What China’s Latest Anti-Corruption Campaign Means for Foreign Investment

July 16, 2014 Posted by China Briefing Reading Time: 5 minutes

SHANGHAI – It has become common practice in China that every major leadership transition be swiftly followed by an anti-corruption campaign, and the last leadership change in March 2013 has certainly proven consistent. President Xi Jinping’s campaign to crack down on “both tigers and flies”— high-ranking officials and lower-level bureaucrats—has adopted a forceful approach to the issue and grown into one of the broadest anti-corruption campaigns in recent memory.

The corruption scandal enveloping British pharmaceuticals company GlaxoSmithKline (GSK) may be the most high-profile corruption case in China to hit global headlines to date, yet the pervasiveness of corruption within the country comes as no great surprise to dedicated China observers. In an atmosphere of slowing economic growth and often unpredictable top-down edicts, many foreign investors have been left wondering what China’s latest anti-corruption campaign means for the future of their operations in the country.

Corruption in China

Despite problems associated with a lack of transparency, it is clear that corruption in China is both widespread and financially damaging—according to an estimate by economist Andy Xie Guozhong, corruption costs China 10 percent of its GDP per year. Undeterred by the severity of this problem, China has nonetheless been able to attract large inflows of FDI. But there are signs this is beginning to change.

The economy has never been immune to the economic fallout of corruption, and as growth has begun to slow, the associated costs are becoming ever more difficult to absorb, especially for the state-owned banking system. More broadly, systematic corruption has raised the inherent risks of the entire market and tarnished the perception of China’s stability and investment potential. With the Chinese leadership aiming to prevent an economic hard landing, but also keen to avoid heavy-handed stimulus spending, the time is ripe to stimulate economic growth through further liberalization and the creation of a more enticing environment for FDI.

The Effect of Corruption on FDI

Assessing the impact of corruption on FDI into China is fraught with difficulties, and so far empirical studies have been unable to reach a clear conclusion on the impact of corruption on decision-making at MNCs. While many studies have found that corruption is an important factor in reducing FDI into the host country, others have found that corruption has no impact or even a positive impact on FDI.

Corruption is often divided into two types – that acting as a ‘helping hand’ for investors and that acting as a ‘grabbing hand.’ Theoretically, the ‘helping hand’ type of corruption, often deemed an ‘efficient’ form of corruption, encourages FDI by enabling investors to pay for better bureaucratic efficiency in a country with a weak regulatory framework. In contrast, ‘grabbing hand,’ or ‘inefficient,’ corruption inhibits FDI flows into a country by acting as an additional fixed transaction cost for investors, thereby reducing the rate of return on investments and raising uncertainty. These extra costs may include bribes for permits or commissions for contracts.

According to Wang Yong, a professor at China University of Political Science and Law, the history of corruption in China can be divided into an ‘efficient’ phase, which lasted from 1980 to 2003, and an ‘inefficient’ phase from 2004 onwards. During this second phase, corruption has hurt efficiency and exacerbated unequal wealth distribution.

The Effect of the Anti-Corruption Campaign on FDI

The most immediate and quantifiable impact of the recent anti-corruption campaign on FDI is that investors will need to implement, alter and/or strengthen anti-corruption compliance and preventative mechanisms as a matter of best practice. This may increase costs in the short-term—a recent survey by the U.S. Chamber of Commerce found that 40 percent of businesses surveyed planned to increase spending on compliance as a result of the anti-corruption crackdown—but responsible investors will realize the importance of doing so.

The crackdown also risks worsening China’s economic slowdown, as fearful officials cut down their spending on luxury goods. Hotels, high-end restaurants and department stores have all been hit, as have the liquor, jewelry, tobacco and automobile sectors. According to a study by the Hurun Report, China’s richest decreased their spending by 15 percent between 2012 and 2013, and the trend is expected to continue this year.

In a long-term perspective, however, the anti-corruption campaign will create a healthier economic environment and attract further FDI. Several studies (Quazi, 2014; Mathew et al., 2009) have predicted that even limited anti-corruption campaigns could have a significant effect on boosting FDI into China. If successful, the anti-corruption campaign will also help to reduce the reputational and financial risk of operating in China. Investors will face less uncertainty and, without the burden of extra costs, investments will have a higher level of profitability. It will also level the playing field for those foreign investors who were put at a disadvantage for being unwilling to engage in illegal practices to compete in China.

The Advantages of Investment Restrictions

The sectors most exposed to corruption, such as infrastructure projects, government procurement, banking and financial services, natural resources and healthcare, tend to be those with an extensive state presence and comparatively little foreign involvement. On the flip side, China’s export-oriented sector, which is deeply integrated into the global market and has extensive foreign involvement, is much freer of corrupt practices. As shown by the allegations against GlaxoSmithKline, corruption is not only a Chinese problem, but this case does highlight the connection between a lack of foreign competition in a given sector and the prevalence of corruption.

Corruption is an extremely complex issue and one should be careful about generalizing its effects—since there are different types of corruption, investors will naturally be affected in different ways. Xi’s crackdown currently shows no sign of abating, and there remains much progress to be made in reducing corruption in China. Only time will tell how investors will react and whether or not it will ultimately be judged as a success.

Asia Briefing Ltd. is a subsidiary of Dezan Shira & Associates. Dezan Shira is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in China, Hong Kong, India, Vietnam, Singapore and the rest of ASEAN. For further information, please email china@dezshira.com or visit www.dezshira.com.

Stay up to date with the latest business and investment trends in Asia by subscribing to our complimentary update service featuring news, commentary and regulatory insight.

Related Reading

China Retail Industry Report 2014
In this special edition of China Briefing, we provide an overview of the retail industry in China and the procedures for setting up a retail shop, focusing specifically on brick-and-mortar physical retail stores. Further, we have invited our partner Direct HR to offer some insights on the talent landscape in the retail industry, as well as tips for recruiting retail personnel in China.

Annual Audit and Compliance in China
In this issue of China Briefing, we discuss annual compliance requirements for foreign-invested enterprises, including wholly-foreign owned enterprises, joint ventures and foreign-invested commercial enterprises, as well as the less demanding requirements for representative offices. We also highlight the most recent tax and legal changes that will significantly influence the way companies do business in China in 2014.