Internal and External Reforms: Experiences and Lessons from China

In 1999, foreign direct investment in China was $40.4 billion, a sharp drop from the $45.6 billion of FDI in 1998. Government officials and economic analysts have voiced concerns about a further contraction of FDI and about the economic consequences associated with such a contraction. The substantial concessions—for example, over foreign equity holdings in the service sector—the Chinese government has made to the United States and European Union during the recent negotiation over its World Trade Organization accession were in part motivated by a desire to stem the contractionary trend of China’s FDI inflows. Also recently, the central government has permitted local governments in the interior regions to offer greater tax benefits on foreign investors wishing to invest there. Since the coastal regions already have various tax benefit programs in place, such a measure would have the effect of bringing down the average tax rates on foreign investment activities. The main point of this paper is to argue that attracting FDI, as a policy stance, should be of secondary importance to those domestic microeconomic and institutional reforms that seek to improve the allocation of resources in the Chinese economy. These domestic reforms would encompass, for example, removing the political, legal/ regulatory, and financial constraints on China’s truly private firms and tackling the state-owned enterprise (SOE) problem not as a management issue but as an ownership issue. FDI is never a goal in and of itself but a means to promote economic growth and development and, to that extent, the benefits of undertaking domestic reforms may be far greater than any policy measures that are designed to attract more FDI.