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KEYWORDS
Governance
environment;
Foreign direct
investment;
Portfolio investment;
Rule-based governance;
Relation-based
governance;
China
Abstract It is widely believed that countries with a poor governance environment (e.g., weak laws and rampant corruption) do not attract foreign direct
investment (FDI); however, our study suggests otherwise. Using China as a case
study, this article argues that the prevailing theory that a good governance
environment begets FDI is incomplete. When faced with a poor governance
environment, investors choose direct investment over indirect (portfolio) investment because the former can be better protected by private means. In fact, China
attracts a large amount of FDI because of, rather than despite, its lack of a good
governance environment. In conclusion, this article offers strategies to better
protect investments and to chart through the pitfalls resulting from rapid changes
in the governance environment.
D 2005 Kelley School of Business, Indiana University. All rights reserved.
1. The puzzle
The prevailing theory on foreign investment is that
countries with good governance environments
(e.g., rule of law) tend to attract more foreign
direct investment, or FDI (Globerman & Shapiro,
2003; La Porta, Lopez-de-Silanes, Shleifer, &
Vishny, 1998). This theory, however, does not
explain Chinas recent large inflows of FDI; despite
its poor legal system and rampant corruption,
B
This manuscript was accepted under the editorship of Dennis
W. Organ.
E-mail address: sli@odu.edu.
0007-6813/$ - see front matter D 2005 Kelley School of Business, Indiana University. All rights reserved.
doi:10.1016/j.bushor.2004.06.002
298
China is, indeed, one of the worlds largest
recipients of FDI, but FDI is only one part of total
foreign investment. The other is indirect investment, or portfolio investment, including the purchase of stocks of listed companies and bonds in
secondary markets. In terms of either total foreign
investment or indirect investment, the largest
recipient, the United States, far surpasses China.
For example, in 2001, the United States received a
total of $556 billion in foreign investment, of which
$426 billion, or 77%, was indirect (portfolio) investment. In the same year, China attracted $45 billion
in foreign investment, of which only $1 billion, or
2%, was indirect investment (IMF, 2003). Chinas
stock market for foreign investors, known as the bB
sharesQ market, is lackluster and small. Despite the
large and fast-growing market, why do so few
foreign investors invest in stocks in its listed
companies or bonds, yet still rush to make sizable
direct investments? Compared to portfolio investments, FDI is more time-consuming, complicated,
and illiquid, thus exposing investors to greater
risks. In an attempt to solve this puzzle, we
examine how investments are protected in different governance environments.
S. Li
that there is a complete vacuum of protection
mechanisms.
When laws are opaque and unfair and the
government cannot enforce public rules impartially, people and firms predominately rely on
private relationships to govern social and economic
transactions. We call this a relation-based governance system, as opposed to a rule-based governance system (i.e., the good governance
environment) (Li, 1999; Li et al., 2003). In a
relation-based society, people rely on private
information and personal networks because public
information tends to be unavailable and/or unreliable. Relation-based societies usually lack public
trust; instead, they put great emphasis on personal
loyalty (Pearce, 2001; Li & Filer, 2004). As a result,
investors in relation-based societies tend to protect
their investments by private means, including
relying on insider information about prospective
business partners, private measures (from giving
poor references to kidnapping) to deter opportunistic behavior, and personal connections with the
authorities for protection.
Several examples are illustrative of the use of
relation-based governance in China. In 1992,
McDonalds signed a 20-year lease with the Beijing
municipal government to open a restaurant in a
prime location. But in 1994, the Beijing government told McDonalds to vacate, because a wellconnected businessman, Li Ka-shing, wanted to
build an officeshoppingresidential complex on
the same site. McDonalds, holding a valid lease,
took the Beijing government to court, but ultimately lost the case. It is well known that Li Kashing has been a close friend of Chinese Communist Party leaders for a number of generations;
thus, he was able to use his personal relationships
with Chinese officials to influence the legal
system in order to secure the site. In the end,
McDonalds defeat was hardly a surprise (Hill,
2003). Another example is that of Bengpu Milk
Products, a milk-product supplier in Anhui, China,
which resorted to collecting its payment by
private means. One of Bengpus clients, an icecream maker in Nanjing, refused to pay for the
milk powder the company had shipped. With the
Nanjing courts siding with the local ice-cream
maker and refusing to enforce payment, Bengpu
Milk Products had one of its subsidiaries order a
large quantity of ice cream and then seized all
the company delivery trucks as collateral. The
Nanjing ice-cream maker rushed to Bengpu, with
firearms, to settle the matter. Out-gunned by
Bengpu in its home base of Anhui, the ice-cream
maker was finally forced to pay its debt. Given
the ineffective and corrupt courts in China, such
299
300
Estimated governance environment index
Country
GEI
Country
GEI
Finland
Norway
Sweden
Denmark
Canada
Netherlands
Iceland
Australia
Ireland
United Kingdom
United States
Germany
Austria
Japan
Belgium
Spain
France
Taiwan
Portugal
Chile
Hungary
Italy
Slovenia
Uruguay
6.80
6.68
6.66
6.59
6.43
6.35
6.31
6.09
5.90
5.87
5.82
5.73
5.69
5.64
5.28
5.18
5.05
4.92
4.81
4.79
4.59
4.54
4.38
4.30
Czech Republic
Poland
S. Korea
South Africa
Bulgaria
Croatia
India
Argentina
Peru
Ghana
Romania
Mexico
Brazil
Philippines
Venezuela
Turkey
Ukraine
Nigeria
Colombia
Bangladesh
Russia
Azerbaijan
Pakistan
China
4.14
4.10
3.97
3.88
3.83
3.33
3.19
3.06
3.01
2.92
2.91
2.83
2.34
2.06
1.87
1.73
1.59
1.44
1.36
1.15
1.01
0.81
0.61
0.47
FDI/FI (%)
Table 1
(GEI)
S. Li
60%
50%
40%
30%
20%
10%
0%
0.000
2.000
Relation-based
4.000
6.000
8.000
Rule-based
5. Strategic implications
What can we learn from these findings? The
following three points may help investors better
formulate investment strategies in China and
navigate through the chaos of Chinas rapid transition from a relation-based to a rule-based system.
301
302
based governance is especially hazardous, as rulebased investors tend to take written rules at face
value. It is true that some of the new rules, such as
many commercial laws, are quite well written in
China. However, rule-based investors may not
realize that many of these rules are not yet being
practiced or enforced; they are, at this point,
merely ink on paper. The rule of stopping in front of
a red light is the same in all countries, and although
it is well respected on the streets of Berlin, it is not
in Beijing. Foreign investors should be aware that
the transition may increase instead of reduce, at
least in the short run, investment hazards, which
may provide opportunities for local financial intermediaries and other agents to cheat investors.
To continue the traffic control analogy, eventually human directing will be replaced by automated lights, and China will move toward rulebased governance in order to remain competitive
as its economy globalizes. Our analysis of China
illustrates such a typical transition. Currently,
most developing and emerging economies still rely
on the relation-based system; however, many of
them, including China, are taking their bgreatest
leap forwardQ to establish a rule-based system. For
these countries, the role of government is to
initiate and promote transition while minimizing
social and economic disruptions. Investors, especially those from rule-based economies, should
pay ample attention to how relation-based governance works, and be prepared to deal with the
incompatibility between the two modes of governance and the possible governance vacuum caused
by the transition.
Acknowledgments
I would like to thank Dennis W. Organ, previous
Editor of Business Horizons, for his valuable comments and suggestions. Thanks also to Darryl
Samsell for his research assistance and comments,
and Nancy Hearst for providing excellent English
editing. A summer research grant from Old Dominion University is graciously acknowledged.
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