Why is there so Much Demand for Foreign Equity Capital

Foreign-invested enterprises (FIEs) are now a significant force in Chinese economy, as measured by their size, performance, and their encroachment on China’s most important industries. This paper challenges many of the conventional views on the factors behind this growth of FIEs. The paper offers an institutional and policy perspective explaining the high Chinese demand for foreign equity capital. The basic contention is that FIEs’ advantages over domestic firms exceed the capital and technological advantages in their possession and these extra-ownership-specific advantages arise from the way the Chinese economic institutions are organized. There are two sources of these advantages. One is that foreign firms provide a range of functions that are under-provided by domestic firms due to regulatory and institutional factors. Another source arises from the fact that premium is conferred on FIEs’ form of organization. Certain advantages, by regulations and policies, are granted to FIEs and thus domestic firms have incentives to acquire these advantages by a process of corporate conversion into FIEs. These two sources of extra-ownership-specific advantages create a higher Chinese demand for foreign equity capital than would otherwise be the case under an alternative institutional and policy context. Why is there so Much Demand for Foreign Equity Capital file:///M|/WEB/cfia/cfiapubs/pdfs/huy01.html (1 of 25) [11/30/2000 11:26:41 AM] Why is there so much demand for foreign equity capital in China?1 In 1997, the Chinese government reported a foreign capital inflow of 64.4 billion dollars and an FDI inflow of 45.3 billion dollars. In 1998, despite the widespread financial turmoil in East and Southeast Asia, FDI inflows into China continued at a strong pace, defying the growing pessimism about China in the Western business community. For the first nine months in 1998, the FDI inflows stood at 31.4 billion dollars, unchanged from the year before (Smith 1998). Starting de novo in 1980, foreign-invested enterprises (FIEs) have become a sizable player in the Chinese economy. The FIEs have accumulated a large capital base and their investment activities account for an increasing share of China’s capital formation. They are a large employer of China’s labor force and their superior pay and flexible employment structure have drawn the best educated of the Chinese workforce. Their ability to raise funds and to import and export capital quickly has a strong influence on China’s macroeconomy. Increasingly, FIEs are making China the manufacturing base of Asia. They can be found in virtually every part of China and in every economic sector. In a number of sectors, FIEs have established dominant positions in Chinese industry, especially in soft drinks, toys, cosmetics, automobiles, etc. FIEs’ foreign trade activities account for a large share of China’s overall trade balance: In 1996, they accounted for 40 percent of China’s foreign trade and for 30 percent of Chinese export.2 The growing financing and economic roles of FIEs in the Chinese economy can be described as an “FIE phenomenon.” This paper explains this phenomenon in two ways. One is to show that much of the existing explanation does not hold up to a close scrutiny and that there is a need for a more vigorous perspective on this issue. The other is to lay out an analytical framework that stresses the importance of China’s institutions and policies in understanding the FIE phenomenon. I call this framework “institutional and policy factors” approach (or IPF approach). There are two main differences with conventional explanations. One is that the IPF approach aims at uncovering the alliance motivations and the characteristics on the part of the Chinese shareholder firms, as opposed to the motivations and characteristics of the foreign investing firms. I argue that Chinese motivations and their operative constraints are a critical part of the story underlying the FIE phenomenon. The other difference is that the IPF approach constructs a micro story explaining growth and performance of FIEs. The typical approach is to rely on macro factors such as economic fundamentals and evolution of FDI regulations as explanations. This paper consists of four parts. The first section gives a more detailed delineation of what is meant by “FIE phenomenon” in China during the reform era and especially in the 1990s. The second section sketches a number of conventional explanations and describes their problems. The third section presents the IPF approach and discusses some empirical evidence. The fourth section concludes and offers some policy implications.