An odd thing has happened to China on its journey toward economic modernity.

Foreign direct investment (FDI) has soared in recent years. This is usually taken as a positive sign that China’s economic policies and business practices are humming along nicely. Indeed, institutions such as the World Bank have credited FDI as a key driver of China’s macroeconomic boom, and international ratings agencies see foreign investment as such an important vote of confidence that they use FDI to determine China’s creditworthiness.

But FDI has proven to be a mixed blessing, according to Yasheng Huang, a professor at the Massachusetts Institute of Technology’s Sloan School of Management and a former professor at the Harvard Business School. In a recently published book, Selling China: Foreign Direct Investment During the Reform Era, Huang argues that the investment capital that has entered China since economic reform began in 1979 is actually a sign of economic weakness. FDI has come to play such a significant role “because of systemic and pervasive discrimination against efficient and entrepreneurial domestic firms,” he writes.

The discrimination was not intentionally designed by the government to benefit foreign firms; instead, it was intended to keep inefficient state-owned enterprises (SOEs) running. More broadly, says Huang, Chinese policymakers have had an even bigger goal in mind in their reluctance to endorse large-scale privatization: the preservation of socialism. Reforms in China have differed from those in Central and Eastern Europe precisely because those transitional economies are committed to promoting capitalism, while China has been unwilling to relinquish its command-and-control, collectivist ideology.

“It is still a socialist government committed to a socialist system,” Huang says in an interview. “They view private entrepreneurs as the political enemy, even though private entrepreneurs are the most successful generators of taxes, income and employment.”

Huang identifies several reasons why the policies of China are anything but conducive to fostering a climate of private ownership. First, although there is plenty of investment capital in China, most of the money is either allocated to SOEs or invested abroad by the government. In addition, China’s political institutions make it difficult for private businesses to flourish; legal protection for private property, while improving, is still poor, forcing owners of private businesses to keep a low profile to avoid being harassed by authorities. What’s more, market fragmentation has hurt domestic firms more than it has foreign firms; local governments fight to protect their hometown industries with the result that it is often easier for private companies to export goods to foreign countries than to cities and towns in other Chinese provinces.

Huang got the idea for the book while poring over economic data. He noticed two things that left him puzzled. China absorbed a large amount of FDI from 1979 to 2000 — about $346.2 billion, most of it concentrated during the period from 1992 to 2000 – but at the same time the country was exporting capital to the rest of the world. This pattern is uncommon among developing countries. The net result, Huang learned, was that private business people have had a hard time getting the money they need to start or expand companies.

Capital finds it way out of China through several channels. The Chinese government itself controls a vast quantity of foreign exchange and the government invests this money in U.S. Treasury bonds and other foreign securities. Private firms themselves also shuttle money out of the country. “It’s murky and hard to know what they do with the money,” Huang says. “They park it somewhere to protect against arbitrary seizures of these assets by the government.”

Most of the capital that does remain in the country is typically destined for SOEs, not for private businesses. The overwhelming portion of bank loans in the 1990s went to state-owned enterprises; until the central government lifted restrictions in 1998, the four largest state-owned banks were simply not allowed to lend to private firms. The only way for private companies to finance growth up until that time was from retained earnings. A World Bank survey in 2000 found that even though China has a huge banking sector, private firms in China were among the most dependent in the world on internally generated capital.

In his book, Huang tells a funny story that illustrates not just financial discrimination against private firms but the uncommonly long memories of some socialist ideologues. A private entrepreneur had a profitable real estate company in Beijing and was the largest depositor at the local division of a major bank. In 1997, the entrepreneur used an intermediary to try to arrange a meeting with the head of the division. The division head refused to see the businessman, saying: “I have a policy of never meeting with private entrepreneurs. Our bank division once lent money to private farmers in 1954 to buy donkeys. They never returned the money.”

Officially, the Chinese constitution did not even recognize privately owned enterprises until 1988, 10 years after Chinese leader Deng Xiaoping launched the economic reform movement. “There is a political pecking order of firms,” Huang explains. “SOEs are at the top and private firms at the bottom, with foreign firms somewhere in between. Even though SOEs have strong constitutional protections and financing — all of which are advantages — they are intrinsically bad firms and they cannot compete with foreign firms. And privately owned firms can’t compete with foreign firms either because they can’t get financing. This is why foreign firms have established such a prominent position in the Chinese landscape.”

It is interesting to note that the Chinese government divides privately owned firms into two types: “individual businesses,” which are allowed to employ no more than eight people, and “privately operated” firms, which are permitted to hire more than eight. Individual businesses are considered more ideologically acceptable than the other kind of private firm. Before the acceleration of reforms in the 1990s, there we so few privately operated firms that they did not warrant inclusion in Chinese statistical sources.

Herbal Medicines

Private firms have been treated so badly by government policies that they are forced to concede market share to foreign companies even when it comes to indigenous products, such as herbal medicines, that the Chinese should have a lock on making and marketing. “These are the kinds of products that Chinese entrepreneurs have been producing for thousands of years,” says Huang. China’s herbal medicine business is dominated by firms from Hong Kong and Taiwan, which are foreign in a legal, if not a cultural, sense.

Other sectors where private firms in China would be expected to do well, but are not, include labor-intensive manufacturing businesses such as shoes, clothing and furniture.

“Even in these industries you don’t really find the emergence of a world-class domestic firm,” Huang says. “Even though China now supplies to the U.S. and Europe a vast quantity of garments and shoes, you don’t find a domestically owned company actively doing design work and distribution. The domestic firms are just doing manufacturing and processing, very simple stuff. Many people say, ‘Give them more time.’ The fact is, China has been doing this since 1978. Turkey began doing garment production at the same time, in the late 1970s, and in Turkey you find large garment manufacturers who also design their own clothes, do research and development, and hold fashion shows. They are very active internationally. You just don’t find the same thing in China.”

Government policies have also stymied attempts by China’s home-appliance industry to become stronger. Since appliances are technologically simple products, private companies in China should be able to excel at making them. In the 1980s, the government threw a lot of financial support behind state-owned appliance firms, but they ended up failing because they were so poorly run. “Had [the government] supported private firms rather than state-owned companies, today you would have been able to see some of the largest firms in the [global] home-appliance industry coming from China,” Huang says. “They bet on the wrong horses in the 1980s. They bet on the slow horses and the fast horses didn’t get a chance.”

Perhaps the best-known Chinese company is Haier Group, a diversified appliance maker that got its start as a refrigerator manufacturer in the 1980s. Haier — whose motto is “Haier and Higher” — now has offices in Europe and the United States and annual worldwide sales of $1 billion. Huang notes that Haier started out as a state-owned firm and was about to go bankrupt when the government, apparently assuming the company was doomed no matter who owned it, allowed it to be taken over by a private entrepreneur. Soon, he turned the company around.

Huang says some of the most successful private firms in China are operated not by educated elites in Beijing and other big cities but by ordinary people in rural areas. The reason is that the government in the 1980s and 1990s was more tolerant of private enterprise in the countryside because officials did not view these companies as potentially serious competitors to state-owned businesses.

One noteworthy rural firm is called Hope, which started out as an animal-feed producer. Today, Hope has other product lines but not much is known about the company. “That tells us something,” Huang says. “Private entrepreneurs are cautious. They don’t want people to know much about them. Once attention is focused on them, that’s the end. They will be arrested or harassed.” Some private business owners who turned up on a Fortune 200 list of the world’s best small companies in 2002 later found themselves under investigation for corruption and bribery, according to Huang.

People who own private firms are often targets of tax audits, Huang adds, despite the irony that the government receives more in tax revenue from the private sector than from SOEs. Harassment can also take other forms. One entrepreneur told Huang that if he were to borrow money from a bank, he would not be able travel abroad. If he tried to leave the country, he would likely be arrested on suspicion that he was planning the trip in order to abscond with the money.

A Comparison with India

In article in the July/August issue of Foreign Policy magazine, Huang and a co-author, Professor Tarun Khanna of Harvard Business School, describe how India in the last couple of decades has outstripped China in incubating companies that operate successfully on a global scale.

“India has not attracted anywhere near the amount of FDI that China has,” Huang and Khanna write in the article. “In part, this disparity reflects the confidence international investors have in China’s prospects and their skepticism about India’s commitment to free-market reforms. But the FDI gap also is a tale of two diasporas. China has a large and wealthy diaspora that has long been eager to help the motherland, and its money has been warmly received. By contrast, the Indian diaspora was, at least until recently, resented for its success and much less willing to invest back home. New Delhi took a dim view of Indians who had gone abroad, and of foreign investment generally, and instead provided a more nurturing environment for domestic entrepreneurs.”

As a result of its more business-friendly climate, India has managed to give birth to companies that are good enough to compete with U.S. and European firms in such leading-edge industries as software and biotechnology. Last year, the Forbes 200 ranking of the world’s best small companies included 13 Indian firms but only four from mainland China.

“The most dynamic small firms are coming out of emerging markets,” Huang says. “The top firm in the [Forbes] survey was an Indian firm, and Haier got a score lower than the 10^th-ranked Indian firm. This tells me two things. One is that China did achieve a dramatic economic miracle, but that the miracle was in large part a result of FDI rather than indigenous growth and indigenous entrepreneurship. The other thing it tells me is the most important thing for the Chinese leadership to do now is promote internal reforms as opposed to focusing excessively on FDI. In the last 20 years, they’ve been focused on FDI as a driver of growth. In fact, they have promoted policies that have suppressed growth.”

Steps Toward Reform

Huang stresses that he thinks China’s leaders have begun taking important steps to counter the mistakes of the past. In 1998, the government allowed banks to make loans to private companies. That same year, authorities also permitted private firms to export goods directly; before that, firms had to sell goods abroad through a state-owned trading firm, an inefficient system that crippled exports. In 1999, the government revised the constitution to strengthen private-property rights.

One result of the reforms that have taken place since 1978 has been the growth of the private sector. In 1991, private companies’ share of one sector of the economy, industrial output, was just 5.7%. By 1998 – before the most recent reforms, but a year after the government explicitly endorsed limited privatization, private firms accounted for 17 percent of industrial output.

More reforms may be on the way under Hu Jintao, who became China’s president in March. On June 12, the Financial Times reported that China had set up a secret, top-level group to draft constitutional changes that would overhaul the country’s political and economic landscape. Among other things, the amendments would give property owned by private enterprises the same legal protection as SOEs. “This would be one of the most significant changes since the 1949 revolution that brought the Communist party to power,” the newspaper said. At present, the constitution provides protection for “socialist public property,” but the document does not mention private enterprises.

Huang considers Hu Jintao “head and shoulders” above previous leaders Jiang Zemin and Zhu Rongji.

“In the next revision of the constitution, the fundamental change will be a political one,” Huang says. “[Chinese officials] have got to be committed to private-property rights. They have to trust the market. They have to create a nurturing environment with neutrality of regulations and equal treatment. You have to have fair rules of the game. You have to have transparency. China needs exactly the same things you would advocate for any country in the world.

“After 25 years of economic reforms, China needs a fundamental institutional change in order to move reforms forward … FDI will only do so much. The main changes ought to come internally.”