35747

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Candidate Number: 35747

MSc in China in Comparative Perspectives (Anthropology Department) 2007 Dissertation in partial fulfillment of the requirements of the degree

Foreign Direct Investment in China and India: Development

Experiences and Determinants in a Comparative Perspective

Word Count: 9965

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TABLE OF CONTENTS

Acknowledgement

Abstract

List of Abbreviations and acronyms

List of Tables

1. INTRODUCTION 8

2. DETERMINANTS OF FDI: A THEORETICAL EXPOSITION 9

2.1 FOREIGN DIRECT INVESTMENT DEFINED 10

2.2 MAIN THEORIES OF FDI 12

2.2.1 INDUSTRIAL ORGANIZATION THEORY 13

2.2.2 INTERNALIZATION THEORY 14

2.2.3 PRODUCT LIFE-CYCLE THEORY 14

2.2.4 ECLECTIC THEORY OF INTERNATIONAL PRODUCTION 15

2.3 SUMMARY 17

3. FDI IN CHINA AND INDIA: AN OVERVIEW 18

3.1 TRENDS AND PATTERNS OF FDI 18

3.2 SOURCE-COUNTRY COMPOSITION 24

3.3 SECTORAL COMPOSITION 28

3.4 REGIONAL DISTRIBUTION 31

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4. DETERMINANTS OF FDI 34

4.1 POLITICAL ENVIRONMENT AND FDI POLICY REGIME 35

4.2 ECONOMIC DEVELOPMENT 39

4.3 SOCIETY 41

4.4 TECHNOLOGY DEVELOPMENT 43

4.5 BUSINESS ENVIRONMENT 44

4.6 LEGAL SYSTEM 46

4.7 SUMMARY 48

5 SUMMARY AND CONCLUSIONS 48

5.1 FINDINGS 49

5.2 POLICY IMPLICATIONS 51

5.3 LIMITATION OF THE STUDY 53

5.4 FUTURE RESEARCH DIRECTIONS 53

BIBLIOGRAPHY: 55

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ACKNOWLEDGEMENT

I express my deep sense of gratitude to Professor Stephan Feuchtwang for

his talented suggestions and intellectual stimulus on this dissertation. I

would also like to thank Dr. Victor Teo and all other staff in the

Anthropology Department for their tutoring and support throughout the

year. Special thanks go to the UK Foreign and Commonwealth Office and

the British Council for their generous financial help with my study in the

London School of Economics and Political Science.

I am deeply indebted to my daughter, Youyou Hu, for the immense

sacrifice she has made for bearing my absence, when she needed me most.

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ABSTRACT

The analogies between Chinese and Indian economies draw obvious

comparison. This research seeks to understand the FDI inflows and

examines the main determinants in the two countries. Since the empirical

work over the past decades has not produced consensus as to the

determinants of FDI, Dunning’s O-L-I paradigm offers a unified

framework of the various theories. To identify the differences of

determinants of FDI inflows in China and India, the changing patterns of

FDI are closely studied with special reference to the source countries of

FDI, the sectoral composition and regional distribution. Moreover, this

study develops a PESTEL framework for analyzing the recent

experiences and determinants of FDI inflows in China and India. It

concludes that on the determinants of political and FDI policies,

economic development, society and business environment, China does

better than India; whilst India is ahead of China in terms of technology

and legal system.

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List of Abbreviations and acronyms

CJV Contractual Joint Venture

EJV Equity Joint Venture

EU European Union

FDI Foreign Direct Investment

GBPC Global Business Policy Council

IPA Investment Promotion Agency

IT Information Technology

IPR Intellectual Property Right

LDC Less Developed Country

MNC Multinational Corporation

MNE Multinational Enterprise

NIE Newly Industrializing Economies

OECD Organization for Economic Cooperation and Development

SEZ Special Economic Zone

TNC Transnational Corporation

UNCTAD United Nations Conference on Trade and Development

WFOE Wholly Foreign-owned Venture

WTO World Trade Organization

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List of tables

TABLE 3.1 FDI INFLOWS IN CHINA 1979-2005 18

TABLE 3.2 FDI INFLOWS IN INDIA, AUGUST 1991-2005 22

TABLE 3.3 COMPARISON OF FDI INFLOWS TO CHINA AND INDIA 23

TABLE 3.4 TOP TEN SOURCE COUNTRIES (REGIONS) OF FDI IN CHINA, 1979-2005 24

TABLE 3.5 TOP TEN SOURCE COUNTRIES (REGIONS) OF FDI IN INDIA, AUG. 1991-2005 26

TABLE 3.6 SECTOR-WISE FDI INFLOWS IN CHINA, 2000-2005 28

TABLE 3.7 SECTOR-WISE FDI INFLOWS IN INDIA, AUG. 1991-2005 30

TABLE 3.8 PROVINCE-WISE FDI INFLOWS IN CHINA, 1979-2005 32

TABLE 3.9 REGION-WISE FDI EQUITY INFLOWS IN INDIA, 2000-2006 33

TABLE 4.1 COMPARISON OF SOFTWARE INDUSTRY IN CHINA AND INDIA (YEAR 2005) 38

TABLE 4.2 COMPARISON OF SELECTED ECONOMIC INDICATORS: CHINA AND INDIA 40

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Foreign Direct Investment in China and India: Development

Experiences and Determinants in a Comparative Perspective

1. Introduction

China and India enjoy a lot in common: long histories, giant markets,

huge populations and soaring growth rates. Both countries have an

ancient and prestigious cultural heritage; both are under the influence of

the Soviet model and have embraced economic reform and liberalization

– China in the late 1970s and India in the early 1990s. Now both are in

the process of liberalizing their economies as they open up to foreign

direct investment (FDI), which is not at the same stage and we shall take

a closer look at it below.

FDI has increasingly been considered as a catalyst to market growth

for the developing countries, particularly in countries such as China and

India. More importantly, besides supplementing capital, FDI, as a

principal conduit of technology upgrade, know-how transfer and

managing skills exchange, heralds the globalisation of host economies

(United Nations Conference on Trade and Development. 2005; UNCTAD

2006).

The global competition for FDI among developing countries is

increasing and in this context, both China and India are aiming for a high

share of the FDI pot for they are now getting increasingly integrated with

the global economy as they open up their markets to international trade

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and investment inflows.

The remaining sections of the paper are as follows. The theoretical

justification for the research propositions is examined in Chapter 2. In

Chapter 3, a overview of FDI trends and patterns in both countries is

presented. The changing patterns of FDI are closely studied with special

reference to the source countries of FDI, the sectoral composition and

regional distribution, which are used as the background information for

following chapters. Relevant determinants of FDI inflows into each

country are discussed and compared in Chapter 4 by using a PESTEL

analysis format. Finally, the major findings of the paper are summarized

in Chapter 5. The policy implications are addressed and the limitations of

the study are highlighted before presenting the future research directions.

2. Determinants of FDI: A Theoretical Exposition

The past three decades have witnessed the emergence of a sizable body of

literature dealing with various dimensions of the determinants and

motives of FDI flow. A review of these studies is essential to know about

the different determinants of FDI and to see how far these determinants

can be applied in the following empirical study on China and India. The

first section of this chapter seeks to define FDI and the impact and effects

of FDI. The second section then reviews the existing discussion on FDI

and shows that FDI is determined by different factors under different

macro economic conditions.

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2.1 Foreign Direct Investment Defined

FDI is an important instrument in the process of globalization and plays a

crucial role in the development of the economies of the developing

countries. As defined by the Organization for Economic Cooperation and

Development (OECD), it ‘reflects the objective of obtaining a lasting

interest by a resident entity in one country (‘direct investor’) in an entity

resident in an economy other than that of the investor (‘direct investment

enterprise’)’. Krugman and Obstfeld define FDI as ‘…international

capital flows in which a firm in one country creates or expands a

subsidiary in another’ (Krugman and Obstfeld 2000: p.159). They go on

to highlight that the distinct feature of FDI is that ‘it involves not only the

transfer of resources but also the acquisition of control’. Södersten and

Reed further point out that FDI ‘is in essence a bundle of capital,

technology and management skills transmitted by multinational

enterprises (MNEs) or transnational corporations (TNCs)’ (Södersten and

Reed 1994: p.489).

Unlike conventional definitions of FDI, the official Chinese

counterpart incorporates three forms of direct foreign-invested enterprises

1(sanzi qiye). They are equity joint venture (EJV) (hezi jingying qiye),

contractual joint venture (CJV) (hezuo jingying qiye) and wholly

foreign-owned venture (WFOE) (waishang duzi jingying qiye) (Huang

1 They are usually established through 1) mergers and acquisitions with another company; 2) a direct subsidiary (greenfield FDI); 3) an EJV; and 4) buying a controlling stake of the public listed company.

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1998).

In case of India, the earlier definition of FDI differed from that of the

IMF, as well as that of the World Investment Report compiled by the

United Nations Conference on Trade and Development (UNCTAD)2.

Since 2003, with the establishment of the Technical Monitoring Group on

Foreign Direct Investment, a new method of compilation of the FDI

statistics has been adopted in India, which makes the data internationally

comparable. The new system includes equity capital, reinvested earnings

and other capital, which are mainly intra-company loans (Tamuli 2006:

pp.2-5).

Much of the discussion on FDI in former years, particularly in the

extractive industries, MNCs were perceived as exploitative terms (Dos

Santos 1969: p.21; Cohen 1973), and indeed were seen to be the cause of

much of host economies’ problems (Caves 1982). In India, the takeover

by the British East India Company of control over the whole India had

created the East India Company syndrome (Gupta, Dahiya et al. 2005:

p.149). The ideological change came about during 1990s, when FDI

inflows had become the most important component of total capital flows

to developing countries, notably in East and South East Asia. FDI not

only adds to external financial resources for development, but is also

more stable than other types of flows. Kawai and Urata demonstrate how

2 IMF’s definition includes external commercial borrowings, reinvested earnings and subordinated debt, while the World Investment Report excludes external commercial borrowings.

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FDI upgrades the technological capability of the recipient economies

(Urata and Kawai 2000) and Urata further notes the importance of FDI

for promoting trade (Urata 2001). OECD, Yusuf, Nabeshima and Altaf

identify the role of FDI in fostering recipients’ participation in global

production networks (OECD 2002; Nabeshima, Yusuf et al. 2004; Yusuf,

Altaf et al. 2004). Moran has done a research covering 183 projects

across 30 countries in 15 years and point out that FDI has a positive

impact on the national income of the host economy in the majority of

projects (Moran and Institute for International Economics (U.S.) 1999).

2.2 Main Theories of FDI

There have been a prolific number of empirical studies on the

determinants and motives of FDI. Some studies have concentrated upon

the ownership specific advantages of the foreign firms which are

necessary to outweigh the disadvantage of being foreign. These studies

have tried to find out the significance of various ownership advantages

arising due to propriety knowledge, financial assets, product

differentiation, plant economic of scale, size of the firm and multi-plant

operations etc. We hereby categorizes such theories as external

(supply-side) approaches. Other studies have focused on the locational

specific advantages as low cost of labor, reduced tariffs, fiscal incentives,

market size and characteristics of the host economy, favorable FDI

policies of the host government, political stability and other locational

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factors. Here this study categorizes such theories as internal (demand-side)

approaches. In sum, the external factors include economic conditions

outside the host country, while internal factors include the economic

conditions of the host country.

Traditionally, most empirical papers have focused on the role of the

external factors in determining FDI flows into developing countries.

These theories so far mainly stress on the ownership specific advantages

of the firms and three of them are examined as follows.

2.2.1 Industrial Organization Theory

Hymer and Kindleberger argue that the ‘ownership advantages’

(including inventory, cost, financial or marketing advantages) motivate

them to establish subsidiaries in the host countries (Kindleberger 1969;

Hymer 1976). These advantages which they assume to be exclusive to the

firm owing them explain why American-type FDI is predominant in a

particular sector of industry but it may be unable to portray a general

pattern of FDI.

Another industrial organization approach, developed by Caves, is

based on models of ‘oligopolistic competition’. He treats a MNC as a

creature of market imperfections that lead a firm to possess specific

advantages over local firms in the host country (Caves 1982).

In fact, some Japanese scholars refute its limitation to explain

Japanese-type FDI, which is based on location factors rather than

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technological superiority, economic scale and management skills (Ozawa

1979; Kojima 1996).

2.2.2 Internalization Theory

The internationalization theory, created by Buckley and Casson, and

developed by Rugman and Hennart, is primarily concerned with the

transactions cost approach (Rugman 1981; Hennart 1982; Casson and

Buckley 1983). The basic hypothesis of this theory is that MNEs emerge

when it is more beneficial to internalize the use of such intermediate

goods as technology than externalize them through the market. The core

prediction of the theory is that, given a particular distribution of factor

endowments, MNE activity will be positively related to the costs of

organizing cross-border markets in intermediate products.

2.2.3 Product Life-cycle Theory

In a classic article published in 1966, Vernon was the first to investigate

the relationship between FDI and technology. He uses a microeconomic

concept, ‘the product cycle’, to explain a macroeconomic phenomenon,

which is the foreign activities of US MNCs in the postwar period (Vernon

1966).

He argues that the product life-cycle can be divided into three stages as

new product stage, matured product stage and standardized product stage.

In the early new product stage, firms place factories in the home country

since the demand for a new product is too small elsewhere. As the

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expansion of production in the home country becomes too expensive, the

mature oligopolist invests in a host country with high income elasticity of

demand and similar consumption patterns to the home country. Therefore

it develops into the second stage of matured product. As the product turns

into increasingly standardized and its competition is based on price, the

product is manufactured in less developed countries (LDCs) for export.

Although this theory considers changes in technology and implicitly

assumes that the MNCs would acquire the manufacturing plants in the

countries with abundant low-cost workers, it is not a dynamic theory for

the rate of change and the time-lag between product stages are not

considered. Chen rebuts that it is also unable to explain FDI in

non-standardized products and special products for overseas markets

(Chen 1983: pp.28-9).

The theories explained above mention only the home country

macro-economic, industry specific and firm specific external (supply-side)

factors. But it is necessary to bear in mind that the host country must

possess certain locational advantages to attract FDI. The O-L-I paradigm

developed by Dunning seeks to offer a comprehensive framework by

combining the company comparative advantages and host country

location endowments.

2.2.4 Eclectic Theory of International Production

The eclectic paradigm of international production, which postulates that

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FDI is determined by three sets of factors, namely ownership

(firm-specific) advantage, internalization advantage and location

(country-specific) advantage, is developed by Dunning and modified by

his associate Narula (Dunning 1981; Dunning 1988; Dunning and Narula

1995; Narula 1996).

According to Dunning, the rationales of FDI can be well-defined by

O-L-I paradigm:

� Ownership (O) advantages: economies of scale, exclusive production

and technical expertise, managerial and marketing skills. These are

the prerequisite to ensure or enable the MNCs to recover the costs of

investing abroad. Itaki further argues that these O advantages largely

take the form of privileged possession of intangible assets and the use

made of them are assumed to increase the wealth-creating capacity of

a MNC, and hence the value of its assets (Itaki 1991).

� Location (L) factors: low labor costs, potential foreign market,

favorable investment incentives. These pull factors of host country

contribute to the MNCs’ decision to employ ownership advantages to

produce aboard.

� Internalization (I) factors: Comparing with licensing and exporting,

by using greater organizational efficiency or ability to exercise

monopoly power over the assets under the governance, an internal

market is created between parent-company and affiliates to control

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key resources of competitiveness or to reduce the risk of selling them

as well as the right of use of them, to foreign firms.

Compared with the above theories, which were founded on ownership

advantages in the form of technology and finance, transaction costs and

differential factor endowments, the unique feature of Dunning’s O-L-I

paradigm is to unify and summarize the various theories, although it is

still a frame which synthesizes most FDI theories rather than a new

theory per se. It signified the ownership, locational and internalization

advantages of the firm and, by extension, the ownership and

internalization advantages of the home country, and locational advantages

of the host country of FDI, which Dunning stipulates that O-L-I is

applicable to ‘home country’ and ‘host country FDI’ (Dunning 1981).

According to this theory, FDI is chosen as a market entry strategy so that

a firm can exploit its ownership advantages through internalizing

transaction costs in a specific location, which possess locational

advantages.

2.3 Summary

To conclude, the relative significance of the motives and determinants as

contained in the above theories differs not only between firms and

regions but also from time to time for a particular firm or region. It is

very difficult to generalize about the determinants of FDI and it is true

that most firms are influenced in their behavior by more than one

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objective and sometimes different values are placed on the same

objective.

The difference in the strength of the determinants is most marked

between China and India which differ radically with regard to economic

structure, development characteristics and socio-economic profiles.

Nevertheless, the above theories provide us with a rich collection of

motives and determinants that can support and guide the following study

of the explanatory variables of FDI flows into China and India.

3. FDI in China and India: an overview

This chapter examines and discusses the trends and patterns of FDI

inflows into China from year 1991 to 2005 and India from August 1991to

2005. Based on published official data, it provides a clear picture about

the longitudinal and latitudinal analysis of FDI inflows, the country of

origin, sectoral composition as well as regional distribution of FDI in

both countries.

3.1 Trends and Patterns of FDI

China

During the period 1979-2005, China has approved a total number of

552,942 foreign-invested companies with a cumulative foreign capital

investment (contract value) of US $1285.7 billion, of which US $622.4

billion was effectively invested.

Table 3.1 FDI Inflows in China 1979-2005 (US $billions)

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Year Contracted FDI3 Paid-in FDI4 1979-1991 52.669 13.018

1992 58.124 11.008 1993 111.36 27.515 1994 82.680 33.767 1995 91.282 37.521 1996 73.276 41.726 1997 51.003 45.257 1998 52.102 45.462 1999 41.223 40.318 2000 62.380 40.715 2001 69.192 46.878 2002 82.768 52.7 2003 115.07 53.505 2004 153.479 60.63 2005 189.065 72.406 Total 1285.673 622.426

Sources: Bureau of Foreign Capital, the Ministry of Foreign Trade and Economic Cooperation (the Ministry of Commerce since March, 2003)

Analyzing Table 3.1 reveals the FDI development in China can be

divided into three stages: 1979 to 1991, 1992 to 2001, and 2002, the year

after the China’s entry into the World Trade Organization (WTO) to

present.

From late 1978, China cast off its self-reliance policy and adopted the

policy of reform and open-up. FDI in China grew rapidly during the first

half of the 1980s. Entering the second half of the 1980s, the growth rate

in China leveled off and turned negative in the aftermath of the

Tiananmen massacre (Chai and Roy 2006: p.133). According to Chen, the

annually growth rate reached 20 percent at that period. Moreover, the

paid-in FDI soared to US $4.36 billion in 1991, making it the largest FDI 3 Contracted FDI based on signed contracts, but not always actual inflow. It’s better for gauging the intention to invest. 4 Paid-in FDI was actually invested in host country. It’s a better measure of the actual size of the investment flow.

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recipient among developing countries. (Chen 2002).

In 1992, after Deng Xiaoping’s tour in the Southern provinces, China’s

reform and opening up policy was further intensified. Besides 11 open

coastal provinces, part of the interior regions was open up for FDI.

Furthermore, two new investment categories were created, namely, the

export-oriented and technology-advanced projects, which were entitled to

additional incentives regardless of their location. From US $4.3 billion

(paid-in FDI) and US $11.97 billion (contracted FDI) respectively in

1991, the FDI volume increased dramatically to US $11 billion and US

$58.1 billion, a jump of more than 150% and 380%. Only since the

outbreak of the Asian financial crisis in 1997, the growth momentum has

slowed down (Zhang 2006).

The WTO accession in November 2001 provided another impetus to

FDI and China received US $52.7 billion in 2002, which made China the

Asia’s and the developing world’s largest recipient of FDI. As noted in

World Investment Report 2003, in year 2002, for the first time, China

surpassed the United States to become the largest global recipient of FDI,

accounting for 9.88 percent of the global flows of FDI (Wu 1999).

India

In accordance with the requirements of the economic development in

different phases, the Indian government’s policy toward FDI has evolved

over time (Kumar 1998). In the 1950s, soon after the independence, the

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anti-FDI environment in India was largely based on two factors. The first

was the strong nationalistic sentiments in the wake of independence.

Second, whatever narrow industrial base the country had at that time, an

overwhelming part of it, almost three-fourths, was British-owned.

Political and business leaders wished for the day when such a large

foreign ownership of industries could be contained and Indian industry

and market became a place for Indian entrepreneurs (Das 2006).

Therefore, FDI was discouraged by a) imposing severe limits on equity

holdings by foreign investors and b) restricting FDI to the production of

only a few reserved items (Gakhar 2006).

In the 1980s the attitude toward FDI began to change, adopting the

policies of liberalization of industrial approval rules, a host of incentives

and exemption from foreign equity restriction. In the middle of 1991, a

package of economic reforms was introduced by the government, which

had greatly affected the magnitude and pattern of FDI inflows received

by India (Gupta, Dahiya et al. 2005).

The average for 1985-90 was less than US $2 million per annum. To

put the lack of significant FDI in the Indian economy in perspective, one

should take note of the two following statistics. First, the stock of the FDI

in 1990 was less than US $2 billion, while the inflow was US $100

million (Kapur and S.Athreye 2001: p.130). These statistics are enough to

bring home that India was a minor player in global FDI flows before

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1991.

After the macroeconomic reform process began in 1991, the economy

was gradually opened up to FDI and policy endeavors were made to

attract it. This becomes clear from Table 3.2 that India is fast emerging as

an attractive destination of foreign investors.

Table 3.2 FDI Inflows in India, August 1991-2005 (US $millions)

Financial Year (April-March) Amount of Paid-in FDI5 August 1991-March 2000 15,483

2000-2001 4,029 2001-2002 6,130 2002-2003 5,035 2003-2004 4,673 2004-2005 5,535

2005-2006(up to Dec.2005) 4,719 Total 45,604

Sources: Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, India

The above table presents the first high point of FDI inflows was

reached in 2001, when it topped at US $4 billion. In 2004, with a total

amount of US $4.6 billion FDI inflows, India was the fifth largest

recipient of FDI in the developing world. China, Hong Kong SAR,

Singapore and Korea were larger recipients than India.

Compared to China, India appears to remain an underperformer in the

global competition for FDI. However, conclusions based solely on those

figures in Table 3.1 and 3.2 need to be interpreted carefully, as the above

indexes have used FDI data provided by official sources in each country

5 The Indian data on inflows do not cover the approval amount of FDI. It is estimated that on an average just 35.8% of approved amount has flown in India from 1991-2000.

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whose definition and measurement methods vary significantly. The

following Table 3.3, using the data from World Investment Report,

elucidates a relatively accurate comparison based on international

standards.

Table 3.3 Comparison of FDI inflows to China and India

(Amount in US $millions)

1990-2000 (annual average)

2002 2003 2004 2005

China 30104 52743 53505 60630 72406 India 1705 5627 4585 5474 6598

Developing economies

134670 163583 175138 275032 334285

World 495391 617732 557869 710755 916277

Source: UNCTAD, World Investment Report 2006 (www.unctad.org/wir)

India’s share of global flows to developing countries appears to be very

small, especially compared with those received by China. The reported

inflows of US $6.6 billion in 2005 represented a mere 1.9 percent of total

inflows to developing economies, in contrast to US $72.4 billion inflows

to china with a share of 21 percent (Ray 2005).

However, as noted by Pfefferman, an IMF 2002 paper asked whether

something was wrong with India’s FDI numbers. The IMF found out that

the India’s FDI statistics exclude reinvested earnings, subordinated debt

and overseas commercial borrowing, which are included in FDI of other

countries (Pfeffermann 2002). On the other hand, the Chinese statistics

are believed to be overestimating the real FDI flows in view of

round-tripping of Chinese capital to take advantage of more favorable tax

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treatment of FDI. According to the World Bank, round tripping accounts

for 20%-30% of FDI in China (World Bank. 2002). This argument is

supported by Song’s research, which shows that the Mainland’s inward

FDI from Hong Kong is overstated by the amount of non-Hong-Kong

(Mainland, Taiwanese and others) capital channeled via Hong Kong, as

Hong Kong’s investment in the Mainland appears to be too larger for the

size of the Hong Kong economy (Song 2005: p.30)

In summary, China and India have pursued radically different FDI

development strategies. So far the absolute amount of FDI going to China

is still much larger than India, but the gap in growth rates is narrowing.

3.2 Source-country Composition

China

Since 1979, more than 200 countries and regions have invested in China.

In the past, most of China’s FDI came from Hong Kong or Macau,

following by those from USA and Japan. More recently, with

normalization of political and economic relation between China, South

Korea and Taiwan, the latter two regions have become important sources

of FDI in China.

Table 3.4 Top ten source countries (regions) of FDI in China, 1979-2005

(Amount in US $billions)

Rank Sector Paid-in FDI %age of total china FDI

1 Hong Kong 288.948 46.62% 2 Taiwan 62.119 9.98%

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3 United States 54.385 8.74% 4 Japan 53.445 8.59% 5 South Korea 31.318 5.03% 6 Singapore 28.956 4.65% 7 United Kingdom 13.287 2.13% 8 Germany 11.517 1.85% 9 France 7.47 1.2% 10 Netherlands 6.967 1.12%

Sources: China Foreign Investment Report 2006, Ministry of Commerce

As Table 3.4 shows, Newly Industrializing Economies (NIEs),

including Hong Kong, Taiwan, Singapore and South Korea, have been the

major investors in China, accounting for 66.28% of the total accumulated

FDI inflows. They represent mainly small and medium-sized businesses

that are export-oriented and involved in assembly and processing

operation. Among them, Hong Kong is keeping as the most important

player. However, its share has dropped from 70% in 1992 to 46.6% in

2005. It is estimated, with the China’s success in industrial upgrading and

greater openness to the outside world, the role of Hong Kong in providing

and intermediating FDI inflows into China will be further reduced in the

future. It should also be stressed here that published FDI figures of Hong

Kong are overstated for the large proportion of round tripping capital,

although no reliable estimates of such part are available.

The USA and Japan have been by far the largest foreign investors

among developed countries investing in China, representing 17.33% of

the total China FDI. The United Kingdom, Germany, France and the

Netherlands constitute the main sources of European Union (EU) in

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China, as together they account for 6.3%, which was quite weak.

India

Table 3.5 Top ten source countries (regions) of FDI in India, Aug.

1991-2005


Rank Sector Paid-in FDI %age of total India FDI

1 Mauritius 11,115.47 37.25% 2 United States 4,912.75 15.8% 3 Japan 2,059.33 6.79% 4 Netherlands 1,987.18 6.65% 5 United Kingdom. 1,911.77 6.26% 6 Germany 1,338.88 4.27% 7 Singapore 962.41 3.14% 8 France 772.99 2.55% 9 South Korea 748.98 2.28% 10 Switzerland 613.58 1.98%

Sources: Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, India. Foreign Direct Investment Policy, April 2006

Table 3.5 gives percentage share of major country sources in the actual

inflow of FDI in India during 1991-2005. Mauritius, as the top-place

contributor, account for 37.25% of total FDI inflows. It is estimated that

Double Tax Avoidance Treaty entered into with Mauritius, exempting

capital gains from Indian Income Tax, 1961 and benefiting foreign

investors, could be only one of the reasons of spurt in FDI inflows from

Mauritius (Chopra 2003: p.158). Hence, investors from other countries,

principally the United States, route their investments through Mauritius to

take advantage of the tax treaty.

The United States occupies the second position with a share of 15.8%

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and Japan stands at the third rank having a share of 6.79%. The share of

major EU source countries, including the United Kingdom, Germany,

France, Switzerland and the Netherlands, is approximately 21.7%.

In reviewing the source countries of FDI inflows to China and India,

two conclusions can be drawn. First, in China there is a clear pattern of

concentration of FDI inflows. A large part of Chinese FDI comes from

Chinese-owned or overseas Chinese owned companies located in Hong

Kong, Taiwan, Singapore and other NIEs. This proportion to a certain

extent forms the basis for the economic integration of the region, which is

sometimes referred to as Greater China. The plausible explanation here is

that the relative geographical and cultural proximity of China and other

East Asian countries with major sources of capital such as Japan and

Singapore may have put India a disadvantage. However, projects from

such countries are mainly in labor-intensive ones, small in scale, with a

low level of capitalization and little technology transfer. By contrast,

source-country composition in India is more diversified. Kumar studied

the changing sources of FDI in India and indicated that the European

countries were the major sources of FDI inflows to India until 1990.

However, they had declined steadily from 66% in 1990 to 31% by 1997,

while US emerged as the biggest player over this period with a share of

13.75% in 1997 (Kumar 2003).

Second, India boasts a relatively larger share of FDI from developed

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countries (including US, Japan and EU), which accounts for 44.3%. In

comparison, China only holds a share of 23.63%. Although the EU

constitutes the world’s largest home base for FDI, it is relatively

underrepresented in the Chinese FDI, at least as compared to its overall

FDI position in the global economy. As Bulcke and Zhang point out, the

weak FDI position of the European Union in China has directly affected

the competitiveness of the EU companies in the Asian emerging markets

(Bulcke, Zhang et al. 2003: p.3).

3.3 Sectoral Composition

China

Table 3.6 Sector-wise FDI inflows in China, 2000-2005


2000 2001 2002 2003 2004 2005 National total 4071481 4687759 5274286 5350467 6062998 6032469 Agriculture 67594 89873 102764 100084 111434 71826 Mining and quarrying

58328 81102 58106 33635 53800 35495

Manufacturing 2584417 3090747 3679998 3693570 4301724 4245291 Electric Power, gas

and water production and

supply

224212 227276 137508 129538 113624 139437

Construction 90542 80670 70877 61176 77158 49020 Transportation,

storage, postal, and telecommunications

services

101188 90890 91346 86737 127285 181230

Wholesale and retail trade and catering services

85781 116877 93264 111604 158053 159871

Banking and insurance

7629 3527 10665 23199 25248 21969

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Real estate 465751 513655 566277 523560 595015 541807 Other sectors 386039 393142 463481 587364 499657 586523

Sources: China Foreign Investment Report 2006, Ministry of Commerce; China Statistical Yearbook, National Bureau of Statistics

Table 3.6 examines the distribution of FDI inflows by industry from 2000

through 2005. It shows that nearly 65-70 percent concentrated primarily

in the manufacturing sector. The next highest share, approximately 9-11

percent, is in real estate. Beyond those two sectors, FDI in China is

scattered across various sectors with single-digit or lower percentage

shares. On the whole, the industry concentration of FDI in China is not

very high compared with the industry concentration in other countries

(IMF 2002).

Regarding manufacturing sector, it is observed that FDI has been

concentrated in the various fields, in particular the electric and electronic

equipment sector, the textile sector, and the chemical and pharmaceutical

sector. However, a shift of FDI away from manufacturing towards

services sector is forecasted because the significant liberalization

following China’s membership in the WTO. The greatest liberalization

will be in financial services, telecommunications, and distribution. These

sub-sectors in the service sector are expected to see rapid increase in FDI.

India

The sectoral distribution of FDI in India between August 1991 and

December 2005 is given in the following Table 3.7.

Table 3.7 Sector-wise FDI inflows in India, Aug. 1991-2005

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Rank Sector Amount of FDI inflows

%age of total India FDI

1 Electrical Equipment6 4,885.88 16.5% 2 Transportation Industry 3,143.09 10.34% 3 Service Sector 2,971.66 9.64% 4 Telecommunications 2,890.12 9.58% 5 Fuels7 2,521.49 8.41% 6 Chemicals (Other than

Fertilizers) 1,899.51 5.86%

7 Food Processing Industry 1,173.18 3.67% 8 Drugs and Pharmaceuticals 948.54 3.18% 9 Cement and Gypsum

Products 746.79 2.54%

10 Metallurgical Industries 627.32 2.12% 11 Consultancy Services 444.48 1.59% 12 Miscellaneous Mechanical

& Engineering 435.45 1.51%

13 Textiles 430.07 1.32% 14 Trading 374.23 1.16% 15 Paper and Pulp 363.46 1.1%

Sources: Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, India. Foreign Direct Investment Policy, April 2006

The table 3.7 shows the electrical equipment is the largest beneficiary

of FDI inflows, which represents one of the most spectacular

achievements for the Indian economy. Transportation, service sector and

telecommunications, which can be categorized as the tertiary industry,

emerge as significant recipients with a share of 30 percent. Compared

with the old pattern of FDI stock before liberalization, the relative

importance of manufacturing sector has declined with the opening up of

infrastructure and service sectors. Furthermore, within the manufacturing

itself, the preference pattern of FDI is shifting away from heavy 6 Computer software and electronics are included 7 Power and oil refinery are included

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industries to light industries.

To sum up the foregoing discussion on sectoral distribution of FDI in

China and India, we note that both countries witness that the opening up

of new industries has led to increased investments in service sector, thus

bringing down the share received by manufacturing. Within the

manufacturing sector, both countries saw a steady upgrading of FDI

inflows from labor intensive industries to capital and technological

intensive industries and from traditional manufacturing industries to

information technology (IT) related industries. Therefore, in the coming

years, China and India will still present a David and Goliath image in

attracting FDI inflows.

3.4 Regional Distribution

China

The geographical distribution of FDI in China is highly uneven and

reflects the history of liberalization, deregulation and government policy,

as noted in section 3.1. In the early period of reform and opening up, the

reformers targeted China’s coastal areas as the leading regions for the

economic development and established four Special Economic Zones8

(SEZs) in Guangdong and Fujian Province. The analysis of Table 3.8

reveals that the coastal areas, particularly Guangdong and Jiangsu, are the

major locations for FDI inflows. The other main locations for FDI were

8 The four SEZs are located in Shenzhen, Zhuhai, Shantou and Xiamen.

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Shanghai, Shandong and Fujian.

Table 3.8 Province-wise FDI inflows in China, 1979-2005

(Amount in US $billions)

Rank Province Amount of FDI inflows

%age of total India FDI

1 Guangdong 151.657 24.36% 2 Jiangsu 89.848 14.44% 3 Shanghai 55.394 8.90% 4 Shandong 52.932 8.50% 5 Fujian 47.851 7.68%

Sources: China Foreign Investment Report 2006, Ministry of Commerce

Using China’s provincial and municipal data, Hsiao and Shen found

out that the development of cities and infrastructure and easy access to

markets are two of the primary factors often determining MNCs’ choice

of where to invest (Hsiao and Shen 2003). Another point is that the close

geographical proximity and tight cultural and linguistic links between

southern China and the overseas Chinese communities in Hong Kong,

Taiwan and Macau have also contributed to the observed geographical

pattern of FDI inflows in China.

India

The major portion of the FDI in India is found to be flowing into the

economically richer states. The five richer Indian states, Maharashtra,

Delhi, Tamil Nadu, Karnataka and Andhra Pradesh accounted for more

than 66.65% of the FDI inflows into India. This trend in FDI inflows

shows the economic inequality that already exists among the Indian states.

Tamuli asserted that FDI inflows to these states seemed to respond to

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infrastructure availability, business managers’ perception of investment

climate, educational qualification of manufacturing workers and

productivity level of manufacturing industries (Tamuli 2006).

Table 3.9 Region-wise FDI Equity inflows9 in India, 2000-2006


Rank Regional office State covered Amount of FDI inflows

%age of total India

FDI

1 Mumbai Maharashtra, Darda

&Nagar Haveli, Daman & Diu

7,486.6 24.91%

2 New Delhi Delhi, Part of Up and

Haryana 7,045 23.42%

3 Chennai Tamil Nadu, Pondicheery 2,295 7.64% 4 Bangalore Karnataka 2,052 6.82% 5 Hyderabad Andhra Pradesh 1,157 3.86% 6 Ahmedabad Gujarat 970 3.26%

Sources: Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, India. Fact Sheet on FDI, from Aug.1991-Dec.2006

To summarize, locational benefits appear to be a prime consideration

for foreign investors contemplating participation in any FDI projects both

in China and India. Especially in China, the selective economic policy

creates uneven regional economic development, which strongly affects

the inflow and location of FDI. The study also finds out that the forces of

convergence are very weak in two countries and the provinces (states) are

showing a tendency of divergence rather than convergence. The

geographical distribution of FDI in two countries today also is the result

of local government’s efforts to create a favorable investment, especially

9 Includes ‘equity capital components’ only

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in fostering industrial clusters in their jurisdictions. The Indian economist

Kurian notes that ‘the better-off states are able to attract considerable

amounts of private investment, both domestic and foreign, to improve

their development potential because of the existing favorable investment

climate including better socio-economic infrastructure’(Kurian 2000:

p.12). It seems both China and India express the concern that a growing

polarization of the country can have an extremely damaging effect on

national unity and harmony. A wider geographic spread of capital across

the country are actively pursued by each country. In China, to narrow the

gap, it introduced The West Development Strategy in 1998. In contrast,

the India’s 10th five-year plan explicitly addresses the need to ensure

equity and social justice and ‘particular attention must be paid to the

importance of ensuring a balanced development for all States’ (India.

Planning Commission. 2003: p.8).

4. Determinants of FDI

Following the analysis and literature review on determinants of FDI in

Chapter 2 and the discussion on trends and patterns of FDI inflows to

China and India in Chapter 3, this chapter in turn examines the various

determinants of FDI and to see how far these determinants can be applied

in both countries. Since the external (supply-side) factors explain the

outward investment by different countries while the internal

(demand-side) factors explain the uneven distribution of FDI among the

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recipient countries. Therefore the focus of this chapter will be on internal

(demand-side) factors, although the separation of the two kinds of factors

sometimes is impossible. It will present the PESTEL (political, economic,

social, technological, environmental and legal) analysis of variables that

have directly or indirectly determined the FDI inflows to both countries.

4.1 Political Environment and FDI policy regime

China is still regarded as a communist regime and one of the most

important characteristics of Chinese political system is the one party rule,

while India is the world’s largest democracy. Therefore, the simplest

language to describe the difference between the two countries is ‘the

world’s largest democracy’ versus ‘the world’s largest autocracy’.

Although this metaphor indeed reflects some truth, the reality is much

more complex. Both countries, despite enjoying different political

systems, have actually come from the same place – Soviet style planned

economies and massive state-owned enterprises. Both countries

undertook significant reforms in the 1980’s and 1990’s. As China

modernizes, it increasingly encourages free trade and capitalist-based

economic model which allows more democracy; whilst as India

modernizes, it’s getting it’s democracy under control for the good of

nation.

The first reason for the FDI gap between two countries is that India is

at least twelve years behind China in terms of launching reforms. As

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discussed in Chapter 3, China opened its doors to FDI in 1979 and has

been progressively liberalizing its policy regime, while the reforms in

India were introduced in June 1991, which ‘aimed at reducing the extent

of government controls over various aspects of domestic economy,

increasing the role of the private sector, redirecting scarce public sector

resources to areas where the private sector is unlikely to enter, and

opening up the economy to trade and foreign investment’ (Cassen and

Joshi 1995: P.13).

In addition to the late start, Franda asserts that failure to effect

far-reaching economic reform in the 1990s could be attributed as an

immediate cause to the enormous factionalism characterizing Indian

political life. For example, the BJP-led coalition formed in 1999 consisted

of almost two dozen political parties with widely divergent platforms and

interests (Franda 2002: pp24-27). Vardarajan also declares that India is

perhaps the only democracy where businessmen don’t become politicians

and political system is dominated by political leaders who base their

appeal on “castemanship, regional factionalism and personal cults”

(Cable and Royal institute of international affairs. International

economics programme. 1995). Therefore, a major consequence of the

fragmentation of Indian political party life is the near-impossibility of

conducting meaningful national FDI promotion campaigns. In this

atmosphere, it is little wonder that FDI volume in India was only

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one-tenth of China from 2000 through 2005 (see above table 3.1 and 3.2).

Additionally, during a debate in the Rajya Sabha on 20 August 2001, the

then planning minister, Arun Shourie, was asked why India had received

only $17 billion in FDI in a decade when China had attracted $323 billion.

Shourie stated that the reason was that the Chinese government is ‘market

savvy, quick in decision-making and better still in executing decisions’

(The Statesman, 21 August 2001).

Another essential reason for China’s unparallel success is its strategy of

creating Special Economic Zones (SEZs) and coastal economic zones,

which has been discussed in section 3.4. Decision-makers in the public

policy community proactively create an enabling environment for the

inflows of FDI in the domestic economy, which are essentially located in

the coastal areas of the eastern and the southern provinces of China (Das

2005). Therefore, the ability of China to attract FDI inflows is largely the

result of special economic zones that give foreign enterprises better and

specialized infrastructure and flexibility in domestic regulations.

Compared with China, India’s SEZs scheme was launched in 2000, again

15 years later than China (Gakhar 2006: p.85). Furthermore, unlike China,

India has not employed fiscal incentives such as tax concessions to attract

FDI. Only in December 2004, the Indian government initiated the reform

of the Foreign Investment Promotion Board, and has established the

Indian Investment Commission to enhance and facilitate FDI in India,

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which acts as a one-stop shop between the investor and the bureaucracy.

The one bright spot for India in its FDI competition with China has

been the ability to invite more foreign software investors. The most

telling demonstration of India’s superiority in software technology is in

FDI inflows and trade statistics (see table 4.1).

Table 4.1 Comparison of software industry in China and India (Year

2005)


Software industry FDI inflows

Software industry Exports

China 932 3590 India 1451 10000

Source: China Foreign Investment Report 2006, Ministry of Commerce; NASSCOM, India10

Software development in China is at the opposite end of the spectrum

from that in India. Beijing’s effort to build sophisticated software

production capabilities did not get started until the mid-1990s and the

Chinese government provided little state support to this effort until the

late 1990s. While India’s lead in software technology can be traced to

1984, when Rajiv Gandhi began to adopt the first liberal economic

policies designed to develop this sector (McManus, Li et al. 2007).

Compared to the above reform and FDI policies, it is worth noting that

the government need to understand ‘how their policies and behaviors

shape the opportunities and incentives facing firms’(WorldBank 2005:

10 NASSCOM is the apex software industry body in India. Useful information on the Indian software industry as well as doing business in India is available at its website, http://www.nasscom.in

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p.12). In brief, the government policies can play an important role in

attracting FDI inflows. It is desirable to give some specific policy

direction to foreign investors, as the cases of China’s SEZ success and

India’s software development demonstrate.

4.2 Economic Development

Chinese gross domestic product (GDP), adjusted for purchasing power

parity, ranked number 2 after USA, whereas Indian adjusted GDP ranked

number 4 after Japan. Over the past two decades, China’s average annual

growth rate was above 9 percent, and the average annual inflation rate

was kept below 3 percent. The Chinese economy continues its robust

development, total growth in 2005 exceeded expectations at nearly 10

percent. In contrast, the Indian rate also jumped from about 3 percent a

year during 1950-79 to between 5-6 percent a year during 1980-2004

(Chai and Roy 2006). According to the research on the contribution of

GDP growth to FDI by Hsiao and Shen, the elasticity of a 1 percent

increase in GDP raises FDI by 2.117 percent (Hsiao and Shen 2003).

Therefore, if both countries could sustain their present growth in the

future, they are likely to attract more FDI.

Table 4.2 compares the current stage of China’s macroeconomic

performance and economic structure with that of India in terms of some

key economic indicators.

Table 4.2 Comparison of selected economic indicators: China and India

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Indicator Unit Year China India China/India

ratio GDP per capita at PPP US $ 2002 4580 2670 1.71 Gross national income

(per capita) US $ 2003 1,100 540 2.0

Rank 2003 134th 159th Share of manufactured

products in exports Percent 2002 90 75 1.2

Share of high-tech products in exports

Percent 2002 23 5 4.6

Electricity production Billion kwh 2002 1,640 597 2.7 Share in multilateral

trade Percent 2004 8.9 1.1

Rank 2004 3rd 20th Position in the WTO

league table of exporters 2004 3rd 30th

Position in the WTO league table of importers

2004 3rd 37th

Foreign exchange reserves

US $ billion 2005 711 144 4.97

Rate of poverty Percent 2002 17 35 0.5 Adult literacy rate Percent 2002 91 61 1.49

Researchers in R&D Per million

people 2002 584 157 3.71

Share of IT industry in GDP

Percent 2002 3 NA

Sources: (1) World Development Indicators 2005, (2) International Trade Statistics 2005, (3) China Statistical Yearbook, National Bureau of Statistics

The comprehensive comparison of the above economic indicators

reveals that India currently is at the level that China had reached in the

early 1990s. Hence, there is roughly a ten-year gap between China’s and

Indian’s economic development. These again prove that China’s

economic reforms, including those related to attracting FDI, were

initiated so much earlier than India’s and proceeded at such a faster pace

over the past three decades. However, in certain field, such as IT industry,

India is ahead of China.

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To sum up, on the basic economic determinants, China does better than

India. China’s total and per capita GDP are higher, making it more

attractive for market-seeking FDI. Its higher literacy and education rates

suggest that its labor is more skilled, making it more attractive to

efficiency-seeking investors.

4.3 Society

The Dunning’s O-L-I framework and other mainstream FDI theories

discussed in the Chapter 2 do not take social factors explicitly into

consideration. Undeniably, social factors are considered by MNCs and

they have a tremendous impact on the causes and effects of FDI inflows.

Firstly, the FDI gap between two countries is partly a tale of two

Diasporas. China has a large and wealthy Diaspora that has long invested

its money. During the 1990s, more than half of China’s FDI came from

overseas Chinese sources (Friedman and Gilley 2005). Yeung revealed

that a large proportion of foreign investment in Dongguan, Guangdong

Province was stemmed from overseas Chinese entrepreneurs (including

the overseas-based subsidiaries of enterprises originating in China). The

competitive advantage for overseas Chinese-funded enterprises in

Dongguan was their ethnic or close relationship with local government

officials (Yeung 2001). The discussions at section 3.1 and 3.2 also

support Hong Kong and Taiwan’s ethnic relationship with China is a

unique advantage, which enables investors to conduct negotiations and

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operations much easier.

By contrast, the Indian diaspora was, at least until recently, resented for

its success and much less willing to invest back home. Until now, the

Indian diaspora has accounted for less than 10 percent of the foreign

capital flowing to India. Recently, the Indian government has noticed this

problem and organizations, such as The Indus Entrepreneurs (TiE) , were

established to provide platforms for formation of social networks

(McManus, Li et al. 2007: p.48).

Besides the ethnic networks, the personal relationship (Guanxi)

cultivated with local officials is also considered by foreign investors,

especially those from Hong Kong and Taiwan. As Yeung indicates that

some open-minded local government officials have established

communication channels exclusively for foreign investors (Yeung 2001:

p.131). It is regarded as an internalization advantage for foreign investors

as it reduces the information costs for clarifying and understanding new

policies. In contrast, feedbacks received from potential foreign investors

indicate that India’s vast market-place and skilled workforce do not

compensate for poor infrastructure and a corrupt bureaucracy (Fortune

India 31 December 2003: p.8). The American congressman, Frank Pallow

once complained that ‘India is not a difficult place to invest, but India has

to contend with the reality that its bureaucratic maze makes it more

difficult to handle than the stringent bur clearer norms of more autocratic

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countries like China’ (Gakhar 2006: p.118). Hence, the FDI

decision-makers are now acutely conscious of India’s corrupt and

inefficient bureaucracy, which could turn into a veritable and bothersome

hurdle.

4.4 Technology development

Much has been made of the implications over China and India’s

political systems, economic reforms and social relations, which maintain

the accepted truth that China is 12 years ahead of India. While this may

be true of the infrastructure development of China, it is not true for

another important determinant of FDI, which India is ahead. With better

English language skills, India may have an advantage in technical

manpower, particular in information technology.

Some of the differences in competitive advantage of the two countries

are illustrated by the sectoral composition of their FDI inflows, which has

been explained in section 3.3. For example, in information and

communication technology, China has become a key center for hardware

design and manufacturing while India specializes in IT services, call

centers, business back-office operations and R&D (Winters and Yusuf

2007). Therefore, foreign investors perceive China and India as distinctly

different markets. While China is well regarded by them as the leading

global manufacturer and the fastest growing consumer market, India is

viewed as a world-class services provider in business processes and

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ICT-enabled services. Therefore, the Times of India claims that India is

the most preferred outsourcing destination in the world (Times of India

Online. 15 February 2005). There is awareness in the global investment

community that India’s service-oriented development over the last two

decades has made it possible for it to bypass some of its glaring economic

weaknesses, like a poor quality physical infrastructure.

Moreover, as we have discussed at the above section 4.3, although with

the help of its diaspora, China has won the race to be world’s factory.

India could become the world’s office with the help of its diaspora on

technological field. The development of Indian software industry

discussed at section 4.1 shows the fact that ‘India’s soft skill and

technology are creating a tortoise that will ultimately overturn the hard

Chinese hare’ (Smith 2007: p.176). Kiran Karnik, president of Nasscom

comments that China has ‘great potential but is far from being a serious

competitor’ and lags three to five years behind India’s software industry,

quoted by FT reporter (Yee 2007).

4.5 Business Environment

As discussed at section 4.1, liberalization of FDI policy is a necessary

variable for FDI, especially in the kick-off stage, but it’s not sufficient for

expanding FDI inflows. The overall business environment continues to

exercise a major influence on the magnitude of FDI inflows, for it signals

to potential investors the growth prospects of host country. Hence, paying

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attention to the overall business climate and creating a stable and

environment will crowd-in FDI.

A survey of global executives was conducted by the Global Business

Policy Council (GBPC) 11 in 2005 and published as FDI Confidence

Index. Both China (2.19) and India (1.95) are at the center of the FDI

radar screen for they are considered as the 1st and 2nd most attractive FDI

locations globally. This is the forth year in a row that China held the top

spot and India rose from 3rd to 2nd place, surpassing the United States

(GBPC 2005). In Year 2004, this extensive opinion-survey put China at

the top with a score of 2.03 for having the best investment environment,

the US second with a score of 1.45 followed by India with a score of 1.40

(GBPC 2004). A noteworthy observation here is that the gap in the value

of the confidence index between China and India is getting tiny.

The result of the GBPC opinion survey coincided with that of a 2005

opinion survey conducted by the World Investment Report team of the

UNCTAD. This team conducted a larger sample survey of the global

investing community, MNCs, FDI experts and investment promotion

agencies (IPAs). Their results revealed that those who were surveyed

regarded China as the most attractive location with 55% of the CEO

surveyed were willing to invest the most in China, followed by India

11 This survey has a wide coverage in terms of sample size. It covers top decision-makers in the 1,000 largest MNCs of the world on their opinions of various FDI destinations and their investment intentions. These 1,000 MNCs contribute over 70% of total FDI flows and represent all major regions and sectors. The survey tracks the impact of political, economic and regulatory changes in the host economies by the global investing community and preferences of decision-makers in these MNCs. The confidence index ranges between zero and three.

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(36%). Again, both countries are considered as the most favored

investment destination (United Nations Conference on Trade and

Development. 2005).

The World Development Report 2005 emphasizes that ‘for

governments at all levels, a top priority should be to improve the

investment climates of their societies. To do so, they need to understand

how their policies and behaviors shape the opportunities and incentives

facing firms’(WorldBank 2005: p.12). From the above surveys, we can

see that a virtual sea change has taken place in the business environment

of India and it is catching up China very quickly. Therefore, in terms of

overall business environment, India does not rank much below China.

4.6 Legal System

Although the FDI literature focuses essentially on political and economic

development, business environment and technology, to some extent, the

legal system and barriers need to be taken into account as well for a

comprehensive analysis.

The lack of a well-structured and transparent legal system in China

poses serious problems for foreign investors. A clear and strict

hierarchical system of norms does not really exist yet. Moreover, different

ministries and departments of the central and local governments have

issued many diverse regulations, which result in the failure of the foreign

companies to find out which regulations exactly apply to them. In

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contrast, India enjoys a strong British-based legal and accounting system,

which helps it to attract more capital from Western countries. Therefore,

the absence of reliable legal and secure property rights and vast

differences in culture help to explain China’s below par performance in

attracting FDI from Western countries, compared with the performance of

India which has been demonstrated in section 3.2. Meanwhile, India’s

long history of private property, democracy and similar law system with

Western countries should prove attractive for potential foreign investors.

In other words, even if economic policy is great and politics stable, if

there are no property rights and contract enforcement in a country, there's

no way anyone can do business.

One of the key issues on legal affairs is the protection of intellectual

property rights (IPR). The most significant change in the Chinese

business regulations for foreign-invested companies was the introduction

and improvement of IPR during the 1990s. The introduction of patent law

has removed a major obstacle to lure FDI in high-tech industries.

However, the full implementation of IPR protection regulations remains

weak in China. For example, according to the Software Piracy Study of

Business Software Alliance12, China has a very high software piracy rate

with 82 percent in 2006. In contrast, India’s rate is a littler lower than

China, which stands at 71% (BSA 2006). Additionally, the Patent Law in 12 The Business Software Alliance (www.bsa.org) is the organization dedicated to promoting a safe and legal digital world. An important mission of BSA’s research portfolio is the BSA/IDC Global Software Piracy Study, which tracks the state of software piracy across more than 100 countries.

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India is being revised in conformity with the required standards of the

WTO in 2002 (Chopra 2003: p.132).

Concisely, there is a growing patent culture in both countries. The

Indian companies are striving to move up the value chain and are

increasingly approaching their competitive positioning with

intellectual-property-based differentiation. At the same time, under

domestic and international pressure, the Chinese government has

tightened its enforcement of IPR protection and will improve judicial

performance of contracts and other business codes, including those

governing IPR and counterfeiting.

4.7 Summary

From the above PESTEL analysis, we may find that the FDI favors China

over India in the following significant areas: pro-business government,

overall business environment, incentives provided by the host

government, quality of infrastructure and macroeconomic management.

All these add up to create a superior investment environment in China

than in India. The same set of decision-makers has favorable opinions on

India’s English-speaking workforce, software talents, rule of law, cultural

affinity and regularity environment. As we have seen, the relative

attractions are now becoming better balanced. Given a choice, some

investors have switched to prefer India.

5 Summary and Conclusions

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5.1 Findings

Research on the characteristics and determinants of FDI in China and

India is still at the developmental stage. The existing literature on FDI is

appraised in chapter 2. However, most of the traditional studies of FDI

explain only the company advantages, transaction costs and differential

factor endowments, while Dunning’s O-L-I paradigm unifies the various

theories. According to this theory, FDI is chosen as a market entry

strategy so that a firm can exploit its ownership advantages through

internalizing transaction costs in a specific location, which possesses

locational advantages for FDI. The third chapter details overall trends and

patterns of FDI inflows in China and India, including its development

stages, sources, regional and sectoral distributions, along with the

government’s policy changes towards FDI. Since the host country’s

internal factors play an important role in influencing the magnitude,

importance, pattern, form and impact of FDI in the economy, the Chapter

4 deals with and compares the main determinants by adopting the

PESTEL analysis format.

Hence, this research has proved to be a useful experiment in the

analysis of the FDI development experiences and determinants strategies

of both countries. The main conclusions of the present study are given

below:

One important finding is that multiple factors, rather than a single

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factor, influence the volume and pattern of FDI inflows, which include

political and social stability, sound macro-economic environment,

well-developed soft and hard infrastructure, competitive supporting

industries, the availability of skilled labor, and open trade and FDI

regimes. Indeed, these factors are considered “fundamental”; they create

an environment that enables foreign firms to enter an economy and

contribute to its growth and development. Through the PESTEL analysis,

this study finds out that in terms of political and FDI policies, economic

development, society and business environment, China does better than

India; whilst India is ahead of China in terms of technology and legal

system.

A second major conclusion of the study is that changes in a country’s

FDI policy regime are not enough to ensure the desired inflow of FDI.

Actually, the policy coherence, consistency, transparency, and effective

implementation matter. In the forefront of effective implementation of

FDI policies is the speedy processing and approval of FDI applications.

This means that both countries shall streamline its bureaucracy, simplify

approval and remove restrictions on foreign ownership, therefore create a

climate of certainty and friendly policies towards FDI.

A third major conclusion of the study is about the question whether the

recent improvement in the image of India in the global investing

community will affect FDI flows to China. It can be answered by saying

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that it will have little impact. This relates only to the part of FDI that

originates from MNCs, which is a small proportion of total FDI going to

China. Regional FDI flows that originate from the Chinese Diaspora will

not change its pattern of FDI. Besides, the sectors that are going to attract

the global FDI in the immediate future in the two economies are very

different. Coupled with the economic impact of the 2008 Beijing

Olympic Games and the 2010 Shanghai World Expo, rising FDI in

services and high-tech manufacturing might contribute to a new round of

FDI growth in China. As for India, in spite of the opportunities available

for attracting FDI, several challenges remain to be met in order for the

economy to sustain a higher growth path, and enhance competitiveness in

order to position itself favorably in the global competition for FDI.

5.2 Policy Implications

In addition to the general policy implications that have been drawn above,

studies of determinants of FDI inflows conducted in the framework of an

extended model of location of foreign production (Kumar 2002) have

found that a country’s ability to attract FDI is affected by structural

factors such as market size (income levels and population), extent of

urbanization, quality of infrastructure, geographical and cultural

proximity with major sources of capital, and policy factors (namely tax

rates, investment incentives, performance requirements). Based on the

above discussions, India is at the verge of an FDI take-off. Whether this

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potential materializes or not will necessarily depend on how the

government manages and upgrades its business policy environment in the

foreseeable future. At the same time, to maintain sustainable growth,

China needs to improve its ability to attract and use FDI, especially on the

issues of establishing a rule-of-law society and encouraging human

capital enrichment. As a guideline to both policymakers, it seems

reasonable to suggest that the encouragement of FDI should take forms

that bring long-term benefits to the host country’s economy. These may

include the upgrading and extension of infrastructure and public

expenditure on education and training.

Another important implication for both countries and economic

analysts is that we shall stop treating India and China as simple,

one-dimensional entities weighable on a single scale to judge which is the

success and which the failure. Indeed, each, as revealed above,

increasingly sees the other better in some ways and worse in others. For

example, two policies that China can learn from India are: human

resource development and the development of local supporting industries.

Human resource development not only ensures an adequate supply of

skilled labor for foreign investors, but helps a country achieve overall

economic efficiency and move up the economic development ladder.

Moreover, the competitive supporting local industries will promote

technology spillover, one of the positive effects for host country.

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5.3 Limitation of the Study

An important limitation of this study is its use of secondary data and

information which may sometimes be problematic. For example, as noted

in chapter 3, the FDI inflows in China is reported to be overestimated

thus the gap between China and India can be exaggerated. Another

limitation is that we cannot compare the determinants of FDI by different

investors. FDI from different countries contains different levels of

technology and would have different motives to invest. However, the

existing data are very aggregate and this study has to examine the

determinants of FDI as a whole, whether they come from the United

States, Europe, Japan and other countries or regions.

5.4 Future Research Directions

This research has proved to be a starting point in the comparison of the

FDI trends, patterns and determinants between China and India. Drawing

on the PESTEL analysis of the Chinese and Indian FDI inflows presented

in the preceding chapters, the further research will perform a strengths,

weaknesses, opportunities and threats (SWOT) analysis on both country

as well as compare and contrast them in relation to each. Furthermore,

comparative analyses in regard to U.S. foreign investment in China and

India are needed since it is now the major investor country source to both

countries. In addition, as China and India continue to utilize FDI as an

integral part of its economic development strategy, it will be interesting to

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do increased research on changing provincial or state environment for

FDI in both countries, particularly with reference to the interior or

backward provinces (states).

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Education

investment fdi

patterns of fdi

comparison of fdi inflows

fdi policies

thedeterminants of fdi

fdi inflows andexamines

sectorwise fdi inflows

provincewise fdi inflows