A new World Bank report released yesterday entitled Foreign Capital Utilization in China: Prospects and Future Strategy praises China for its success in attracting foreign direct investment (FDI), and recommends China to opt for policies that encourage FDI to align more with the country's new objectives of achieving a harmonious society.

Attracted by the country's relatively good investment climate and low wages, and more recently by its growing domestic market, China received about 25 percent of all the FDI to the developing countries over the last decade. In the years from 2006 to 2010, China is expected to account for some 30 percent of the projected US$250 billion of FDI inflow to the developing countries. "In the 11th Five-Year Plan period, China is likely to focus on more balanced development. The 'Five balances' call for growth that is more focused on domestic development, that is more evenly spread across China's regions, and that is less resource intensive," said Zhao Min, World Bank economist and lead author of the report. "For FDI policies, this would imply that greater attention should be given to investments in domestically-focused industries, to investment in the interior, and to investments with a higher level of technology."

The report made five policy recommendations on how to optimize the use of FDI:

• maintaining an attractive investment climate;

• leveling the playing field in taxation;

• opening up further the service sector for FDI and competition;

• maximizing technology transfer and directing more FDI to go into the high-tech industry; and

• improving the investment climate and investor relations in the interior regions.

The report suggests that while China's investment climate is overall strong, it can be better if China reduces the complexity of investment approvals; increases government effectiveness by reducing overlap in authority and duplication in registration and approval requirements among agencies; improves access to equity finance of foreign- invested firms through capital market reforms; and reforms its judicial system.

Fewer tax incentives for foreign investors are unlikely to reduce FDI inflow significantly, although "round-tripping" may disappear, causing a drop in measured but not actual FDI, according to the report. Equalizing domestic and foreign income tax rates can best be done through merging the two existing tax codes, as has already been decided by the Government. In merging the tax codes, China should remove distortions from the current codes, including the limited tax deductibility of the costs of R&D, labor, marketing and depreciation. If tax preferences are to be given, they should not discriminate on the basis of ownership, and should be in line with China’s industrial and regional development policies going forward. Presenting the costs of tax incentives together with the budget could reduce the lobbying for inappropriate incentives.

The rising costs of land and labor in the eastern provinces open up opportunities for the central and western provinces. At the same time, lower costs is no guarantee that industries will move there over time as competition from other countries as well as efficiency gains in the Eastern provinces play a role as well. Inland provinces could gain a competitive edge in attracting FDI by stepping up their efforts to improve the investment climate, focus their efforts to attract industries in line with their comparative advantage, and seek cooperation with the coastal regions. Central government can play a role as well: it could level the playing field by phasing out the incentives that largely benefit the eastern region, such as special economic zones and tax preferences; it should review the restrictions on FDI in sectors in which the interior has a particular advantage, including natural resources and public utilities such as water, electricity and gas; and it should step up efforts to remove regional policies and practices that prevent domestic market integration; and improve the efficiency of the transport industry.

To promote its goals in service and high-tech sectors, China should continue to boost the educational level of its labor force; put more efforts into enforcing intellectual property rights; improve the environment for R&D, in particular for in-firm R&D, and improve the general living environment of cities.

(China Development Gateway September 28, 2007)