New rules make foreign investment a little easier in China




Slowly but surely, market access for foreign direct investors in China is improving. The latest hop forward is a comprehensive Foreign Investment Law—not because it breaks much new ground in terms of allowable sectors, but because it should reduce red tape.

China is advancing a range of new investment regime changes as part of a 2020 economic reform agenda first unveiled in late 2013 at the Third Plenum of the Communist Party’s 18th Central Committee, just after the launch of the Shanghai Free Trade Zone (SHFTZ). The SHFTZ opened with great fanfare, but so far has not delivered on its expectations, leaving many investors skeptical of China's willingness or ability to increase market access for foreign firms.

The most prominent changes proposed in this new round of reforms are arguably the new Foreign Investment Law and to the existing foreign investment catalog. The number of restricted sectors is also scheduled to shrink a little more. However, most of the open sectors are in industries where significant overcapacity exists or national champions are already well-established and would be difficult to dislodge. The largest opportunities in the future are likely to be in service sectors, such as finance, healthcare, and education, and are still restricted to varying degrees.

Overall, the market for direct investment has substantial room for growth. Although China is the world’s No. 2 destination for foreign direct investment (FDI) after the United States, its scale of foreign investment relative to the size of the economy remains well below average. FDI in China continues to increase, but at a reduced rate. Most of the Chinese economy outside manufacturing remains off limits to foreign investors, and manufacturing on its own has grown so much that there are fewer attractive FDI opportunities available

A law is born

The new Foreign Investment Law, slated to go into effect by the end of 2016, will replace a number of older, heavily revised laws, which had elements that sometimes conflicted with China's Company Law. The new set of statutes is designed to dovetail with the existing domestic Company Law, and most foreign lawyers say it succeeds in this respect.

The draft law includes five key provisions:

  • Nationwide treatment of foreign entities. Receiving a clear green light on an investment will be much easier now, as only the bureaus of Industry and Commerce will need to give their approval, as opposed to from many different national and provincial agencies.
  • A “negative list” of business sectors. These are areas where foreigners either aren’t allowed to invest entirely or to which they are given only restricted access. The list is not a comprehensive one, but the sectors that are not shown on the list represent economic areas where foreigners can compete on equal terms with domestic players.
  • A national security review. This is mandated for any project that includes a greenfield investment, long-term financing, a license to mine natural resources or build critical infrastructure, acquisition of real property, or the establishment of corporate control of a domestic entity. Unlike the old national security law, the new national security provision is almost wholly discretionary, and grounds for rejection may possibly include the protection of domestic economic interests. Such decisions will not be subject to appeal. Some foreign companies are concerned about this provision, especially if they have to provide detailed business plans to review committees.
  • Control as a form of ownership: The draft law defines foreign control of an organization to mean foreign equity of over 50%, a right to nominate at least half the board of directors, or sufficient voting rights to have a major influence over shareholder and director decisions.
  • Reporting changes: The draft law also introduces reporting requirements that may potentially be used to discriminate against foreign companies after their market entry. Like the national security review requirements, the form that this new reporting requirement takes is likely to signal how far the Chinese government is willing to pursue the principle of national treatment of foreign investors.

Clear demarcations made by the foreign investment catalog

The foreign investment catalog, formally known as the Revised Catalog for the Guidance of Foreign Investment Industries, divides the economy into three sets of industries: sectors in which foreign investment is prohibited; sectors in which it is restricted; and sectors in which it is encouraged.

In the first set, sectors on the prohibited list are off limits to foreign investors. In the second set, sectors on the restricted list typically present additional administrative hurdles in entry, including the need for approvals from higher-level authorities, which may be slow in coming. In the third set, sectors on the encouraged list specify where foreign investment is not only permitted but actually encouraged—for example, via tax concessions.

In some cases, these concessions vary by region. Some encouraged sectors, for instance, receive additional concessions if the investment targets China's less developed western regions. For the most part, the latest catalog improves market access for sectors where investment was already permitted, while sectors previously closed to foreign investors stay closed.

In the new edition, the number of prohibited sectors fell from 39 to 36, the number of restricted sectors from 80 to 38, and the number of encouraged sectors from 354 to 349. 

Uncertainty remains concerning the overlap between the existing Catalog for the Guidance of Foreign Investment Industries and the proposed negative list. Clarification about the relationship between these lists is a key issue that observers hope to see worked out in the final version of the law. It is wholly possible, and very likely in the view of IHS, that the initial negative list will simply replicate and replace the “Prohibited/Restricted Sectors” lists from the current Foreign Investment Catalog.

Changes introduced by the new catalog

Although parts of the country’s agricultural, industrial, and services sectors were liberalized, the changes tend to favor service-sector development, aligning with the government’s long-time objective of “economic restructuring.”

For China’s agricultural sector, the new catalog makes relatively few changes to foreign ownership rules. However, some of the changes could be hugely important for foreign agricultural firms, especially those that focus on research and development.

For the industrial sector, encouraged segments within resource extraction and manufacturing saw plenty of tweaks and consolidations. While many of the changes are merely clarifications or affirmations of the status quo, in some cases production thresholds were added or removed as eligibility requirements for investment incentives. In many heavy manufacturing sectors, openings were made for sectors that had weaker growth outlook but nonetheless may be of importance to firms in those segments.

Not surprisingly, the services sector saw substantial changes under the latest catalog. It is the sector of the economy that has shown greater stability during the economic slowdown, and also the area that Chinese leaders have emphasized because of the pace at which it has hired workers. Services also happen to be an area where restrictions lingered longer after China became a member in 2001 of the World Trade Organization (WTO), even as a majority of legal barriers gradually fell for much of China’s industrial sector. Given China’s vastly underdeveloped elderly care sector and expected demographic trends in the coming decades, services is likely one of the most promising additions to the encouraged list.

I.  Encouraged/Permitted sectors

A. Encouraged sectors: In the new proposed catalog, a few more business areas have been added to the list of encouraged sectors, including:

  • Agriculture: Farming of crops used in Chinese traditional medicine.
  • Industry: Improved exhaust systems for motorcycles; light-rail transport equipment (but only through a joint venture); geologic sensing equipment; environmental monitoring equipment; electrical network construction and management.
  • Services: Accounting and auditing services (which no longer require a joint venture, or that the head partner in China be a Chinese national); environmental protection; Internet of Things research; and applications design services related to industrial facilities, architecture, fashion, and other creative industries. Operation of theatrical venues (previously a joint venture was required); encouragement of non-degree vocational training (which replaces several similar educational segments under the prior list, and now allows full foreign ownership); and
 eldercare facilities.

B. Permitted sectors

  • Agriculture: Cultivation of genetically modified trees; processing of precious tree species; cotton seed processing; and research and development related to genetically modified seeds.
  • Industry: Mined ores; beverages; tobacco; printing and inks; raw chemicals production; pharmaceuticals; chemical fibers; non-ferrous metals smelting and pressing; and transportation equipment.
  • Services: Retail operations, and includes a waiver on the restrictions on the number of stories in a chain that can be established; insurance real estate investment; land development; premium hotel and office buildings; second-hand markets; agency services; and foreign legal consulting (i.e., interpreting the legal systems of foreign countries).

II. Restricted sectors

Services where investment is now restricted will include tobacco sales; the financial sector (prior restrictions adjusted, but the minority shareholding cap will maintained); commercial banking; and securities firms. Finally, primary-tertiary education now requires a Chinese majority shareholder.

III. Prohibited sectors

  • Agriculture: Production of genetically modified seeds is not allowed.
  • Services: Investment in law consulting, such as a foreign firm interpreting local law, is no longer permitted. Higher-education facilities are off limits as well.

Why the changes overall?

The industrial sectors being opened are primarily those that currently suffer from overcapacity. Reclassifying these sectors from “restricted” to “permitted” will have relatively little impact on the macro-economy.

Where more meaningful openings are occurring, they are generally incremental. This is most evident in the service sector. For example, the loosening announced in several finance segments is very familiar to those that witnessed China's banking sector "liberalization" after its WTO entry, in which some nominal liberalization took place but actual changes happened slowly and not to a degree attractive to foreign investment. To an extent, China tends to reserve the most promising opportunities for its own companies. IHS believes that protected industrial and service sectors such as education, healthcare, and utilities will continue to be among those least open to FDI, either through explicit barriers or due to other complicating domestic policies (e.g., those that regulate operating conditions for any private firms in a sector).

But even though the impact of the reclassification may be limited overall, there will still be a major effect in certain industries. For example, the April catalog revision liberalized FDI into e-commerce platforms. Following that development, FDI growth in the retail sector (which includes e-commerce) surged from 17% during January-May to 126% in June—likely related to an announcement of Wal-Mart becoming one of the first foreign retailers to take full ownership of a local e-commerce platform, Yihaodian. 

Complementary policies

Three other new policies are being introduced that relate closely to China’s goal of reforming its entire investment regime, both foreign and domestic:

  • A 2020 deadline for domestic investment reform. The government is looking at 2020 as the deadline for domestic investment rules that will improve consumer choice and unfettered market allocation of basic resources. For example, the government now proposes the drafting of negative investment lists for domestic investors by local governments, which provincial-level governments will send to central authorities for approval.

    Other changes will include a shift to “filing for record” to replace the current system of “apply for approval”, along with demands that the number of forms and response time be significantly reduced. The document also called for improving China's bankruptcy system, breaking regional monopolies, and more related market oversight by regulatory bodies.

    Although negative investment lists might sound like a circuitous way to achieve an unfettered economy, these policies could represent a step forward in China's domestic investment regime. However, this will first require concrete steps from the many organizations involved in China's labyrinth of central and local investment administration.

    Significantly, these provincial negative lists will apply to domestic investors, not foreign investors. Nonetheless, the lists are expected to shorten over time; improved market entry for domestic private investors is also a positive for productivity growth in the economy. While the progress toward implementation is unknown, some provinces have already indicated they will publish detailed lists of administrative approval rights, including for domestic investment, in 2015, with sub-provincial governments to follow in 2016 and 2017.
     
  • A bilateral investment treaty with the United States. China is negotiating a bilateral investment treaty with the United States. At the 2013 Strategic and Economic Dialogue summit, the two sides agreed to negotiate on the basis of pre-establishment national treatment, a considerable milestone that should ensure a standard of national treatment considerably higher than in many other agreements, such as under the WTO, which normally uses a post-establishment national treatment standard. Under the chosen format, there should be no restrictions on US firms investing in China, and vice versa, except in areas where domestic private firms are unable to invest due to government restrictions or monopoly. Both sides predict that negotiations will take three years, but they may be overly optimistic: a similar China-Canada agreement took 18 years to negotiate.
     
  • Freer trade within Asia-Pacific. In late 2014, China concluded a free trade agreement with Australia that opened up more of China’s service economy to Australian firms. Similar trade negotiations continue with South Korea and the Association of Southeast Nations (ASEAN) bloc of countries. Most of these efforts point toward incremental liberalization over time.

Service sector investment

The government is also reconsidering service sector investment. A February document by the Chinese State Council added a number of service-related items to its to-do list, including:

  • Expand service trade volumes
  • Optimize the service trade structure
  • Build functional service trade zones
  • Promote foreign investment in finance, education, culture, and health care
  • Relax foreign investment controls in child and elderly care, architecture, design, accounting, auditing, commerce, logistics, and e-commerce

FDI, ASAP?

FDI is often framed in protectionist terms. But viewed purely as capital, restrictions to FDI lock foreign capital out of the market. Between the 1990s and 2013, IHS estimates that declining FDI intensity cost China $400 billion in new investment. Going beyond just maintaining the 1990s status quo, if China’s FDI intensity (and related rules) matched those of the United States, China’s stock of FDI could have been $1.7 trillion higher in 2013. Reform today wouldn’t attract this much capital right away, but it could bring back growth to FDI of 15-25% a year for the next decade.

Unfortunately for foreign investors, however, policymakers have not yet demonstrated the kind of commitment to sector-access liberalization it would take in order to dramatically encourage new capital to enter the market. Instead, authorities have continued a piecemeal approach. Market entry, for instance, is only a first step, as the Chinese government would also have to ensure a level playing field for foreigners operating in the domestic market—which involves addressing an entirely separate set of laws and policies.

Brian Jackson is senior economist, IHS Economics & Country Risk