The following is an outline of a talk co-blogger Steve Dickinson gave yesterday at The China Economic Review” forum on “Foreign Direct Investment in China: Optimizing FDI strategy in the current economic climate” [link no longer exists]
I. Major features of the current FDI system in China as of January 1, 2009.
The PRC FDI system dramatically changed during the period of 2006 to 2008. The main features of that change are:
A. Tax neutral FDI policy.
In 2008, China reversed its prior tax policy concerning FDI. Under the old policy, foreign investors were taxed at a lower rate than domestic investors. Investors in specific regions such as Pudong were provided with various tax exemptions. All this was eliminated in the new income tax code, which mandates a neutral FDI investment framework: no incentives based on nationality or region. Incentives are instead provided for specific encouraged business activities. A limited exception to this policy is provided that allows for tax benefits for investment in the central and western regions.
B. FDI through M&A strongly discouraged.
C. Direct foreign investment in real estate prohibited, with remaining foreign investment in real estate strongly discouraged.
D. FDI policy changed from export led growth to quality investment supporting domestic led growth. This shift was a result of the general economic policy adopted by the 11th Five Year Plan and set out in detail in the 11th Five Year Plan on the Utilization of Foreign investment. This plan is a combination of prohibitions and incentives.
1. Prohibitions, as stated in the 11th FDI Five Year Plan:
• No projects that rely on cheap Chinese raw materials or energy
• No projects that waste energy or raw materials, are excessively polluting or that rely on outdated technology, as listed in the 2005 Catalog of Industrial Restructuring
• No projects that are oriented solely towards export
• No projects that center on low technology, low investment, low value added and high employment: toys, apparel, furniture, house wares, shoes, etc.
• No projects in luxury real estate, with general investment in real estate also significantly restricted
• No support for such projects in the form of VAT or other tax benefits
2. Incentives, as provided in the 2007 Catalog of Foreign Investment and the 2008 Catalog of Foreign Investment in the Central and Western Regions
• List of encouraged industries listed in the Catalog is greatly expanded
• Foreign investment is encouraged in business areas emphasized by the 11th Five Year Plan. These areas include: energy and resource saving (“circular economy”), environmental protection, transportation infrastructure development, hi-tech manufacturing, logistics, business outsourcing, improvements in agricultural technology. The revised tax code allows tax incentives to encourage such investment.
• Regional investment is encouraged in the central and western regions. The encouraged investment category for such regions is expanded in the revised 2008 Central/Western Catalog. Regional tax breaks are still permitted for this region, as an exception for the general prohibition on regional tax incentives.
II. The new investment policy in 2009: Facing the global economic downturn.
A. Quality Investment or Export Led Growth?
The question for 2009 is whether China will continue to pursue the quality FDI approach, or whether China will return to the export led growth model. The key factors are:
• FDI in China saw a large downturn in 2008: As of November, approved projects were down by over 25%. An even greater decline is expected in 2009.
• The macroeconomic factors that supported the “quality over growth” program were: unsustainable high growth in GDP, general price inflation, hot money inflows, consistent growth in exports, consistent growth in FDI. All of this has reversed. Wen Jiabao, in a recent article, stresses that growth is of paramount importance. Recent action on the part of the government in support of traditional export manufacturers included reinstatement of VAT rebates, access to lending, and other revisions to tax policy. China appears committed to reliance on the export led growth model, at the expense of other competing exporters.
B. What should we then expect in Chinese FDI policy for 2009:
The current response from the PRC regulators suggests that there will be a qualified return to the export led growth model. This means the following:
• Support for low tech, high employment manufacturing will return.
• Support for pure export manufacturing will return. The resulting high trade deficit is no longer a political concern.
• However, projects listed as prohibited in domestic Industrial Restructuring Catalog will continue to be restricted or prohibited. There will be no return to approval of high pollution, high waste, high-energy usage projects merely to obtain investment.
• Projects that use excessive amounts of energy will be highly restricted. Energy is still in short supply in China, even in the face of economic slowdown.
• However, projects that take advantage of low raw material costs will no longer be discouraged.
• No major changes in the income tax code will occur. The level playing field in tax policy will be maintained.
• The current ineffectiveness of tax policy for encouragement of investment will continue. Tax incentives to encourage FDI in the central and western regions will continue to be ineffective.
• However, the VAT tax system will undergo major changes that will benefit FDI focused on export and low-tech manufacturing. There will be a revival of VAT rebates in support of export-oriented manufacturing, which will benefit FDI focused on low-tech manufacturing. There will also be a general restructuring of VAT, which will benefit FDI based manufacturing in China.
• The incentive systems based on the catalogs for foreign Investment will remain relatively unchanged. However, the actual encouragement for investment arising from such categorization will continue to be relatively weak.
• No major change will take place in the general policy discouraging M&A investment.
• The policy on FDI in real estate remains unclear. It seems likely that the restrictions on FDI in this area will be loosened. However, there is no indication at this time of any move in this direction.