Could China Close The Door To Foreign Investment?

After nearly three decades of economic growth fueled in large part by massive foreign investment, there are an increasing number of voices in China saying that it may be time to rethink the country's openness to foreign capital, brands, and companies. While fully closing the door to these influences would undoubtedly result in significant harm to the Chinese economy and is thus unlikely, if not impossible, critics argue that shutting the door partway could help cool over-investment and protect Chinese companies and interests from what they term a new generation of foreign raiders. These same critics also advocate fostering and protecting Chinese national champions to do battle with foreign multinationals both in and outside of China.

China's National Bureau of Statistics, for example, recently warned that the purchase of Chinese companies by foreign competitors is likely to lead to monopolies and, after a lengthy investigation, the State Administration for Industry and Commerce published a report warning of the danger of monopolies posed by multinational companies in China and proposed countermeasures. One government think tank also advocated the creation of an early-warning mechanism to safeguard against foreign takeovers of Chinese companies.

Even a limited reversal of Chinese openness to investment could have significant ramifications for global investment and trade patterns. Foreign Domestic Investment ("FDI") into China has been growing at a steady pace for years and, although the increase has leveled from its meteoric rise in the years leading up to and following China's WTO Accession in 2001, it is still significant. According to World Investment Report 2006, China was the third largest recipient of FDI in 2006 and the largest FDI destination among developing countries. Official Chinese government statistics show that FDI into China topped $72 billion in 2005, up from more than $60 billion in 2004 and $53 billion the year before. Acquisitions of Chinese firms by foreign entities are reported to account for approximately one-fifth of these investments.

It is important to note that some numbers relating to FDI into China may be overstated as a result of what has come to be called "round tripping." Round tripping occurs when investment capital is sent out of the country by Chinese entities only to return as foreign investment, which can result in a number of preferential tax benefits and other subsidies for the recipient enterprises. A review of the primary sources of China's FDI indicates this practice may add significantly to China's FDI total. The largest sources of FDI into China, in order, are Hong Kong, the Virgin Islands, Japan, South Korea, the United States, Singapore, Taiwan, the Cayman Islands, Germany, and Western Samoa. Clearly, some of these sources could serve as a convenient place to turn what was originally Chinese money into foreign capital. Regardless, however, of whether China might actually be the fourth largest recipient of FDI or even the seventh, the fact of the matter is the country is a major destination for foreign capital, and the continued lure of the "China market" virtually ensures it will be for the foreseeable future, unless of course the Chinese government decides to stop or slow it.

There are many reasons why some Chinese view foreign investment cautiously. First, many people speak openly about the need to protect the Chinese identity from foreign influence. Some of this sentiment can be traced to what Chinese call the "century of humiliation" running from the mid-19th to 20th centuries, during which many in China perceive the country was bullied by foreign powers. More pragmatically, factors such as WTO accession and the resulting competition from foreign companies has caused large layoffs around the country and an end to what was previously termed the "iron rice bowl" - a promise of job security, a steady income, and other benefits from the state. There is also some concern that state-owned assets could be improperly privatized and sold off to foreign interests for a quick profit but to the long-term detriment of the country.

Commensurate with the large volumes of FDI flowing into China, the Chinese government has actively encouraged Chinese companies to invest overseas. In fact, Chinese foreign investments grew at an annual rate of 65 percent between 2002 and 2005. While some of these campaigns succeeded, such Lenovo's bid for IBM's personal computer division, others did not. The failed attempt by the China National Offshore Oil Company ("CNOOC") to acquire Unocal in 2005, for example, is cited by some in China as an example of how Chinese investments are not welcome overseas, leading naturally to questions about why foreign capital should be welcome in China. These same individuals point to the decision by the French Government to declare Groupe Danone, maker of Dannon yogurt and Evian water, part of one of several unspecified "strategic sectors" to be protected from foreign takeovers as justification for similar measures in China.

Although recent signals from the government of China about foreign investment are mixed, it does appear critics of foreign investment may be making headway. Although foreign investment in China continues, Chinese government approvals of applications for foreign invested enterprises fell in 2005. Moreover, government approvals for two high-profile investments appear to have stalled, and at least one more is the subject of significant opposition from competing Chinese companies. The National Development Reform Commission, China's most important economic planning agency, is also mulling over a list of enterprises where acquisitions by foreigners would be prohibited.

In addition, the Government of China recently promulgated new M&A regulations governing the acquisition of Chinese firms by foreign entities. Called the Provisions on Acquisition of Domestic Enterprises By Foreign Investors , these regulations replace similar provisions issued in 2003 and are part Hart-Scott-Rodino , part Exon-Florio , and at the same time unlike anything else. The regulations are intended to help the Chinese government more carefully regulate money flows into the country (and manage economic growth), as well as to resolve tensions between central and provincial authorities about who is ultimately responsible for overseeing investment. Generally, the new provisions were welcomed by practicing attorneys as an improvement on the status quo, but they remain intentionally vague on a number of important issues.

The M&A regulations were jointly issued by an impressive array of Chinese government agencies including the Ministry of Commerce ("MOFCOM"), the State-Owned Assets Supervision and Administration Commission, the State Administration of Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission and the State Administration of Foreign Exchange. Given the nature of inter-agency rivalries in the Chinese government (one senior U.S. diplomat once remarked that the dysfunction in the Chinese interagency process made its U.S. counterpart look like a Swiss watch), getting all of these agencies to agree on a single set of regulations is no small accomplishment. MOFCOM now appears to be the lead agency for regulating cross-border transactions, which many perceive as fortunate given the propensity of MOFCOM officials to be foreign-trained and internationally minded.

Like its predecessor, the new M&A regulations require regulatory approvals for cross border transactions involving the acquisition of the equity or assets of a Chinese company. They also contain antitrust provisions and enhance the Chinese government's powers to prohibit or undo acquisitions on the basis of national security. Interestingly, the new regulations also require notification of transactions that would affect ownership of "Chinese famous trademarks and traditional brands," which like many important terms such as "national economic security" and "large market share," remain undefined. The regulations could also result in MOFCOM becoming involved in negotiations if the consideration for a Chinese company is deemed inadequate. The M&A regulations do include a much-anticipated "share exchange" rule. This will allow transactions involving the exchange of shares between Chinese and offshore companies, with certain paternalistic conditions including that the foreign shares be traded on a recognized exchange and enjoy a stable price.

Although not yet enacted, the Chinese government is also considering an antitrust law that would de facto apply almost exclusively to foreign companies. The draft has been under consideration in different forms for nearly a decade, but a revised version was submitted to the State Council (China's cabinet) in 2004 and approved for submission to the National People's Congress in June 2006 and has a fair chance of passage in the near future.

Although trumpeted as targeting monopolistic practices in all industries, many observers worry that the sole target of the law would be foreign companies operating in China. Some observers also worry that "public interest" exceptions in the current draft may lead to the protection of domestic companies at the expense of consumers and foreign companies. The current draft defines a monopoly as one company with a market share of fifty percent or more, two companies acting in concert with a two-thirds market share, and seventy-five percent for three companies acting together. The draft would also require administrative approval of mergers or acquisitions when one party has turnover in China of RMB 1.5 billion (roughly $200 million) or more.

Taken as a whole, it does not appear that China will shut its door entirely to foreign investment in the near future. What is clear, however, is that China appears to have decided to slow, however slightly, the pace of foreign investment, especially when it comes to the acquisition of Chinese firms by foreign companies, and that more restrictions could be forthcoming.

Published December 1, 2006.