Using Foreign Direct Investment and Market Integration to Measure the Foreign Economic Strategies of China

Paul Andreas Fischer

6/26/2016

Shirley Gedeon

Using Foreign Direct Investment and Market Integration to Measure the Foreign Economic Strategies of China

Chinese foreign success has recently been indicated in the gains made abroad. The region which substantially benefits from synergistic reforms with the commercial giant can be defined with two groups of emerging economies. New industrial economies (NIE) surfaced first, and the development there can be traced to the 1980s, and even includes or included China. Some of these are located elsewhere in the developing world. The investment that China has made is that other economies in the Southeast Asian region will join them.

In light of the savings and loans crisis of the 1980s and 1990s and resource pricing issues of 1999, the government of China has recently ensured that the dependence, both real and implied, of the “forced” entry into the World Trade Organization and supplication to the International Monetary Fund can be mitigated or eliminated within their sphere of influence. Direct foreign investment (DFI) is among the best ways of showing the trends of changes in the Chinese regional strategies. This mechanism can be seen as a progression from horizontal to vertical integration of industries and firms. Both of these measuring tools are available to arrive at a realistic understanding of the nature of continued growth and the conditions under which it can continue in the future.

While domestic growth during the 1980s is touted and Deng’s Four Modernizations are emphasized as critical to liberalization and transformation of the Chinese economy, it will be possible to see that market inefficiencies increased during this period. It was not until later, when Deng encouraged China to “cross the river by feeling the stones” that substantive changes were found. The Soviet Union had fallen, and not as a consequence of war with China.

As a recipient of DFI, China allowed liberalization of some markets. Others, notably petrol, were subject to price controls and governmental control increased early on. By doing so, all potential economic progress from free market institutions had been lost. The political gain remained.

Pressure increased with the fall of the Soviet Union, and China’s consumers were lost. Liberalization proceeded quickly. The way the Chinese market then transformed is remarkable. A distinct cultural shift accompanied this change, though it is not a valid economic tool because this shift was present even at the beginning as the market changed in name only. Understanding the nature of the Chinese market success is critical to the continued health of the global economy: if the transformation was a miracle, then the effort to export it regionally will fail and spell catastrophe for both China and for better qualified recipients of DFI.

By examining the DFI, a trend is found in which the Chinese investments in regional nations may actually be self-defeating in nature. Even during the crisis of 2008, foreign investment to other countries from China only slowed their growth temporarily. Rather than investing in nations that consume Chinese products, investments are being made into competing countries. This arising vertical integration is a new trend, and part of the incentive to invest in China during the 1990s was created by the benign nature of bland Chinese political ambitions on a geopolitical, or at the time even regional, scale.

This paradox of investment options has created a difficult decision for China which is not being decided on rational economic advice, but under supervision of the government which has relative control of the mechanisms of economy. Politically, the money is more safely invested within the range of the bulky People’s Liberation Army, with its limited projection capabilities, than in parts of the world where the global community may be hesitant or unwilling to become involved should complications arise. Unfortunately, this also has stunted the economic development of other nations and embodies a false sense of security into an unsustainable level of growth which may be dependent on exploitation of regional economies.

Competition with other regions of the world could fuel Chinese development into a new and sustainable era of technological progress and growth. Whether investments in regional or domestic endeavors will fulfill this purpose remains to be seen. The ultimate risk is that no objectives will be achieved, and that regional investments may foster substitutes and replacements for the limited consumer demands of larger economic systems while failing to provide adequate competition to increase productivity in China to spark growth after the demands of foreign consumption has been met.

There are two important conclusions which may be drawn from the broader trends in DFI to and from China. Firstly, the only hope China has of continuing the growth secured by horizontal integration is to encourage competition and increase profits from successful vertical integration with foreign emerging or recently emerged markets. Secondly, this goal has only been partially realized as two thirds of Chinese foreign investment has stayed in the region.

Political Goals and Increasing Centrality of Chinese Strategy

While it is possible that political goals come in conflict with each other, ie. China sees regional investments as investments in security with value regardless of the long-term success of such investments, the environment of synergy naturally predicates growth. Loss of synergy can be evaluated as an opportunity cost of development and is evident in the integration of Chinese economic developments in the past. Early outsourcing occurred as a result of Japanese technology firms seeking a lax source of labor and standards, which were found in China. The firms that refused to cross over subsequently failed.

Executives and corporate names remained in Japan at that time, which made the process one of horizontal integration. In order for growth to be sustainable, and rates of successful loans to increase, competition must be indicated by vertical integration. The best way to distinguish between these two phenomenon is by measurement of the domestic value added (DVA). As competition increases, and synergy with it, the DVA increases while a lower DVA indicates a fragmented economy in which competition is prohibited by virtue of governmental standards, or discrepancies in environments.

The amount of value added from import to purchasing price among Chinese goods, or the DVA, has risen from 25% to 50% as a result of increasing development. That number is still terrifying by industrial standards, a developed country such as the Netherlands expresses concern when the DVA has dropped to 80% at any point. The DVA is an indicator which serves a function beyond that of just actual production in a nation, but also indicates the stability and centrality that economy plays to the global economy.

One quick note which may help the less numerically inclined to understand the increasing relative importance of DVA is that it may help to reverse the method of calculation when looking at DVA across industries or nations. A DVA of 50% means the exported product is worth 200% of the price of the imports. With a value of 80%, a change of just thirty points, this becomes 400%, add another ten and the increase in value is 1000%, and so on in an exponentially increasing fashion. In other words, small percentage changes in the West correlate to massive shifts in developing results.

China has an economy which currently plays an indispensable role in the global economic structure. This role was occupied in just a generation. Growth beyond sustenance requires more than performance, it also necessitates creation. The massive elimination of poverty as well as the difficulties of developing a consuming class sums up the achievements and the shortfalls of the economic miracle in China.

It should be assumed that through brute force alone, China will reach parity with Western economies. Regional investments in competitors should mean that Chinese firms will have just as difficult a time retaining the status quo as Japanese firms did in decades past, even if exclusion of other markets abroad slows the process down slightly. That is a point at which current economic policies will fail dramatically.

DVA parity between Western and Chinese economies necessitate a level economic playing field, and even the smallest governmental interventions outside of direct necessity or protectionist practices could disrupt global supply chains. Currently the impact of China’s experimentation with economic policies is mitigated by the universal nature of economic institutions and foreign nations. China’s political system must evolve in order to be allowed to assume a greater level of responsibility.

Had the World Bank invested with a similar geographical prejudice, there would have been a humanitarian crisis in China unrivalled in the history of mankind. Some would argue that during the rise of Mao Zedung, under the “protection” of the iron curtain, such a situation had already occurred once in Chinese history, though without an intentional perpetrator. Entrusting such a responsibility and risking that event to occur as the consequence of intentional policy making is not a viable option currently, but may be in the future. In detailing the optimistic growth and achievements of the Communist regime in China, this paper will assume such political development only facilitates and does not interfere with the continued development there.

Growth and Prosperity: From Potatoes to Refrigerators

The documentary film detailing one hundred years of Chinese Revolution, Born Under a Red Flag, details the shift from agricultural economic zones to manufacturing in terms of culture, politics, and economy. This is echoed in reading as well and evaluation of whether the Chinese economic transformation is a miracle or economic fact, and whether it is reproducible, determines the direction of the burgeoning economy. That is because the centrality of the developments in China actually mean that the government will have a role in determining how the global economy changes in consequence to success there.

Discussion of the incipient role of China on the global stage would be ungrounded without understanding the provinciality of the recent past. Watching the development of China must have been something similar to watching a history of economics. Towns without even a scale or a market for decades have now seen their young living in new skyscrapers in urban centers, and even engaging in political activism.

Many decisions by government and private interests alike have been correct. The Chinese transformation was ignited by a decree allowing the agricultural workers to keep a portion of their crop after paying a quota to the government. All of the agricultural zones immediately reported bumper crops.

This is an example of incentivization that has supplanted the iron rice bowl or, more frequently, impoverishment of the past. These policies were not limited to humanitarian concerns, or forced exclusively by necessity. Incentives were extended to foreign companies as well, which made China considerably more attractive for direct foreign investment than abroad or local opportunities.

In this sense, the Chinese government helped to foster the development of the economy through careful micromanagement of resources and policies. The policies of incentivization has proven to be effective and have been thoroughly implemented. It has also helped level the playing field when the competitive advantage lies against Chinese firms in terms of technological prowess and labor costs. Excessive costs from protectionist policies are mitigated by shared profits from the massive development found later.

Even as the source of funding for industrial expansion has turned outward, the horizons for consumers have effectively been focused inwards. This is both encouraging and worrisome. The indication would be that there is proof here of a reliance of the consuming class on some domestic production, or stimulus provided there. As long as Chinese growth is limited reliant on Western consumption and progress, any development into industries which are efficient or operate at parity will begin to limit the demand for Chinese goods.

This is particularly concerning now because with the development of a Chinese middle class, a wonder in and of itself, there is evidence that the growth of that middle class does not match that of the producing class. With available foreign demand held constant and limited to factors outside of the Chinese government’s control, competition for this demand has become increasingly fierce. The evidence for this is apparent in the politically and geographically motivated DFI of the last decade from China.

The manifestations of the middle class go beyond increased standards of living, refrigerators in the home and the like. It is a result of a massive investment in infrastructure which has completely rocked country and city lives socially, politically and economically. Skyscrapers, highways, and migratory workforces that come to the cities for portions of their lives all typify this development. The Chinese middle class must now also compete with nations who have sustained such lifestyles for centuries for patents, efficiency, and resources.

There is no word for sustainable growth. Optimistic goals of maintaining continuing increases in growth have already failed. That is an indication that the limits of easy expansion are already being neared.

There are three factors which play a role in the approach to these limits. Firstly, the economic factors of production which were employed by foreign nations that China now makes use of are being exhausted. Secondly, supply for foreign nations can only be necessitated by the rate at which those developed economies can grow. Finally, competition which arises may pose the same or a similar threat to Chinese firms.

Even if emerging markets are not more efficient or cheaper, capitalists in the West are sure to know that fragmenting a strong union can be in their interest despite a moderate financial setback. It is also worth noting in conclusion that it may very well be that the financial recession saved the Chinese economy from immediate ruination. Competing emerging markets were devastated as Western nations gobbled up stimulus money and FDI, at their expense. While there is no point in retrospectively imagining what might have happened, it is interesting that those countries had about the same chance of taking on the Chinese economy as China ever had at taking on the Rust Belt, but unlike America which has an established and strong middle class, loss of manufacturing in China would certainly result in a humanitarian crisis of the sort the world has never before seen.

Lingering Problems: Corruption and Bilateralism

Interestingly, in China, with a communist government, a bad work ethic can be a crime against the state. The policy of the iron rice bowl has also created a crisis of low quality production. Attempts to regulate this have been either misdirected, during Deng-era crackdowns on crime, or inefficient, as seen in subsequent redundancies in quality checks.

In a certain way, these policies are being recreated in trade agreements. By overlapping Free-Trade Agreements with bilateral trading incentives, a “noodle-soup” syndrome has arisen which is of great concern to the international business community. This is the sort of threat to long-term security which has characterized foreign hesitancy to invest in China.

To understand this hesitancy in the future, it is necessary to look at the past once again. During the rise of the current government, many teachers and those labeled corrupt were shot. Students were sent to the countryside, which crippled not only the Chinese academic system, but those throughout satellite Soviet nations which had some level of interdependence. The extreme reactionary behavior with underlying motives of consolidation of power is not completely departed and both in Tiananmen Square and in the execution of thousands of criminals in the wake of a threatening “gang of four”, violence has been noted with concern by the rest of the world.

Today that history of politicized violence translates into regional friction and unwillingness for other nations of the world to allow their educated to participate in research in development or pursue contracts in a country with a government that has eliminated such assets in order to maintain control in the past. Of the three barriers to the development of China into sustainable growth, the inability of academic structures to build confidence in foreign talent or to incentivize local brainpower to stay in China is probably the most concerning. While membership in the World Trade Organization has lended some credibility to the endeavors of the government now, such gestures of goodwill are betrayed by a recurring wheel and spoke nature to regional trade agreements.

This lingering problem can be addressed in the form of increased institutionalization throughout the nation. Sent down youth did return to the cities and liberalization commitments, though shallow, are present. The proof will be in pudding as the case were, and that will be indicated by rising levels of development, and with them competition with Western middle class industries and a rising DVA.

Other issues remain in the form of ensuring that China peacefully occupies its transitory role without eclipsing existing economies or fueling competition within economies that are close geographically or politically. The crisis of 2008 cannot be emphasized enough as an indicator of the sensitivity of this topic. Regional investments not only threaten China’s position as the world’s greatest exporter, but also threaten to cut into the domestic market.

By investing in developing countries abroad and developed nations both of those threats can be effectively eliminated. While the USA went through a position in 2009 that was similar to the Cultural Revolution’s “sent-out” youth programs by cutting out student loans, the position was short-term and institutions were neither eliminated nor shut down. Progress continued on a skeleton crew basis, an indicator of financial turmoil and not of fundamental political change. This means that American consumerism will continue to be a determining factor in Chinese economics in a way that China did not develop into a viable partner for the Soviet Union after World War II.

Now that China has developed a middle class, it must navigate a treacherous path of maintaining the barriers which prevent local or even foreign manufacturing from serving a similar impact to its economy as the USA and Japan suffered with the emergence of China. This may necessitate re-evaluation once the development level in China is equal to the United States today. A good estimate for the time frame involved here should be found in DVA.

Provided that the stumbling block provided for emerging economies has set them back in a significant fashion, with this 600 billion dollars in re-allocated investment that had been expected in those economies, for several decades, analysis of the DVA to create a time-frame for China’s chains to manufacturing can be conducted. It took approximately a quarter century for the DVA to rise from 25% to 50% in China. In order to be competitive with Western markets and allow encroachment on manufacturing industries without risking humanitarian disaster, the DVA must rise to at least 75-80%.

Unfortunately this level of increase in DVA in terms of total output represents a greater change than the development required to increase from 25% to 50%. This means that it costs more dollars and takes more time to acquire higher levels of development. Without analyzing production curves and assuming an equilibrium market for patents and technical advancements, it should take between double and three times the amount of time and resources to bring DVA from 50% to 75%. This is because a DVA of 25% only represents under 40% less total output than 50% while a DVA of 75% represents 200% more output than 50%.

If China has the 50 years necessary to reach the development of the United States, and the domestic or foreign investment needed to do so, then success should be guaranteed. A middle class will emerge and be well established. Competition can begin in earnest with Western institutions, and growth as well as development in regional and foreign markets can be encouraged. Ironically, it is the very sources of capitalism which have enabled this progress which threaten the Chinese economy the most.

Given the opportunity, these sources of capital will give no regard to humanitarian concerns and divide the monopoly on manufacturing enjoyed by China simply to gain a greater bargaining power. There will be no sense of security or of loyalty in such a situation. This is the risk created by investment in Western economies and should be treated with as much caution as an investment in regional economies. The latter is substantially preferable, for while the Chinese military may not be able to enforce political objectives in the target of such investments, security in such investments is high, and there is another layer of opportunity before money goes into economies which lie in direct competition with Chinese manufacturing.

The bottom line is that any political action which can be taken to ensure investment remains domestic must be taken, or the risks are an entity in the rest of Southeast Asia, which is as large in population if not development as China, emerges in competition for the same limited role as China. 2008 was not a solution, but a mere stumbling block, and impediments to development and the barriers which arose as a result could be removed as quickly as in a decade or take as long as half a century. Which one of these actually results will likely determine the long-term success of the Chinese economy, and will likely be the result of carefully targeted investment by the global community as well as the Chinese government.