China's Foreign Investment at a Critical Juncture

 | Nov 06, 2012 | 5:00 PM EST
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In two days, China will begin the country's fourth generational power transfer as it opens the 18th National Congress. The process of forming a new government and choosing who the country's leaders will be throughout the power structure will take several months.

As the structure and personalities of China's new government become known, the country's probable political and economic course, both domestically and internationally, will be revealed. For that reason, I will be coming back to this topic periodically throughout 2013.

The three major issues facing China and its relationship to the rest of the world are:

  • Oil prices and access to oil.
  • Foreign direct investment (FDI).
  • Domestic economic growth.

Each of these issues effects and is affected by the others. I wrote most recently about the oil situation, so I will not address here again.

In this column I will address China's foreign direct investment, and tomorrow I will write about the country's domestic economic situation.

Foreign direct investment in China has declined about 4% over the past 12 months but is still quite strong and indicates that investors are not worried about actions being taken by the new Chinese government that may negatively affect them.

This is impressive, because the foreign direct investment going into China now is for much more capital-intensive projects than has been the case for the past 30 years. The first wave of FDI that occurred mostly during the 1990s was for physical infrastructure construction. The second, during the past 10 years, was mostly directed at housing and manufacturing. The third phase is targeting the attraction of capital-intensive technology investments, and this is a critical leap in the development of China.

The foreign investment in manufacturing was driven by labor arbitrage and has now been exhausted, as labor costs in China are on par with most of the rest of the developing world and rising. The attractiveness of China as a destination for technology investment is being driven by a very business-friendly and hands-off regulatory environment; especially when compared with the U.S., Japan and Europe.

So far, this has caused FDI inflows to China to remain strong, even as tensions between China and the U.S. have increased and as the Chinese government appears to be preparing for a much more conservative government than has been the case over the past 10 years.

The continuation of this process is absolutely necessary for the Chinese economy to advance further. The ending of the labor arbitrage benefit to foreign companies means that China will have to rely less on exports and more on an increase in domestic consumption and activity.

As the country goes through this change, the inflow of FDI for technology purposes to counteract the diversion of manufacturing investment to other parts of the world is paramount, as there is no turning back.

If China loses the technology FDI as a result of alienating investors with a new overly conservative government, the country will be set for a crash of historic proportions, and that has occurred repeatedly throughout history.

For now, everything appears to be on track for a smooth transition to a new government in China that continues to be friendly to foreign investors.

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I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
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