming the legal environment. Formulation of legislations with regard to intellectual property rights is one of the commitments that the country intends to uphold.

Other reforms that the government has initiated relate to ensuring trade and foreign exchange rate balancing. These reforms will market the country as a very attractive investment hub to foreign investors, who are members of the WTO. Consequently, there is a high likelihood of the country sustaining its rapid rate of economic growth (Tseng & Zebregs 2002, p. 13).

China has also commenced on its commitment towards expanding the markets available to foreign investors. This move has been attained by eliminating the restrictions and geographical barriers that had previously been imposed. The service sector is one of the markets that have become open to foreign investors.

Currently, foreign investors can invest in the telecommunications and banking sectors, which were previously a preserve of domestic investors (Tseng & Zebregs 2002, p. 13). The high rate of economic growth will be sustainable courtesy of the numerous tax incentives that the Chinese government has implemented with regard to FDI.

The incentives will continue to attract investors in specific regions, industries, and economic sectors. These tax incentives relate to standard income tax rated, special economic zones, high technology development zones, open coastal cities, and economic and technology development zones (Tseng & Zebregs 2002, p. 15).

Conclusion

One can assert that China has a relatively high degree of attractiveness to foreign investors. The country’s attractiveness to FDI has arisen from a number of factors. Some of these relate to capital availability, improvement in the regulatory environment, and trade openness. Enhancing capital availability to foreign investors has significantly improved its attractiveness to FDI.

The numerous economic reforms that the country has undertaken during the last three decades have continuously improved the country’s attractiveness. The most notable economic reforms undertaken relate to the transformation of the country from being a closed economy to being market-oriented. Consequently, China has expanded its market for both domestic and foreign investors.

The country’s attractiveness has also improved given the availability of labour. This aspect has led to foreign investors, especially the export-oriented companies, to consider China as a feasible investment destination. Over the years, the country has maintained a high level of economic, social, and political stability, which has led to a significant reduction in the degree of the country’s risk.

Despite the above attributes, the extent to which China will sustain its rapid economic growth in the future varies depending on several factors. Some of the factors that will enable the country to continue with its high economic growth touch on its recent ascent to the WTO, commitment to implementing legal and economic reforms, and market expansion.

On the other hand, the country’s rate of economic growth will be negatively impacted by increased competition with regard to low cost labour, which is readily available in the neighbouring countries such as Vietnam.

The high level of corruption, increment in regulatory burden, and the country’s risk poses a threat to China’s economic growth. Nevertheless, as exposited in this paper, China’s current economical growth is sustainable even in the future.

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