The Significant Role of Foreign Direct Investment (FDI)

Key Insight

Foreign Direct Investment (FDI) played an unusually large role in China's industrial development, distinguishing it from East Asian peers like South Korea, Taiwan, and Japan. From 1985 to 2005, annual FDI inflows averaged nearly 3 percent of GDP, significantly higher than the approximately 0.5 percent for South Korea and Taiwan during their high-growth eras, or less than 0.1 percent for Japan. Foreign companies had a particularly strong presence in China's export trade; since the early 1990s, a third or more of exports were produced by foreign-invested firms, peaking at 58 percent in 2005. For 'high-tech' exports, the foreign role was even more dominant, accounting for well over 80 percent from the early 2000s until 2012, and still around three-quarters currently.

This extraordinary pattern resulted from a combination of circumstances and deliberate policy choices. Politically, China could not replicate the protectionist models of Japan and South Korea, which as U.S. allies were tacitly allowed to maintain mercantilist economies while accessing the U.S. market. As a condition for integrating into the U.S.-dominated world trading system, China needed to grant substantial market access to foreign companies. Pragmatically, in the late 1970s, China desperately needed foreign exchange to acquire technology. Allowing export-oriented foreign companies to establish factories, initially through Special Economic Zones (SEZs), provided a quick solution. Later surges in FDI, particularly in the early 1990s and after WTO entry in the early 2000s, were strategic, aimed at introducing competition to accelerate domestic economic reform.

A notable aspect of the FDI strategy was that a significant portion was not truly foreign. Nearly half of inbound direct investment originated from Hong Kong, often involving mainland Chinese companies 'round-tripping' their capital through offshore entities to leverage tax breaks and other benefits reserved for foreign firms. This practice persisted even after preferences were phased out, as some Chinese internet giants like Alibaba and Tencent are classified as 'foreign' due to offshore holding structures for international stock listings. The FDI model peaked between 2002 and 2006, when China's WTO accession required increased market access for foreign firms. By 2006, FDI accounted for 6 percent of total investment, down from a 1994 peak of 17 percent, and further declined to less than 3 percent by 2014, as China's growing domestic economy became less dependent on foreign capital. FDI brought substantial benefits in technology, production techniques, and management skills, which domestic companies assimilated.