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Centrally Imposed Constraints and Local Rule Bending

When CCP leaders initiated the open-door policy in the late 1970s, their basic strategy was to maximize the potential gains from foreign trade and investment and minimize any “undesirable” effects of economic internationalization. The potential gains from FDI are similar to those perceived by national governments elsewhere (Caves 2007), including increase of capital supply, expansion of foreign market connections and opportunities, access to advanced technology, infusion of international management know-how, growth of employment and revenue, and stimulating effects on domestic enterprises through competition, transaction, and demonstration. The “undesirable” effects include the threat of foreign competition to domestic vested interests (e.g., SOEs), foreign control of vital economic resources and activities, political, social, and cultural influence from abroad, and erosion of the dominance of public ownership. It is the concern about these effects that has led the central government to impose restrictions on where and how foreign investment takes place in the country.

Unlike many small economies where the national government is the sole gatekeeper and regulator of FDI (Caves 2007), China is a large country with multiple levels of government that hold varying degrees of authority over foreign investment. To align foreign investment with its policy imperatives in face of this reality, the central government has resorted to three major measures: rule setting, direct involvement in gatekeeping and regulation, and use of informal influence on local governments.

In 1980 the central government designated Shenzhen, Zhuhai, Shantou, and Xiamen as special economic zones (SEZs). In 1984 fourteen coastal cities were given the special status as “coastal open cities.”[1] A similar status was granted to Hainan Island, which was subsequently elevated to a special economic zone in 1988. In 1984-1986 the central government also designated fourteen industrial parks, which were called National Economic and Technological Development Zones (NETDZs) and mostly located in the coastal open cities (except for one located in Guangzhou). Several batches of NETDZs were added in the ensuing years, including twenty-one during 1989-1995, sixteen during 2000-2001, six during 2002-2009, and ninety- five during 2009-2014. In 2013-2014, the central government authorized Shanghai, Guangdong, Tianjin, and Fujian to pilot free trade zones in select areas under their jurisdiction. What all these centrally created special policy enclaves have in common is that they have been allowed to adopt more liberal and flexible rules than other locales on a wide range of issues related to foreign trade and investment, such as project approval, financing, custom clearance, land use, taxation, currency controls, and labor practices (Howell 1993; Zweig 2002). The intention is to make them the focal areas of experimentation of centrally defined foreign economic policies.

Along with the uneven rules concerning the geographic locations of FDI, the central government has also defined the organizational forms and laid out the sectoral entry requirements for FDI. During the first decade of reform the central government enacted three important laws that set joint venture (JV) and wholly foreign-owned enterprise (WFOE) as the basic organizational forms of FDI, as mentioned in chapter 1. Starting from 1987 the Chinese government has issued a series of guidelines that stipulate the scopes

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of FDI entry and the organizational forms that must be used for entry into different economic sectors. These guidelines, revised six times (in 1995, 1997, 2002, 2007, 2011, and 2015), classify the entry conditions of FDI in different economic sectors into four categories: encouraged, allowed, restricted, and “prohibited.” The guidelines are not exhaustive, though. Foreign entry into sectors not explicitly listed in the guidelines has been subject to the ad hoc review and decision by the pertinent gatekeeping authorities, mostly at subnational levels.

Before the mid-1990s joint venture with public enterprise was the dominant organizational form prescribed by the central government (Pearson 1991; Roehrig 1994; Randt 1996). Although WFOEs were legally allowed as of 1986,[2] the general rule was that wholly foreign-owned enterprises must be treated as the least preferred organizational form (MOFERT 1986, 23).[3] That policy bias persisted until the turn of the century. In the FDI entry guidelines revised in 1995, for example, joint venture was explicitly listed as the only organizational form permitted for a number of economic sectors listed as “encouraged” and “restricted.” In some sectors there was the further stipulation that domestic (public) enterprises must hold the controlling stakes in the joint ventures formed. Over time the number of sectors in the “encouraged” category increased and that in the “restricted” category declined; yet the number of sectors with explicit j oint venture stipulation was also expanded.[4]

Before the start of massive privatization in 1997, this policy bias toward joint ventures was further coupled with rules that steered joint ventures toward partnership with public enterprises and restricted the formation of joint ventures between domestic private owners and foreign investors.[5]

Throughout the 1980s and early 1990s there were very few such enterprises, largely because of the highly restrictive political environment for private business and the lack of statutory ground.[6] In fact the equity joint venture law (1979) and the contractual joint venture law (1986) defined joint ventures as legal persons but did not make any provision for the formation of joint ventures between parties that were not legal persons. This in effect precluded the formation of joint ventures with domestic private owners as natural persons.

Under Chinese law getihu, private sole proprietorships and partnerships, are not considered legal persons and have to face unlimited liability. Private enterprises using these organizational forms thus could not directly form joint ventures with foreign investors until the mid-1990s. Although the Provisional Ordinance on Private Enterprise in 1988 allowed the establishment of private limited liability companies (with legal person status) as an organizational form of private enterprise, no implementation details were made available before the enactment of the Company Law and the corresponding implementation guidelines in 1994.[7] And it was not until 1995 that the implementation guidelines on the formation of joint ventures involving parties without legal person status were issued. Before these developments, any action taken by local licensing authorities to approve the formation of foreign-private joint ventures would inevitably involve a risk due to the lack of statutory clarity. The stigma and sectoral entry restrictions faced by the domestic private sector before the late 1990s also cast a constraining shadow over the formation of foreign-private joint ventures. The adverse institutional setting made foreign- private joint ventures the least-used organizational form for FDI in the 1980s and early 1990s despite their potentially stronger capability of limiting political meddling and containing agency problems than joint ventures with public enterprises.[8]

For economic sectors not explicitly specified in the four categories defined in central FDI guidelines, the approving authority has been divided among different levels of government. The main criterion for determining this division is the size of initial capitalization of foreign-invested enterprises (Randt 1996). The central government has held the authority to approve and license very large investment projects. In the mid-1990s, for example, approval by the State Council was required for projects involving more than US$100 million of foreign investment. Those involving more than US$30 million but no more than US$100 million and those involving more than US$10 million but no more than US$30 million required approval by the State Planning Commission (SPC) and the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) (renamed Ministry of Commerce in 2003) and by provincial-level authorities respectively. Smaller projects under the $10 million threshold were left to lower-level governments for approval and licensing.

A major consideration affecting the decisions of gatekeepers is the competitive threat posed by foreign investment to the enterprises already under their purview, especially public enterprises directly “owned” by the governments concerned and situated in the same sectors that foreign investors seek to enter. Such competition may take place on multiple fronts, including financial, physical and human resources, supply chain relations, and product sale and distribution.11 To protect their vested interests, local gatekeepers of FDI can block the attempts at entry that they perceive as threatening. They can also defuse the threat by requiring that the prospective entrants form joint ventures with their local counterparts. For the central government, however, direct use of these strategies is often out of reach, as many centrally controlled SOEs are situated in locales and sectors where local governments are the immediate gatekeepers “on the spot.” Moreover, there was no unified authority in the central government that supervised all nonfinancial SOEs before 2003 (when the SASAC was formed to take on that role through consolidating control over the surviving central SOEs after massive privatization). Instead central SOEs were controlled by various industry-specific ministries and agencies. What these authorities could do, though, was to use their clout in the central government to pressure local governments to act on their behalf by denying entry and/or demanding the use of a joint venture structure as the [9]

only avenue for entry where face-off situations arose between central SOEs and foreign entrants.

There is no guarantee of full compliance by local governments with centrally set rules and pressures, though. Although local governments share many of the considerations behind central policies on FDI, they tend to be less concerned about the well-being of centrally owned SOEs and about the more “encompassing” issues deemed important by the central government, such as national security, cumulative hazards posed by negative externalities (e.g., environmental pollution and resource depletion), broad sectoral and interregional positive spillover effects in terms of technology and organizational practice, noneconomic influence from abroad, and even the ideological and political ramifications of (foreign) private ownership. In the meantime, they are strongly interested in parochial agendas that foreign capital may facilitate. The inflow of foreign capital may have a positive impact on local economic growth, expansion of revenue base, linkages among related local sectors and activities, and job creation, all of which are conducive to the career advancement of local officials, as discussed in chapter 4.

Under the new political performance assessment system, achievement in luring foreign investment, known as zhaoshangyinzi (attracting business and channeling [foreign] capital), is often a concrete performance indicator in itself. An additional benefit of FDI is that it can provide a conduit for the rescue of poorly performing local public enterprises that have become liabilities of the local government (Huang 2002). Moreover, foreign entry may also bring about opportunities for local officials to leverage bank lending and manipulate fiscal resources (e.g., by extending tax breaks with strings attached or to transaction partners of foreign-invested companies), to make personal gains (e.g., through bribe taking), and to benefit their own family members or associates who conduct business with or through foreign investors.

In the meantime, local governments face competitive pressures among themselves (Zweig 2002). Unlike local governments, foreign investors are geographically mobile. They may be able to take advantage ofsuch mobility to pit different local governments against one another and bargain for more liberal and flexible

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terms of entry and regulatory treatment. The fact that there is rent (e.g., in the form of first mover’s advantage) associated with institutional unevenness across different jurisdictions (Vogel 1989; Montinola, Qian, and Weingast 1995) also drives local governments to create and maintain more accommodating policy environments for the purpose of better positioning themselves in regional competition for FDI (Zweig 2002). While undertaking this endeavor, they need to be vigilant in guarding the sectors already populated by local companies, especially public enterprises. When inconsistencies arise between addressing centrally defined policy imperatives and concerns and attending to their own short-term and parochial interests, however, local officials may be inclined to bend the rules for the latter. Such behavior is likely to be more pervasive at the sub-provincial level, as provincial governments are more closely monitored by the central government than lower-level jurisdictions, which nevertheless have been the gatekeepers of the vast majority of foreign-invested entities.[10]

In chapter 1 I have already highlighted the temporal trend of FDI growth in the reform era. Table 6.1 provides further information on such growth in the industrial sector (which was the main domain of foreign investment before China’s WTO accession in 2001 and subsequent opening up of service sectors) up until the time of massive privatization. Between the 1985 and 1995 industrial censuses, for example, the total number of foreign-invested industrial enterprises increased by eighty-six times. The percentage of geographic areas (at the prefectural level) and industrial sectors (with four-digit classification) with foreign presence also experienced significant expansion—from 22.4% and 20.0% to 94.2% and 90.4% respectively.

Table 6.1 Selected statistics of foreign-invested industrial enterprises

Indicators

i985

1992

1995

1998

Total number of foreign-invested industrial enterprises

516

9,325

44,293

26,448

% of prefectural jurisdictions with industrial FDI

22.4%

67%

94.2%

86.1%

% of four-digit industrial sectors with FDI

20%

88.3%

90.4%

90.7%

% of sub-provincial jurisdictions where central or provincial

public enterprises faced

foreign-invested enterprises in the same four-digit sectors

3.7%

31.3%

40.4%

33.9%

% of sub-provincial jurisdictions where local public enterprises faced foreign-invested enterprises in the same fourdigit sectors

1.3%

17.3%

19%

18.1%

% of joint ventures among foreign-invested enterprises located in the same prefectures and same fourdigit sectors as central and provincial public enterprises

94.6%

87.7%

77.3%

70.6%

% of partnerships with subprovincial public enterprises among joint ventures located in the same prefectures and same four-digit sectors as central and provincial public enterprises

94.3%

87.1%

78.2%

75.8%

Note: The data cover all industrial enterprises in 1985 and 1995, all industrial enterprises with independent accounting status (Holz and Lin 2002) in 1992, and all industrial enterprises with annual sales of at least 5 million yuan in 1998. Other than the total number of industrial enterprises, all the figures for 1985 are estimated using the information on inaugural year from the 1992 NBS industrial survey.

Sources: SSIC1985; data of the 1992 NBS industrial survey, the 1995 industrial census, and the 1998 NBS industrial survey.

What is particularly noteworthy is that sub-provincial governments acted in ways that deviated from the interests of higher-level authorities. Statistics in the table show that over time FDI expanded its presence in the same regions and sectors already populated by public enterprises. The percentage of such presence was in some cases twice as high for centrally and provincially owned public enterprises as for those owned by subprovincial authorities. The vast majority of the foreign entrants that entered the same regions and sectors already populated by public enterprises were organized as joint ventures. For central and provincial authorities, however, this was not necessarily good news. The joint ventures formed in the same regions and sectors as centrally and provincially owned public enterprises mostly partnered with public enterprises owned by sub-provincial authorities. What this implies is a reinforcement or intensification of the competitive relationship that might have already existed with sub-provincial public enterprises.

While using the joint venture form to protect and even advance their parochial interests, sub-provincial local authorities also tended to be more accommodating in allowing foreign investors to be organized as wholly foreign-owned ventures, especially where foreign entry did not pose a direct threat to locally owned public enterprises. Despite the central policy bias toward joint ventures, however, the changing balance between joint ventures and wholly foreign-owned enterprises over time was not necessarily entirely driven by the rule-bending behavior of local officials. It is possible, for example, that some foreign investors might actually have preferred joint ventures to wholly foreign-owned enterprises for reasons such as initial lack of experience in China, uncertainties in the institutional environment, and desire to tap into the social and resource networks of local enterprises. Such need, though, may have weakened over time as foreign investors accumulated more experience and as the institutional environment improved. One may also argue that the growth of WFOEs under local governments might have simply been a reflection of the delegation of gatekeeping authority and the concurrent relaxation of the restrictions by the central government on the use of WFOEs during the process of economic opening.

But there is more to the story. The statistics reported in table 6.2 illustrate a pattern of seemingly direct bending of centrally imposed rules on not only the organizational forms of FDI but the sectoral entry by FDI.[11] The increasing relative significance of WFOEs was accompanied by apparent deviations from the FDI entry guidelines mentioned earlier. In particular, there was a nontrivial and indeed increasing presence of WFOEs in the “restricted” and even “prohibited” sectors and in the sectors with explicit JV stipulations.

The rising percentage of foreign-controlled JVs with public enterprises and that of private-foreign JVs among all JVs, which is shown in tables 6.2 and 6.3 and figures 6.1 and 6.2, also indicate parallel developments that squarely ran counter to the policy preference of the central government.[12]

Given greater regulatory laxity at sub-provincial levels, many foreign investors also sought to evade direct regulatory control by higher-level authorities through collusive efforts with local governments. A common strategy used for this purpose was to split investment into different phases and several concurrent projects or locations (Randt 1996; Smart and Smart 1993). In 1991 the Federation of Hong Kong Industries (FHKI) conducted a survey among 511 member companies that had investment in the Pearl River Delta. It revealed that 79.5% of them had invested less than HK$20 million (US$2.5 million) in the region, which was significantly below the threshold (of US$10 million) for provincial approval. Of those that had invested HK$20 million or more, 77% had operations in more than one location.[13] While this might have been a reflection of the predominance of small and medium enterprises among FHKI member companies, the fact that the larger ones tended to split their investment was indicative of a possible link to the attempt to deal with local gatekeepers and regulators only, as there could be further differentiation of entry thresholds at sub-provincial levels. Of the 251 sub-provincially licensed foreign-invested industrial enterprises for which detailed data on foreign equity capital are available for both 1994 and 1995 from the 1994 NBS annual industrial survey and the 1995 industrial census, 15% increased their foreign capitalization above the $10 million threshold required for provincial approval in the year immediately following their formation.[14] Some of the increases might well have been attempts at bypassing, through investment delivered in phases, more stringent entry and regulatory requirements from higher-level authorities.

Another strategy that was more extensively used to cope with centrally imposed regulatory rigidity in the early years of reform is to disguise foreign direct investment through processing contracts, known as sanlai yibu in Chinese.[15] This was particularly common in the southern province of

Table 6.2 Selected statistics on wholly foreign-owned enterprises and joint ventures in the industrial sector

Year

% ofWFOEs in total number of foreign-invested industrial firms

% of WFOEs in total number of FDI firms in “restricted” industrial sectors

% of WFOEs in total number of FDI firms in “prohibited” industrial sectors

% of WFOEs in total number of FDI firms in industrial sectors with JV stipulation

% of public- foreign JVs with foreign majority (50+%) shares

% of private- foreign JVs in all JVs

1992

15

21

12

1995

23

24

22

17

26

29

1998

30

37

27

23

38

39

Sources: data of the 1992 NBS industrial enterprise survey, the 1995 industrial census, and the 1998 NBS industrial enterprise survey.

Table 6.3 Percentage of joint ventures with more than 50% of equity capital held by local partners

Year

All JVs

All newly formed JVs

JVs with public enterprises

Newly formed JVs with public enterprises

1995

59

51

59

51

1998

28

19

30

22

Sources: Data of the 1995 industrial census and the 1998 NBS annual industrial survey.

Percentage of newly registered JVs with foreign investors holding more than 50% of equity capital

figure 6.1 Percentage of newly registered JVs with foreign investors holding more than 50% of equity capital

Note: After the 1997 issue (which contains 1996 data) the Almanac of Chinas Foreign Economic Relations and Trade ceased to publish information on the percentage of equity capital held by foreign owners in newly registered joint ventures.

Source: ACFERT1983-1997.

Guangdong, which attracted the bulk of the foreign capital inflow during the 1980s. Figure 6.3 shows the significance of foreign capital involved in processing contracts relative to that of FDI in the province. The FHKI survey mentioned above also found that even in the early 1990s some 23% of the 511 Hong Kong manufacturers that had invested in the Pearl River Delta used processing contracts as their main form of investment.

On the surface these processing contracts did not meet the twin criteria for FDI—direct foreign ownership and direct foreign participation in management—and therefore would not have to face the pertinent regulatory

Number offoreign-private joint ventures in the industrial sector, 1992-2001 Sources

FIGURE 6.2 Number offoreign-private joint ventures in the industrial sector, 1992-2001 Sources: Data of the 1992-1994 NBS industrial surveys, the 1995 industrial census, the 1996-2001 NBS industrial surveys.

Foreign investment in Guangdong

FIGURE 6.3 Foreign investment in Guangdong: FDI (%) versus processing contracts

(%) 1979-1996

Source: GDSY (various years).

scrutiny required by the central authority. As contractors or subcontractors of foreign manufacturers, local companies received a processing fee (known as gong jiao fei) for the tasks and consignments they carried out. In reality, however, not only did many foreign investors holding processing agreements own at least part of the equity capital of these enterprises (e.g., in the form of equipment, facilities, and even factory buildings) but often they also dominated decision-making.[16] This de facto FDI status under domestic organizational shell could help foreign investors reduce approval time (e.g., from at least one month, needed for regular FDI application, to about one week); evade centrally imposed regulations on environmental protection, cost auditing (for tax purposes), and labor practices applicable to FDI companies; and provide a “backdoor” to enter sectors explicitly listed by the central authority as “restricted” or even “prohibited” for FDI.[17]

  • [1] These cities include Tianjin, Shanghai, Dalian, Qinhuangdao, Yantai, Qingdao, Lianyungang,Nantong, Ningbo, Wenzhou, Fuzhou, Zhanjiang, and Beihai.
  • [2] Before the 1986 law a very small number of wholly foreign-owned enterprises had been formedthrough ad hoc approval procedures (Pomfret 1991).
  • [3] The implementation guidelines of the 1986 law on wholly foreign-owned enterprises also containedgeneral statements (Articles 4, 5, and 6) on the broad sectors where wholly foreign-owned enterpriseswould be banned, restricted, and denied entry.
  • [4] In 1987 there were 169 and 208 sectors in the “encouraged” and “restricted” categories respectively.These numbers changed to 171 and 113 respectively in 1995 and 354 and 80 respectively in 2011. On theother hand, the total number of sectors with joint venture stipulation increased from 34 in 1995 to 99in 2011.
  • [5] Before 1997 the central government required that SOEs be the Chinese partners in sectors where thecontrolling stakes had to be held by domestic enterprises in Chinese-foreign joint ventures.
  • [6] It is possible that given these constraints some of the joint ventures with public enterprises (e.g., collective enterprises) were in fact formed with domestic private enterprises that disguised themselves by“donning the red hat” (falsely registering themselves as public enterprises). Such cases cannot be identified from official statistical data, though.
  • [7] Before the amendment of the Company Law in 2006, there was no legal allowance for single-ownerlimited liability companies (the minimum number of owners was two), which could add organizingcost and thus pose a hurdle to the formation of foreign-private joint ventures.
  • [8] In 1989, for example, only 5, or 4%, of the 124 industrial joint ventures in Fujian were formedbetween foreign owners and domestic private enterprises (1989 Fujian industrial survey data set).
  • [9] “We have to be extra careful when we review applications from foreign investors that seek to entersectors where our local [public] enterprises already operate,” said a leading official in charge of foreigneconomic affairs in Jiangmen of Guangdong province (informant, 12/1997). “They may emerge as moreattractive clients to banks, making it harder for our enterprises to maintain the existing terms of borrowing. They may drive up the prices for the common inputs used, plus electricity and even water. Theymay lure away valuable personnel from our enterprises, including technicians and even skilled workers.They may put more bargaining chips in the hands of our [enterprises’] suppliers and disturb and complicate the long-established business ties therewith. And they may encroach upon the sales networks ofour enterprises and crowd them out with better-selling products.”
  • [10] From 1980 to 1990 the cumulative number of FDI establishments in China was 25,389. Only 222 ofthese were directly licensed by the head office of the SAIC, the central licensing agency, whereas only4 of the 222 were wholly foreign-owned ventures (SFYCICA, 81, 118). An examination of the data ofthe 1995 industrial census reveals that the foreign equity capital of some 84% of the newly establishedFDI firms (n = 4,496) was below the threshold (of $10 million) for provincial level approval, 11% ofthese firms had foreign equity capital in the range (between $10 and $30 million) that would requireprovincial level approval, and only 5% had foreign equity capital above the threshold (of $30 million)for central-level approval.
  • [11] Detailed data on the ownership composition of industrial firms are unavailable for the years beforethe 1995 industrial census.
  • [12] What is particularly noteworthy here is that despite the lack of statutory basis for the formation offoreign-private joint ventures before the enactment of the Company Law in 1994 (as noted above) suchenterprises had already had a nontrivial presence among all joint ventures, as can be seen in figure 6.2.
  • [13] These figures are calculated using the survey data.
  • [14] This is derived by using data from the 1994 NBS industrial survey and the 1995 industrial census.
  • [15] These contracts involve manufacturing or assembly of products using materials, components, andsamples supplied by foreign companies, as well as compensation trade where local manufacturers usesales proceeds to finance the purchase of equipment and facilities loaned by foreign companies.
  • [16] An interesting case study about Dongguan, which had a significant presence of various processingagreements, can be found at http://www.law-lib.com/lw/lw_view.asp ?no=4i39.
  • [17] After China’s WTO accession in 2001, the central government began to introduce measures tolimit the space for such “backdoor” access. By 2013 Chinese companies undertaking processing contracts with foreign investors were banned from the manufacturing of some 804 types of products. Anestimate by the Guangzhou office of the Hong Kong Trade Development Council claimed that someone thousand Hong Kong-invested companies in the Pearl River Delta of Guangdong province wouldvery likely have to be closed down because of new restrictions introduced in 20i3 (http://www.cre.org.cn/index.php?m=content&c=index&a=show&catid=9&id=8).
 
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