For executives of global companies assessing where to build a new factory or set up an office, China was once an obvious choice. But those making such decisions today face a new question: is the world’s second largest economy losing its allure?
China’s official data would suggest not: foreign direct investment inflows (or FDI) into the country hit a record high in 2021, reaching just over $170 billion, according to the Ministry of Commerce. The upward trend continued in early 2022, before turning down in the second quarter of last year.
The headline data, however, belies a gloomier reality when it comes to investor interest in tangible, job-creating projects in China, according to a recent report by research firm Rhodium Group. A significant chunk of the official figures include money flowing into China’s stock and bond markets which, Rhodium says, shouldn’t count as direct investment.
Rising labor costs in China have made it less attractive as an investment destination relative to other countries in recent years. More recently, the country’s harsh policies to constrain Covid’s spread, increasing geopolitical tensions with the U.S., and more heavy-handed government intervention in the economy have further diminished the country’s appeal.
The question now is whether the end of ‘zero-Covid’ will turn those fortunes around — or whether political risk will continue to dampen enthusiasm for foreign investment into China.
Think about a German Mittelstand company that wants to invest in China to produce some widgets it uses in domestic production processes. That company might now look at Southeast Asia.
Frederic Neumann, chief Asia economist at HSBC
“It’s one thing for official statistics to be trumpeted as a sign of great success in attracting foreign investment but the true test is if capital from foreign companies is actually being used to make impactful investments,” says Mark Witzke, a senior analyst at Rhodium who co-authored the report, in an email to The Wire. “When shovels actually break ground that’s a more credible sign of commitment and confidence than just moving money around.”
Deng Xiaoping’s economic reforms, beginning in 1978, first opened China’s door to foreign investors looking to pour money into a growing and underinvested market. China began to welcome capital and technological know-how from large multinational companies — although it still tightly controlled foreigners’ business activities, for example, through requiring joint ventures with Chinese companies in several major industries.
As migrant workers poured into China’s new industrial centers like Dongguan and Shenzhen, multinational producers of everything from textiles to electronics rushed to set up shop through the 1990s and 2000s, capitalizing on the surplus of cheap labor. In 1990, FDI inflows to China were just $3.5 billion; by 1998 they had climbed to around $45.5 billion, and by 2008 they were nearly $110 billion, according to data from the United Nations Conference on Trade and Development (UNCTAD).
While official FDI numbers have continued trending upward for the last decade or so, the number of new, or ‘greenfield’ projects, as well as job-creating expansions of existing projects have largely been heading downward, according to fDi Markets, a database of cross-border capital investment whose figures date back to 2013.
Foreign investment has become far more concentrated in the hands of a few large companies too. In the last four years, the top 10 European companies investing in China have accounted for some 80 percent of all investment from the region, according to Rhodium: over the decade from 2008 to 2017, that figure was closer to 50 percent.
While large companies — including auto manufacturers such as Volkswagen and BMW — are already heavily invested in producing in China, mostly for the local market, smaller companies that might have previously outsourced parts of their production process to China are now less likely to do so.
“Where you saw a lot of investment come through in previous years was medium-sized companies outsourcing some production into China,” says Frederic Neumann, chief Asia economist at HSBC, based in Hong Kong. “That’s no longer necessarily terribly commercial because labor costs are rising. Think about a German Mittelstand company that wants to invest in China to produce some widgets it uses in domestic production processes. That company might now look at Southeast Asia.”
But factors beyond rising labor costs are now at play too. Covid-related travel restrictions have made it hard for executives from smaller companies to travel to China to assess opportunities. For them, political risk has also become a more important consideration when contemplating investment in China than it has been in the past.
“Covid really has been the major obstacle as of late,” says Jens Eskelund, vice president at the European Union Chamber of Commerce in Beijing, adding that “there’s a huge underutilized potential simply because China is too complex, perceived as too risky, there are too many issues to make it attractive for smaller companies.”
While China has continued to liberalize parts of its foreign investment regime in some sectors, especially in digital technologies, access remains challenging. Beijing’s openly-stated goal of self-sufficiency in key industries, experts say, has reinforced some of these barriers.
China is still in many ways a very compelling proposition. You have these amazing clusters of everything that works seamlessly together, and it’s very hard to wean yourself off when you’ve experienced that level of convenience and capability.
Jens Eskelund, vice president at the European Union Chamber of Commerce in Beijing
“In the past, China was relatively open with respect to FDI. There were restrictions, especially in services and in select manufacturing sectors… but they were much more open than either Japan or Korea was at similar periods in their development in terms of allowing room for multinationals in the domestic economy,” says Loren Brandt, the Noranda Chair Professor of International Trade and Economics at the University of Toronto. “There were constituencies and interest groups that would have been absolutely delighted to allow that to continue. But there were others who were much more focused on indigenous innovation, self-sufficiency, and security considerations. And they are the ones that have effectively won the day.”
Add in geopolitical tensions with the U.S. and China’s increasingly uncertain economic outlook to the mix, and it’s unclear whether the current relaxation of zero-Covid policies will be sufficient to attract foreign firms in high numbers once again. Conversely, few see a rapid exodus on the cards: Businesses are more likely to diversify through so-called ‘China Plus’ strategies — whereby firms hedge against supply chain risks by opening additional factories in a range of locations.
“I have yet to see clear cut evidence that companies are wholesale turning away from China,” says Neumann, from HSBC. “The reality is that China is such a juicy market. It is the second largest economy in the world. It still has enormous growth potential, even with current economic challenges.”
Eskelund, from the EU Chamber of Commerce, adds that there’s no easy replacement for manufacturers. “China is still in many ways a very compelling proposition. You have these amazing clusters of everything that works seamlessly together, and it’s very hard to wean yourself off when you’ve experienced that level of convenience and capability,” he says. “But of course there are concerns.”
Isabella Borshoff is a staff writer based in London. Previously, she worked as a climate policy adviser in Australia’s federal public service. She earned her Master’s in Public Policy at Harvard’s Kennedy School. Her writing has been published in POLITICO Europe. @iborshoff