Is China Mercantilist?

The fact that so much foreign money has been of the FDI variety has helped shield China from the kind of jolts recently administered to other Asian economies where a higher proportion of investment was indirect -- such as bank lending or stock portfolios.

Strong evidence of China's emergence as a global economic powerhouse are these twin facts: a large foreign exchange reserve that China is holding, especially in dollar-denominated assets, and a large amount of foreign direct investment (FDI) going into China that rivals FDI into the United States. A popular (and politically charged) explanation for these facts runs as follows: China's rapid rise in the foreign exchange reserve is a consequence of its mercantilist policy, exporting like mad by relying on a deliberately undervalued currency, cheap labor, and foreign investors, particularly those from the United States.

But in The Chinese Approach to Capital Inflows: Patterns and Possible Explanations (NBER Working Paper No. 11306), authors Eswar Prasad and Shang-Jin Wei suggest that the reasons behind China's increased foreign exchange reserve and its success at attracting FDI -- as opposed to more volatile financial and equity markets --are too complex for this kind of simple theory. They argue that the mercantilist explanation is an "intriguing story, but the facts do not support it."

To start with, they note that more than 87 percent of the acceleration in the increase in China's foreign reserve holding from the period 1988-2000 to the period 2001-4 can be explained by a surge in non-FDI type of capital inflows (sometimes called "hot money"), including a dramatic reversal of capital flight. Only 13 percent of the increment can be attributed to an increase in the current account surplus and an acceleration of the inward FDI.

Furthermore, they note that China's FDI, which in 2004 was $61 billion, comes from countries that are running a current account surplus with China rather than those with a deficit. The main contributors are based in advanced Asian economies such as Japan, Korea, and Singapore. Europe and the United States combined account for, at most, about 30 percent of China's FDI.

Prasad and Wei also view the focus on an undervalued currency as off the mark. As recently as 1997 and 1998, China chose not to devalue its currency even though such a move would have aided exports. And in the 1980s and 1990s, China's currency was more likely to be overvalued than undervalued. "Further research will be needed to disentangle the competing explanations for [the rise in FDI in China], but there is little evidence that mercantilist stories are the right answer," they write.

Prasad and Wei nonetheless believe it is important to understand more about China's success in "tilting" the flow of money into China toward FDI, "especially as China continues its integration into world financial markets and becomes more exposed to the vagaries of these markets." As it now stands, the fact that so much foreign money has been of the FDI variety has helped shield China from the kind of jolts recently administered to other Asian economies where a higher proportion of investment was indirect -- such as bank lending or stock portfolios -- and tended to be withdrawn at the first hint of trouble. "It is not just the degree of financial opening but the composition of capital inflow that determine the quality of a developing country's experience with globalization," the authors state. "In particular, FDI appears to be less subject to sharp reversals than other types of inflows, particularly bank lending."

Prasad and Wei observe that during the Asian financial crisis of the 1990s, "FDI inflows were only marginally affected" while other forms of investment showed "sharp increases in outflows" and took two or three years to recover. According to their analysis, China's capital controls along with incentives offered to foreign investors "appear to have played a big part in encouraging FDI inflows." For example, foreign firms investing in China don't have to pay corporate income tax on their first two years of profits and in subsequent years pay only half the corporate income tax rate of Chinese companies. Overall, Prasad and Wei find that China probably "offers more incentives to attract FDI than most countries in the world."

But every theory, they note, seems to have certain flaws. For example, they point to a seemingly plausible argument linking China's upsurge in FDI to government actions that deprived private firms of capital in favor of state-owned firms. According to this theory, FDI increased as private Chinese firms aggressively used pro-FDI policies to secure the investments they needed to expand. Prasad and Wei believe this explanation could account for some of the FDI flowing into China in the 1980s. But it appears flawed in explaining the more recent surge, as Chinese banks have become "increasingly willing" to make loans to private firms.

Similarly, the notion that China's specific incentives for FDI have provided the spark has its problems, since China also erects many barriers to investment. "The story is not that straightforward since one would expect a counteracting effect from factors such as weak governance, legal restrictions on investment by foreigners, and poor legal infrastructure and property rights," they note.

-- Matthew Davis