China attracted a record US$46.9 billion in foreign direct investment (FDI) in 2001. Actual FDI in the first five months of this year rose 12.38 percent year on year to US$16.92 billion , according to China’s Ministry of Foreign Trade and Economic Co-operation (Moftec). The word actual, in this context, indicates the money was invested rather than just contracted.

Although still impressive there is some indication that the immediate post-World Trade Organisation (WTO) entry euphoria is wearing off. That initial surge may have been due simply to overseas investors waiting for any uncertainty regarding WTO entry to be clarified. Doomsayers can point to a downward trend because actual FDI reached US$14.13 billion between January and April, surging almost 30 percent compared with the same period a year ago. Still, standing at some US$2.79 billion the apparent fall-off in the fifth month (May) looks, well, more apparent than real.

Contracted FDI - which indicates investment intentions - picked up in May however, rising 7.29 percent year on year to total US$27.86 billion in the first five months of the year. By comparison, contracted FDI rose 5.1 percent to US$21.28 billion between January and April.

All of which would seem to suggest that while the level of actual FDI may be falling slightly, promises of future investment remain buoyant.

It is worth bearing in mind that FDI figures are by nature volatile and can change from month to month as big deals are signed.

Moftec also announced that 11,612 new foreign-invested enterprises (FIE) were set up in China in the first five months of this year, up 23.26 percent. This looks encouraging and the casual observer would take all this as proof of the confidence foreigners have in China’s economy continuing to boom.

Except that much of this FDI is not foreign at all but is comprised of funds originating in China and recycled back to the mainland. No one is sure of the scale of this recycling, but many believe it accounts for a very sizeable proportion of the total. There are several causes, but the most common (and the easiest to understand) is the disparity between taxation rates imposed on local Chinese firms and those applied to FDI enterprises.

Since the early 1990s, when China under then paramount leader Deng Xiao-ping, opened it’s doors to overseas investment and began the process of liberalising its economy, special advantages have been offered to foreigners as an inducement to enter the mainland. The Special Economic Zones (SEZ) were set up specifically to offer all kinds of inducements – tax breaks and favourable tariffs being just two. Soon almost every city of substance was busy touting similar or better breaks and, in no time at all, even townships and villages were giving out tax holidays to overseas investors.

The results were often that local companies might be footing tax bills of 30-40 percent while nearby FDI enterprises paid nothing.

Although many Chinese companies, and especially the lumbering State Owned Enterprises (SOE), were indeed woefully inefficient by any criteria, the better among them were obliged to compete on a decidedly uneven playing field. A fact often overlooked by those pointing to the success of FIEs against domestic competitors.

Needless to say it was only a matter of time – and by all indications very little time at that – that local Chinese companies, both those privately owned and the managers of large SOEs, realised that all they had to do was move funds out of the country and reinvest back into China when it would qualify as ‘foreign’ capital and open to all the breaks open to FDI.

No one knows the size of this circular flow of capital, but it could be very large. It could easily account for anywhere between one quarter and one half of FDI total. There is good cause to believe that much was sanctified, certainly condoned, by very senior people in the government. There was certainly enormous financial gains to be made and, arguably, it was just good business. Why invest in a new development with a 30 percent tax rate when, with a little imagination, that same money could be invested tax free, and with some other concessions – such as free factory buildings – being thrown in maybe as well?

The scheme of special allowances for FDI had a legitimate purpose, and it worked. The loser, however, were government coffers. As always, someone ends up paying.

Now, the announcement that FDI tax breaks will start being phased out beginning, according to government sources, in 2003.

The move is triggered by China’s WTO entry, under which special tax concessions are specifically prohibited. But, even without WTO membership the move is long overdue and would probably have been initiated anyway. From next year on the level of FDI will be a more accurate barometer of how overseas investors really view investing in China. If overall levels fall of sharply, as they likely will, they will nonetheless be a great deal more meaningful.