Not a day goes by without a glittering news report about China’s attractiveness to foreign investment. China is always eager to harp on its favorable investment climate, and many foreign investors are reinforcing this idea. However, whether foreign investors can truly profit in China remains a big question mark.
At the Fortune Global Forum held in Beijing on May 18, China’s Minister of Commerce Bo Xilai enumerated the achievements of profitability by foreign investors in China, and claimed that out of the 280,000 enterprises with foreign investment, two-thirds of them are profitable. Bo cited a 2004 survey by the American Chamber of Commerce in China: three-quarters of the American firms in China surveyed are profitable, with 42 percent reporting higher profit margins in China compared with the rest of the world. In particular, Bo indicated that the profits of Germany’s Volkswagen joint venture in China accounted for one quarter of Volkswagen’s total profits.
Recently the Chinese version of Fortune magazine published the "2005 Survey of Foreign Investments in China." Once again, it stressed, "Doing business in China is not as unprofitable as rumors may indicate. Another result of our survey indicates that by expanding their existing businesses or establishing their new businesses in China, 56 percent of foreign businessmen believe that they can be profitable within three years, and 90 percent think it is achievable within five years."
However, is the picture so rosy? As a matter of fact, foreign capital flowing into China is near the turning point of a declining curve.
Half of the Foreign Investments Have Been Withdrawn, with Barely More than Half of the Remaining Firms Profitable
The fervent official portrayal of high profitability of foreign investments in China is a warning sign in and of itself. In his report, Mr. Bo omitted two important facts: 1. The retreat of foreign capital in China as a result of investment losses accounts for half of the total foreign investments in China; 2. Out of the remaining half million firms in China with foreign investments, about 220,000 are currently not operational.
These are considered "state secrets" by China, so how did they get leaked? It turns out to be a coincidence. Last year, a fight among high-level officials took place with regard to merging the tax codes of Chinese and foreign enterprises. The State Development and Reform Committee indicated in a report that there is currently so much foreign investment in China that it is threatening the domestic economy. As a result, they proposed to eliminate tax benefits for foreign investors. To counter that, the officials of the Ministry of Commerce in charge of foreign investments disclosed the following data in December of 2004: The foreign investments in China that had been actually used, totaled US$559.023 billion, with nearly half of those funds already withdrawn from China; and 504,568 foreign companies have registered in China, though less than two-thirds of them were actually operational.
Huang Hai, the Assistant to the Minister of Commerce who disclosed the data, said publicly that because of the lack of statistical data in China for direct foreign investments, the widely used metric of "cumulative actual usage of foreign investments" does not reflect the termination of the operations of foreign enterprises or the retreat of foreign capital. So, as of the end of 2004, the net usage of foreign investments was approximately US$250 billion, which was only about half of the US$501.4 billion—the cumulative usage of foreign investments. 
So how is the profitability of these foreign enterprises? The data tells the story.
In July of 2004, Su Xiaolu, an anti-tax-evasion official at the State Bureau General of Taxation of China, publicly disclosed that 55 percent of the foreign enterprises reported losses, although he believed that many of them tried to avoid taxes by doing so. 
The local statistics also demonstrate that the profitability of foreign investments in China is not that good either. According to a survey of 696 major foreign enterprises in Guangdong Province, by the provincial Bureau of Statistics, over half of the enterprises on the east and west side of Guangdong and in the northern mountain area had suffered losses. 
For the sake of convenience, let me summarize the above statistics:
• As of the end of 2004, US$501.4 billion of foreign investment had flowed into China, with half of it already retreated. The net investment is actually US$250 billion.
• Currently there are 504,500 foreign enterprises registered in China, with approximately 280,000 being actually operational. In addition, only two-thirds of the operational foreign firms are profitable.
So can China still be called the "Land of Fortune" for foreign investments?
It is not exactly true that foreign investors are unaware of the truth. In a February 17, 2005, article published in the Financial Times, entitled "China: the Land of Fortune or Tomb for Foreign Investors?" Geoff Dyer enumerated the data that contradicted Mr. Bo’s conclusion: In 2003, the 1.3 billion people of China provided US$4.4 billion in profit for American firms in China, while the 19 million people in Australia helped American firms to pocket US$4.9 billion, and the 95 million people of Mexico provided US$5.75 billion to American firms.
China Is Facing the Second Wave of Foreign Investment Retreat
Currently there are flows of foreign investments both into and out of China. In April of 2005, a number of international giants such as General Electric, Alstom, and Siemens retreated from the Chinese market. If the wave of retreat of foreign investment in China’s power industry between 2000 and 2001 is called the first wave, the current one can be named the "second wave of retreat." 
Peak Pacific (China) Investment Ltd., a foreign enterprise in China, is ranked No.5 in China’s power industry. It is mostly owned by U.S. company Alliant Energy Corporation. As of the end of 2004, this company has invested US$247.28 million in the seven thermo-electric power plants that have a capacity of 400,000 kilowatts. In 2004, four out of the seven power plants of Peak Pacific in China suffered a loss, while the remaining three plants had meager profits. Overall, the company will report a loss.
Siemens also acknowledged at the end of 2004 that together with a German company called HAW—a subsidiary of Sweden’s Vattenfall, it had sold 40 percent of the stock ownership of the Hanfeng Power Plant of Hebei Province.
For the power plants in China that received foreign investment, 2004 was a year of loss, or a barely profitable year. Currently the remaining foreign investment in China’s power industry totals US$14.86 billion. It is questionable if they can still survive in China. The retreat of many of the investments in China is the result of foreign companies wishing to cut their losses.
The automobile industry is another area that foreign investors have had a hard time with in the Chinese market. As Goldman Sachs predicts, the future of Volkswagen in China is not pretty, with a possible loss of 400 million Euros—the biggest loss in the company’s history. While the performance of Volkswagen in the U.S. and European markets is depressed, the company has been on the declining trend in China, an important strategic overseas market for Volkswagen, as a result of its strategic missteps in its products. Since Volkswagen’s auto sales in China peaked at 690,000 in 2003, this number slipped to 640,000. More importantly, Volkswagen’s profits in China have been declining rapidly. According to the Financial Times, in the first quarter of 2005, Volkswagen’s businesses in China were stuck in operational loss. The company is currently striving to keep themselves from a loss on a yearly basis. As Volkswagen’s CFO pointed out, in the very competitive Chinese market, there are still risks in inventory and pricing. The profitability of Volkswagen’s two joint ventures in China has rapidly changed from the 106 million Euros of profit a year earlier to the 17 million Euros of loss in the first quarter of 2005. In response to such rapid deterioration, Volkswagen is being forced to shuffle their top management in China.  It appears that the Chinese Minister of Commerce’s report at the Fortune Global Forum in May was either highly inflated or had grafted Volkswagen’s 2003 profit number to the current one.
How Much "Cost Advantage" Does China Still Have?
The major reason for China’s attractiveness to foreign investments is its cheap labor and low cost of land and rental properties. In addition, the yuan, the undervalued Chinese currency, also makes it possible for cheap Chinese products to compete in the world market.
Since last year, however, China’s advantages have been challenged. Some foreign businessmen complained that in the past ten years, the three categories of costs including operational, management, and external costs have been too high. This has depressed their business development in China, and negatively affected even the foreign businesses in the special economic zones, where foreign businesses enjoy various tax breaks.
The operational costs certainly rise along with the rise of the cost of energy and raw materials. While the import expenses of these two key manufacturing elements are far higher than the cost of land or labor, China’s reliance on the import of energy and raw materials continues to accelerate. As the cost rises, the over-capacity, the lowering of the barrier for imports, and the official stance of high tolerance for widespread low-return investments in China continue to squeeze the profit margin. As many foreign manufacturers estimated, the domestic manufacturers in China spend a lot more on energy and raw materials than their counterparts in other countries, because they have to bear the shipping costs, the import tariffs, and the 17 percent value-added tax.
The most painful problem facing foreign investors in China comes from the overly high management costs as a result of government behavior. Because of the uncertainty of government policies in the eyes of businessmen, many foreign companies are forced to spend a lot of money to lobby the Chinese government. In addition, taxation and other miscellaneous fees by the government are never transparent, which makes it harder for foreign businesses to adapt or predict. In terms of "external costs," protecting intellectual property is one good example. In the past few years, the United States has had more complaints over the breaching of intellectual property than any other and has been forced to spend the most energy and capital. In spite of tremendous efforts, they have still not solved the problem of intellectual property violations by Chinese companies.
These various problems have made the competitive advantage in investing in China a mirage. While China proudly enumerates the annual foreign investments, they are actually in decline.
Foreign Investors Begin to Wait and See
On June 13, the Ministry of Commerce of China disclosed that both the number of foreign invested enterprises and the actual dollar amount of foreign investments declined. Between January and May, 16,437 new foreign companies were approved, a 4.75 percent drop from the same period last year; contractual foreign investments totaled US$64.971 billion, a 14.88 percent increase from the same period last year; the actual usage of foreign capital, however, was US$22.366 billion, a 0.79 percent drop from last year. 
The trend is also reflected in another major example. At the beginning of this year, Jiangsu Province, the Chinese province with the highest level of foreign investment, saw a slight decline in this area as compared to the year before.
From January to November of 2004, there were US$34.591 billion of foreign investments contractually registered in Jiangsu Province, an increase of 31.17 percent from that of 2003. However, only US$10.172 billion actually registered, reflecting a 1.65 percent increase from the same period in 2003.
Despite the No.1 position that it still maintains in attracting foreign investments, Jiangsu Province witnessed a dramatic decline in the growth of foreign capital inflow. What worries the government of Jiangsu the most is: while the actual utilization of foreign investments totaled US$15.8 billion in 2003, that number dropped to US$10.172 billion during the first eleven months of 2004. In order to keep up with the 2003 number on an annual basis, it needs US$5.6 billion more of tangible foreign investments in the last month of 2004. This is almost impossible. To put it another way, the absolute value of foreign investments that arrived in 2004 actually declined tremendously. No matter how the government of Jiangsu explained the gap, the drop in the inflow of foreign capital is an undisputable fact. 
Out of the foreign investment in China, a high proportion is speculative investment. Three agreements have been signed recently between the Chinese and U.S. governments, which will have a profound impact on the flow of speculative investments into China.
The two official documents on the Chinese side include:
1. The No. 11 Document, or "Notices regarding perfecting the administration of foreign investors purchasing foreign currencies," published on January 24, 2005, by the Bureau of Foreign Currency Administration. The main purpose of the document lies in preventing capital from leaving China.
2. The No. 29 document, titled "Notices on registration of overseas investments by Chinese residents and of foreign investors purchasing foreign currencies in China," was issued on April 8 by the central government because the No. 11 document was not detailed enough and too hard to enforce. In the eyes of international venture capital investors, this document signals a trend of policies to tighten the capital markets.
The two official documents have the same goal, namely, to make it harder for speculative investments to exit.
The "Homeland Investment Act" initiated by the U.S. government back in October of 2003 became effective on May 1, 2004. This act dramatically lowered the income tax of overseas profit by American firms from 35 percent to 5.25 percent within a one-year period, provided that the overseas income is re-invested back to the U.S. According to Morgan Stanley, this will bring over US$400 billion back into the U.S.
It is said that after being broadly impacted by the No. 11 and No. 29 documents, speculative investments are currently stalled. According to people familiar with the industry, the ultimate goal of the speculative investments is to profit from the potential initial public offering (IPO) or the Merger and Acquisition (M&A) of the invested companies in the international markets. Such investments rely on a mechanism of utilizing foreign capital and safely exiting in the overseas markets.
The operational model of speculative investments is described as follows: First invest in a domestic company in China; register an offshore holding company at British Virgin Islands (BVI) in the name of a subsidiary; then let the holding company purchase the operating company in China, and finally push it to the IPO market by the well-financed holding company. For such investments to succeed, the exit channel is critical. Without the exit channel such as IPO or M&A, speculative capital will not flow in at nearly the same rate.
As indicated in the "2004 Investigation and Analysis of the Speculative Capital Industry in China," out of 123 venture capital investments that exited in 2004, 40 percent or 49 investments exited in the form of purchasing domestic firms, while only 3 percent, or four projects, exited in the form of IPO. In 2004, speculative capital in China totaled US$43.9 billion, an increase of 34.93 percent over those of 2003. 8
With both exit routes blocked, the venture capital investments are stalled. This is certainly not the original intent of the two official documents, but they have indeed negatively affected how Chinese firms can be capitalized in the overseas markets.
Based on the above analysis, the trend is clear: The frenzy in China is fading. Many managers in the investment banking industry admit that the global interest in the IPOs of Chinese companies is declining, and the investment funds are shifting to other markets. The decline of the direct foreign investments in Jiangsu Province and the retreat of foreign investments in the manufacturing sectors are only the beginning of this wave of retreat.
 "Local governments need foreign investment, suspension of the merger of two taxation system," http://finance.sina.com.cn, December 18, 2004
 "Foreign companies evade taxes of 30 billion Yuan every year," Global Times, July 7, 2004
 "Half of foreign companies in the east and west side of Guangdong and its northern mountain area have losses," Private Economy, May 25, 2005
 "Hundreds of billions Yuan of foreign capital retreats, the cause of second wave of retreat," http://finance.sina.com.cn, May 13, 2005
 Ke Zhixiong, "Dramatic drop of foreign investment, understand the reasons behind the retreat of foreign investment," 21 Century Economic Report, June 15, 2005
 "Will Latin America phenomena appear in South Jiangsu and Guangdong," http://www.sina.com.cn January 12, 2005
 "International speculative capital starts to wait and see", http://www.eobserver.com.cn/
Mrs. He Qinglian is a prominent economist and journalist from China.