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Truth about FDI in China

Truth about FDI in China
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First Published: Wed, Mar 07 2007. 01 28 PM IST
Updated: Wed, Jul 25 2007. 06 54 PM IST
The bosses of the Chinese Communist Party meet this week in their country’s parliament. Two decisions they are likely to make could have long-term implications, not just for businessmen in that country but for businessmen here as well. I wonder why there is no discussion in India about these two pending changes.
We’ll get to the more dramatic decision later, and stay with the seemingly minor one for now—a change in the rules of corporate taxation. The official People’s Daily says the tax rate on the profits of Chinese companies is currently 33%, while that on foreign companies is 15%. This means that Chinese companies pay more than twice as much tax as their foreign counterparts do for every dollar of profit earned. The Communist Party now wants the tax rates to be equalized at 25%.
So tax rates for Chinese firms will drop and those for foreign firms will rise. (This is before various exemptions and incentives, however.)
The current differential in corporate tax rates in China is not an aberration but part of a conscious strategy. Understanding this unusual strategy can be useful to all those—in business, government and academia—who agonize about the India-versus-China issue, and especially about the starkly differing abilities of the two countries to pull in foreign direct investment (FDI).
Yasheng Huang of the Massachusetts Institute of Technology says that the success that China has had in getting huge FDI is actually the consequence of a failure.
Huang argues that China has had to depend heavily on foreign investment because its own financial system has not been able to allocate capital efficiently. Why? The Chinese government heavily backs its inefficient state-owned enterprises and forces banks to lend to them. By doing so, it denies more efficient domestic private firms the funds that they need to grow.
Add to that the fact that China has neither a vibrant entrepreneurial culture nor the institutions required to promote such a culture. There is thus a vacuum in the Chinese economic system—and foreign investment fills this vacuum. This is why the Chinese government goes out of its way to woo foreign investment, and offers lower tax rates. Huang believes that the fact that a country gets large amounts of FDI is often a sign that its domestic entrepreneurship is of a poor quality. That is the true story behind China’s FDI success.
Earlier, Singapore and Malaysia too had a bias against domestic firms. The reasons can often be political. Both these countries thought that their local Chinese population, which controlled a large part of business activity in the 1950s and the 1960s, was too sympathetic to communist insurgents who took orders from China. In China itself, the party has a reason to be wary of domestic capitalism, since its success could strengthen civil society against the state.
From Huang’s analytical perspective, there are three good reasons why India is less dependent on FDI for its growth—a vibrant entrepreneurial culture, a strong banking system and an institutional arrangement that is based on private property and the rule of the law. In many ways, India is closer to Hong Kong and Taiwan, where growth was also driven by vibrant domestic enterprises.
So, now, what do we make of the decision of the Chinese Communist Party to stop discriminating against domestic firms? Does the party now believe that Chinese capitalism—or socialism with Chinese characteristics, as the convenient euphemism goes—is now at a point where it can flourish? Add to this two other developments. First, the party wants to legalize private property (which is the other big decision that I had alluded to earlier). Second, the government there has been trying to clean the mess in the banking sector to ensure better capital allocation.
It’s too early to tell, but these reforms could have significant implications for the Indian economy. The widely accepted theory is that China scores over India in its macro economics, but India is leagues ahead in its micro economics because of robust domestic enterprise. In fact, Huang and his Harvard collaborator Tarun Khanna believe that India will eventually overtake China because of the quality of its companies.
The Chinese game plan now seems to have veered around to promoting domestic firms, from small start-ups to state-supported monsters. Going by Huang’s very provocative analysis on the balance between domestic enterprise and FDI, this could mean that China is less interested in FDI than it earlier was.
A China with stronger domestic firms and less of an appetite for FDI can transform the rules of the game. Are the Indian government and companies prepared?
Your comments are welcome at cafeeconomics@livemint.com
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First Published: Wed, Mar 07 2007. 01 28 PM IST