Openness to Foreign Investment

China maintained its position as one of the world's top two destination for foreign direct investment (FDI), adding $64.0 billion for a cumulative total of $563.8 billion through the end of 2004. Partly as a result of holdover investments from the slow FDI growth year of 2003 plagued by Severe Acute Respiratory Syndrome (SARS), FDI increased 19.7% year-on-year. FDI growth rates in previous years were 1.4% in 2003, 12.5% in 2002 and 14.9% in 2001. New U.S. direct investment in China fell slightly short of its previous year's total to just under $4.0 billion, but still accounted for 6.15% of China's annual FDI total last year, lagging behind Hong Kong, the British Virgin Islands, South Korea, and Japan as the fifth largest investor in China. On a cumulative basis, the United States, with $48.0 billion invested through the end of 2004, remains the second-largest foreign investor after Hong Kong. (Note: These statistics, which may be subject to revision, are based on preliminary year-end data released by China's Ministry of Commerce on January 16, 2005.)

Throughout 2004, the Chinese government employed macroeconomic measures in an attempt to cool the economy, which has been growing at over 9% annually. Despite these measures, in addition to administrative measures to limit certain overheated sectors such as real estate and construction, foreign and domestic investment continued to reach new heights. Some observers say that more visible effects of government measures to cool investment might not be seen until later in 2005 given the lag time between investment decision and actual investment infusion. They predict that FDI will continue to be strong in 2005, but expect the growth rate to ease. However, in a sign of continued foreign investor confidence, contracts for intended foreign investment, often an indicator of future trends, reached $135.0 billion by November 2004, up 34.4% from a year earlier. FDI accounts for less than 10% of China's total fixed assets investment, but foreign-invested enterprises account for a disproportionate amount of China's foreign trade, approximately 55%, a fact which increasingly draws the concern of Chinese officials.

China's investment climate has changed dramatically in 25 years of reform and opening. In the early 1980's, China restricted foreign investments to export-oriented operations and required foreign investors to form joint venture partnerships with Chinese firms in order to enter the market. Since the early 1990's, however, China has allowed foreign investors to manufacture and sell a wide variety of goods on the domestic market. In the mid-1990's, China authorized the establishment of wholly foreign-owned enterprises (WFOEs), now the preferred form of FDI. However, the Chinese government's emphasis on guiding FDI into manufacturing has led to market saturation and over-capacity of some industries in that sector, while leaving China's service sector highly underdeveloped.

China became a member of the World Trade Organization (WTO) on December 11, 2001. Although the WTO is primarily concerned with trade, China also took on obligations to eliminate certain trade-related investment restrictions, like requirements for domestic content, foreign exchange balancing, and technology transfer, and to open gradually opportunities for foreign investment in specified sectors that had previously been off limits. New laws, regulations, and administrative measures aimed at implementing these general and sector-specific commitments are being issued at a rapid pace. Even so, issuance of some measures has fallen behind schedule, and application of liberalizing regulations has not been uniform. Prospective U.S. investors will want to examine carefully the particulars of these new measures as they emerge. The relaxation of absolute barriers to entry has not led to a rush of foreign investment in telecommunications service and banking, for example, due to remaining regulatory restrictions, high capital requirements, and foreign firms' judgments about market conditions.

Prior to China's WTO entry, many international firms allied with Hong Kong companies to gain access to the China market. Partly as a result of this, Hong Kong is the largest "foreign" investor in Mainland China. By the end of 2004, the cumulative value of Hong Kong's direct investment in the mainland stood at $241.5 billion, accounting for nearly 43.0% of total FDI into China. In part, Hong Kong's investments in China outpaced investments by other economies because Hong Kong's entrepreneurs were willing to accept the risks of investing in developing China before other investors. With China's WTO entry making the operating environment more transparent and predictable, however, firms increasingly are investing directly in the Mainland. As part of this trend, Shanghai is emerging as a major alternative to Hong Kong as a regional headquarters for foreign investors in China, although China's limitations on currency convertibility continue to present problems for many investors, regardless of investment form, destination within China or origin.

A growing number of firms are opting to channel their China investments through vehicles registered in the freeports of the British Virgin Islands, the Cayman Islands, and Western Samoa. In 2004, new FDI nominally from these three tax haven economies accounted for 15.5% of total new FDI. The ultimate origin of this FDI is unclear, but anecdotal information suggests that it includes investments from corporations headquartered in OECD economies, Taiwan, and even China itself. The rise in investment from these free ports in 2003 correlates closely with the decline in investments from Hong Kong, suggesting that some firms shifted the nominal origin of their investments. Some Chinese researchers have estimated that as much as one-third of nominally foreign direct investment in China is ultimately Chinese funds returning in the guise of foreigners to take advantage of preferential treatment.

Types of Foreign Enterprises in China: Among the three main investment vehicles available to foreign investors, WFOEs are currently the most popular. New registration of WFOEs exceeded that of joint ventures (JVs) for the first time in 2000. WFOEs accounted for 70.3% of projects approved in 2004. By value, WFOEs represented 74.9% of these deals, a dramatic increase from previous years, as wholly-owned ventures became possible in a greater range of industrial sectors. JVs with Chinese firms are still required, however, in many industries of interest to U.S. investors such as insurance and telecommunications.

Encouraged versus Restricted Investment: China attempts to guide new foreign investment towards "encouraged" industries and regions. Over the past seven years, China has implemented new policies introducing incentives for investments in high-tech industries and in the central and western parts of the country in order to stimulate development in those less developed areas. A new Catalogue of Foreign Investment took effect January 5, 2005, replacing the April 2002 Catalogue. The catalogue designates sectors in which foreign investment are encouraged, restricted or prohibited. Unlisted sectors are permitted.

According to an accompanying regulation to the catalogue, projects in "encouraged" sectors benefit from duty-free import of capital equipment and value-added tax rebates on inputs. The same regulation states that approval authority for "restricted" investments rests with the relevant central government ministry and may not be delegated to the local level. For a number of restricted industries, a Chinese controlling or majority stake is required. Industries in which foreign investment is prohibited include national defense, firearms manufacturing, most media content sectors, and biotechnology seed production.

Among other things, the April 2002 catalogue aimed to implement sectoral openings that China promised in its WTO accession agreement, including in banking, insurance, petroleum extraction, and distribution. As part of the fulfillment of this promise, on April 2004 the Ministry of Commerce introduced regulations, effective June 2004, that considerably liberalized the distribution services sector. Most important, from December 2004 the new regulations provide for the removal of the existing mandated Sino-joint venture requirement for foreign investment in China's retail, wholesale, franchise and commission agency sectors. The January 2005 catalogue opens minority participation to foreign investors in television programming, distribution and movie production. It also adds several categories to the encouraged list, while eliminating others. New investors should consult carefully the latest catalogue. (As of January 21, 2005, only the Chinese version is available at www.ndrc.gov.cn/a/news/200412101b.htm.) While the catalogues lift restrictions, American businesses complain that government officials in practice continue to consider such factors as local content when deciding on government approvals or recommendations for loans from Chinese policy banks.

With the exception of real estate, service sector investment has been minimal, mainly due to Chinese government restrictions. The ratio of manufacturing to service investment should shift over the coming several years as China phases out current barriers to foreign access to more service industries as part of its World Trade Organization (WTO) accession agreement. The extent of this shift will depend on the details of new regulations governing the opening of these sectors. In some cases, onerous requirements contained in new regulations have limited foreign interest in investment in newly opened service sectors. For example, education, culture, arts, radio, film, and television broadcasting, which have opened only minimally under WTO, collectively received only $58 million in FDI 2003. Still, FDI in the banking and insurance sector more than doubled in 2003, and is expected to continue rising as increasing numbers of foreign firms have obtained licenses to operate in more places and foreign banks are now permitted to conduct local currency business in many more cities.

Foreign indirect investment (FII) still plays only a modest role in foreign investment in China, despite an extraordinary surge in 2000. In China, almost all FII is focused on foreign investors buying and selling shares of Mainland Chinese companies listed on foreign stock exchanges, primarily in New York (N-shares) and Hong Kong (H-shares). There has been some broadening of investment options since late 2002, however, with qualified foreign investors permitted to purchase limited quantities of renminbi (RMB) shares in the domestic stock market, and even obtain state-owned shares under certain circumstances. According to Chinese official statistics, mainland companies raised $6.5 billion through overseas equity placements in 2003, up from $2.2 billion in 2002. The 2003 total nearly reached 2000's record $6.8 billion, and continued a trend of great volatility in overseas equity placement figures. (2004 statistics were not available at the time this report was prepared.)

Mergers and Acquisitions (M&A): Over the past two years China has issued new regulations governing foreign purchase of stakes in domestic enterprises that have heralded an upsurge in M&A activity. Regulations issued in November 2002 permit foreign purchase of traded and non-traded (designated state) shares of Chinese enterprises. In addition, China issued regulations that took effect in April 2003 that specified procedures for foreign acquisition of and merger with domestic enterprises. These regulations require pre-merger notification and allow for examination of antitrust considerations in some cases. By requiring approval of all owners of the domestic enterprise, the regulation implicitly prohibits hostile takeovers. Because the enterprise resulting from the M&A will be foreign-invested, the procedures require approval according to both the M&A rules and the general approval requirement on FIEs. The Ministry of Commerce so far has not actively blocked M&A activity, and foreign firms are reportedly finding that they increasingly are able to invest in attractive firms and sectors.

China also issued provisional regulations in November 2002, effective January 2003, on using foreign investment to reorganize state-owned enterprises (SOEs). These reorganizations, however, require extensive approvals and full agreement of the domestic enterprise's labor union; these requirements are likely to limit the appeal of such investment. Furthermore, M&A professionals cite numerous difficulties in obtaining accurate business information regarding SOEs during the due diligence investigation stage.

Even before the issuance of these new regulations, the Chinese government began approving a small but growing number of foreign M&A deals involving domestic enterprises. While worldwide cross-border M&A deals in 2003 had declined in value to about 25% of its year 2000 peak, cross-border M&A deals involving sales of firms in China grew nearly 70% over the same period to reach $3.8 billion, based on data from the UN Conference on Trade and Development. Several Chinese economists favor modernizing China's Company Law to accommodate more cross-border mergers and acquisitions. China has also been working for many years on drafting an antimonopoly law, which may eventually replace or subsume the procedures established for domestic and cross-border M&A in the April 2003 regulation. Some expect that the current draft, which is now under review by the State Council, could pass as soon as mid- to late- 2005. Mergers and spin-offs involving only foreign-invested firms are governed by the Regulations on the Merger and Division of FIEs, which were amended in November 2001 to improve the conditions for M&A activity among such enterprises.

Investment Incentives: China has developed and expanded a complex system of investment incentives over the last twenty years. The Special Economic Zones (SEZs) of Shenzhen, Shantou, Zhuhai, Xiamen and Hainan, 14 coastal cities, hundreds of development zones and designated inland cities all promote investment with unique packages of investment and tax incentives. Chinese authorities have also established a number of free ports and bonded zones. In recent years, SEZs have sought to enhance their autonomy while officials from inland China have pressed the central government to reduce SEZ privileges. To make progress toward a consistent (and required) national trade regime as part of its WTO accession, China has indicated that it will not introduce any new SEZ investment incentives and will decrease existing incentives over time. It also reduced by more than half the number of special economic zones in 2004.

The vast majority of FDI is directed to China's coastal provinces. From 1979 through 2003, 85.3% of cumulative FDI went to the 11 provinces and provincial-level cities along the eastern and southern coast. Nearly two-thirds of cumulative FDI receipts had gone to just five provinces: Guangdong (25.8%), Jiangsu (14.23%), Fujian (8.75%), Shanghai (8.4%). and Shandong (7.1%). All five areas have been particularly targeted by Taiwan and Hong Kong-based manufacturers, attracted by low labor costs for export production. Shandong has also been especially popular with South Korean firms.

In 1999, China announced special investment incentives to attract foreign investors to its underdeveloped central and western regions. A national-level catalogue of "encouraged industries" for the interior provinces was published in July 1999, with a subsequent edition in June 2000. Individual provinces have also issued their own additional incentives.

Western China continues to struggle to attract significant amounts of FDI. China touted a high-visibility "Great Western Development" campaign and included a variety of western development provisions in its 10th five-year plan (2001-05). However, provincial and local governments in the western areas have generally tried to steer prospective investors to invest in failing state-owned enterprises (SOEs) in hopes of saving jobs at these large employers. Prospective foreign investors have found these SOEs to be almost uniformly unattractive business propositions. In the few attempts by foreign investors to buy SOEs, the government rejected the offers balking at what they considered low offers. The government has insisted that bids fall within a range no lower than 10 percent below the government's appraised value of an SOE. Many offers came in at a third of the government appraisals. Furthermore, governments have not been as willing to promote some of the very promising private enterprises to foreign investors. The investment climate and business environment are also significantly less sophisticated and transparent than in the coastal areas, making it difficult for foreign investors to assess accurately prospective investments. Finally, the most attractive export routes and domestic consumer market segments are concentrated in the East. As a result of these limitations, few foreign investors have made significant moves in China's west, which took in only 4.8% of cumulative FDI received by the end of 2003.

Since 2003, China has been touting yet another development campaign, this time targeting the revitalization of the Northeast, which has traditionally been the country's heavy manufacturing center. As part of the campaign, the government is introducing reforms on ownership transfer that allow non-government investors to manage state-owned enterprises. It is too early to determine whether the campaign will be any more successful than the "Great Western Development" campaign, though it has reportedly resulted in some new investments in China's automotive and food industries. Although starting from a relatively low base of foreign investment, year-on-year FDI growth rates in 2004 in the Northeast reached nearly 80 percent, well over the national average of about 20 percent, according to some academics. The Chinese government began discussions in late 2004 regarding the 11th five-year plan, which will set new policy direction for the economy. The new plan is due for release in mid- 2005.

New FDI in China continues to flow overwhelmingly to the manufacturing sector, which took more than 70% of FDI in 2003. In the initial phase of China's economic opening, manufacturing FDI was concentrated in low technology garments and other soft goods. Starting in the 1990s, however, China also began receiving growing amounts of capital-intensive (chemicals and petroleum processing) and technology-intensive FDI. In the electronics sector, in particular, industrial clusters are starting to crop up in China, adding momentum to the shift by major manufacturers and their suppliers of production from other Asian locations to China. Nokia, for example, established the Xingwang Industrial Park in Beijing in 2001 in an attempt to draw in its suppliers. Other clusters have grown up naturally, such as the laptop manufacturing cluster in and near Shanghai.

Incentive Programs: Foreign investors sometimes have to negotiate incentives and benefits directly with the relevant government authorities as some incentives and benefits may not be conferred automatically. The incentives available include significant reductions in national and local income taxes, land use fees, import and export duties, and priority treatment in obtaining basic infrastructure services. Chinese authorities have also established special preferences for projects involving high-tech and export-oriented investments. Priority sectors include transportation, communications, energy, metallurgy, construction materials, machinery, chemicals, pharmaceuticals, medical equipment, environmental protection and electronics.

China encourages reinvestment of profits. A foreign investor may obtain a refund of 40% of taxes paid on its share of income if those profits are reinvested in China for at least five years. Where profits are reinvested in high technology or export-oriented enterprises, the foreign investor may receive a full tax rebate. Many foreign companies invested in China have adopted a strategic plan that reinvests profits for growth and expansion.

As part of a national campaign to standardize tax treatment and increase collection rates, the State Administration of Taxation began work in 1998 on a planned unification of tax treatment for foreign and domestic firms. Concerns over the impact of the Asian financial crisis and, later, China's accession to the WTO led officials to delay the process. On several occasions in recent years, senior officials have announced the imminent reunification of tax rates or elimination of preferential tax treatment of foreign firms, but no definite action has occurred yet. Discussions in January 2005 indicate a likely target date in 2007 to unify tax rates somewhere in between the current domestic and foreign rates. Due to the need for National People's Congress approval, which takes a minimum of three months, there would be some advance warning of a unification of the tax rates, and any such unification could grandfather previously issued incentives.

China's tax incentive system is complicated and difficult to implement. Discrepancies between central, provincial and local government tax regulations hamper foreign investment, and these problems are particularly acute in remote and impoverished areas. Still, initial efforts at reform are beginning to take effect. Collection efforts have been centralized and the responsibility for assessment and filing of returns was shifted to the taxed enterprise in late 1999. A computerized standard reporting and payment procedure has been progressively expanded nationwide to reduce overpayments and loopholes. In 2004, the Chinese Government also announced an average three percentage point reduction in value-added tax (VAT) rebates for exports.

National Treatment: China committed to granting national treatment as part of its accession to the WTO. Not all of the thousands of government officials understand this concept, however, and implementation is likely to pose periodic problems. China is conducting training programs to educate central and local government officials on China's WTO obligations. In addition, WTO national treatment rules aim to eliminate discrimination against imported goods and do not apply fully to investment. In July 2004, after the United States initiated WTO consultations, China agreed to remove VAT rebates for semiconductors produced in China by mid-2005, thereby providing national treatment for imports.

Basic Laws and Regulations Covering or Affecting FDI: The basic laws and regulations governing FDI in China are complex. A summary of some of the most important of those currently in effect is provided below.

The Chinese central government is currently reviewing and revising all laws, rules, regulations, and implementing regulations for consistency with new WTO commitments. The Chinese government acknowledges that it will take more time to promulgate all the new and revised laws, regulations, and implementing regulations, but is officially committed to meeting China's WTO obligations.

Chinese laws are typically drafted broadly, requiring reference to regulations and even more detailed implementing rules for practical application. Under the terms of its WTO accession agreement, China obligated itself to publish in a single official journal all trade related laws, regulations, and other measures in advance for comment prior to implementation, and this obligation should encompass many regulations affecting foreign investment. This transparency requirement has not yet been fully implemented, however.

A potentially significant recent development is the emergence of industry associations distinct from government agencies. In mid-2003, industrial associations fell under the supervision of the State-owned Assets Supervision and Administrative Commission dashing hopes of the development of a completely independent voice for local industry. Currently, the associations act as an intermediary between government agencies, including line ministries, and private businesses. Some foreign observers are concerned that FIEs might be barred from membership in some industry associations and thus are excluded from the self-regulatory and standards setting functions these groups aspire to carry out. Participation of foreign firms depends on the individual charter of each association. However, the State Council is considering draft legislation that would clarify membership rules. Thus far, industrial associations appear to have offered a more cutting-edge channel for raising local business concerns with the government.

Laws Affecting Foreign Enterprise Establishment:

Forms of Foreign Ownership: In most sectors where foreign investment has been allowed, FIEs can exist as WFOEs, equity joint ventures (EJVs), cooperative (or contractual) joint ventures (CJVs), or foreign-invested companies limited by shares (FICLS). The foreigners must own at least 25% of a firm for it to be considered an FIE for purposes of investment incentives and other measures. Regulations issued in late 2002 and in 2003 permit registration of enterprises with foreign ownership of between 10 and 20% as "enterprises with foreign investment below 25%," while noting that such enterprises do not qualify for incentives aimed at FIEs. Under China's Company Law, foreign firms theoretically can now also open branches in China, but in practice only foreign financial institutions, namely commercial banks and non-life insurance companies, can establish branches. Foreign investors with multiple investments may also be eligible to establish holding (investment) companies.

Investment in WFOEs is now the most popular FDI vehicle in China. The WFOE Law was originally promulgated in 1986, and the law and implementing regulations have been amended five times. The WFOE Law was amended most recently in October 2000 and amended implementing regulations were promulgated in April 2001. The 2001 revisions of the WFOE Law and implementing regulations (State Council Order No. 301) amended or deleted sixteen articles. The revisions eliminated requirements for foreign exchange balancing, struck requirements for domestic sales ratios, removed or adjusted technology transfer and export performance requirements, and modified provisions on domestic procurement of raw materials. Several former requirements remain "encouraged," however.

Under the amended WFOE Law, China may reject an application to establish a WFOE for five reasons: (1) danger to China's national security, (2) violation of China's laws and regulations, (3) detriment to China's sovereignty or public interest; (4) nonconformity with the requirements of the development of China's national economy; and (5) danger of environmental pollution.

The "Law on EJVs" was amended in March 2001, and implementing regulations were amended in July 2001. EJVs had historically been the main organizational form of FIEs in China but have fallen out of favor as dissatisfaction grew with respect to choice of local partners and with board decisions, capital formation, dividend distributions and other matters. EJVs declined further as restrictions on WFOEs loosened. China had traditionally favored investment in JVs, in hopes of rescuing poorly performing domestic SOEs. The March 2001 amendments remove the requirements that FIEs balance their foreign exchange receipts and expenditures. However, many joint-venture contracts still contain a clause requiring such balancing, but under the terms of China's WTO accession such clauses are not to be enforced.

CJVs: The Law on CJVs was amended in October 2000. Although not requiring strict proportionality with respect to investment terms, return on capital, governance and dividend distribution, and thus more clearly resembling partnerships in the United States sense, CJVs have never been as popular as EJVs, in part because of investors' unfamiliarity with CJVs. The principal exception has involved infrastructure projects in which the foreign investor is allowed an early return on capital in consideration for relinquishing any claim to residual assets upon expiration of the CJV's term.

FICLS: FICLS are organized as shareholding companies in which foreign investors hold at least 25% of equity. They have been difficult to organize because of demanding regulatory preconditions and requirements for Ministry of Commerce (MOFCOM; known prior to March 2003 as the Ministry of Foreign Trade and Economic Cooperation) approval. They should become more popular as more Chinese companies organized as share companies establish market presence, reducing the benefit of forming joint ventures.

Branches: As stated above, branches in practice are permitted only in certain financial industries.

Representative Offices: Foreign firms may also establish representative offices in China, but these are prohibited from engaging in any profit-making activities. Foreign law firms, however, are allowed to operate only through representative offices and are an exception to the prohibition on profit-making activities.

Holding Companies: There has been some relaxation of the restrictions on business scope and operations of holding companies, although minimum capital requirements normally make them suitable only for corporations with several sizeable investments to manage. Foreign firms have commonly complained that China's administrative rules governing holding companies prevent the consolidation of accounts of subsidiaries for tax purposes, limit engagement in import business, and hamper the performance of true central treasury functions. On February 12, 2004 the Ministry of Commerce promulgated an amended version of its administrative regulations governing holding companies. Among the changes in the regulations, a holding company meeting certain criteria may now import and sell the products of its parent company in China, and import raw materials and spare parts necessary for providing maintenance services for products of its invested subsidiaries and multinational corporations. The amended regulations also stipulate that it is no longer necessary for subsidiaries of a holding company to be manufacturing entities. A separate regulation that took effect in April 2003 made it possible for holding companies to manage human resources across their affiliated companies and provide certain market research and other services to their affiliates. Distribution and trading functions of holding companies are scheduled for phase-in over a five-year period under China's WTO commitments. However, some restrictions on financial operations and ability to balance foreign exchange internally will remain for holding companies even after full implementation of the WTO commitments. Profit and loss consolidation within holding companies is still prohibited.

Regulations and periodic updates on China's investment projects and conditions can be found on MOFCOM's website: www.mofcom.gov.cn and its affiliated website www.fdi.gov.cn.

Other laws relating to investment include the following:

Contract Law: China's Contract Law went into effect on October 1, 1999. The NPC passed the law to unify three earlier laws covering domestic economic contracts, foreign-related economic contracts, and technology contracts, and to address the rising use and complexity of contracts in China. The new Contract Law moves China closer to international legal norms and to greater legal transparency. It encourages stronger contractual compliance by providing legal recourse - although enforcement of judgments will continue to be a problem. Certain contracts involving foreign firms (including those involved in establishing a FIE, many technology import contracts, and infrastructure project contracts) are still subject to government approval. Certain contracts, such as foreign loan contracts, other technology import contracts, and real estate contracts, must be registered but are not subject to approval requirements.

Securities Law: The Securities Law, effective on July 1, 1999, codifies and strengthens the administrative regulations that govern the underwriting and trading of corporate shares, as well as the activities of China's stock exchanges in Shanghai and Shenzhen. The Securities Law does not distinguish between State-owned enterprises (SOEs) and non-SOEs. (At the end of 2003, 940 of the 1287 companies listed on China's exchanges - 73 percent - were SOEs.) In practice, however, few non-SOEs have been allowed to sell "A" shares. "A" shares are local currency shares. "B" shares, denominated in foreign currency, were originally for sale only to foreign legal persons and continue to be subject to separate administrative regulations. In February 2001, the authorities opened the "B" share market to Chinese citizens with legally obtained foreign currency holdings. Despite press reports indicating the "A" and "B" share markets will gradually be integrated, the exact timing of this move - which would be closely linked to changes in China's foreign exchange regime - remains unclear.

In December 2002, the People's Bank of China and the China Securities Regulatory Commission (CSRC) implemented new joint regulations for "qualified foreign institutional investors" (QFII) that gave eligible foreign firms conditional access to the country's domestic equity markets, including "A" shares and traded government and corporate bonds. The State Administration of Foreign Exchange (SAFE) also issued supplementary regulations on the use of foreign exchange for investment by QFIIs. Interested foreign investment firms apply first to CSRC for a QFII license. Once a license has been obtained, they apply to SAFE for an investment quota. As of December 2004, 27 foreign firms had been granted QFII status, and 24 of these had received investment quotas totaling $3.425 billion. Many observers, however, expect QFIIs to limit their exposure to the Chinese share market due to perceived overvaluation, shortcomings in corporate governance, and restrictions on the percentage of shares and the types of industries that can be listed in the market.

Foreign-Invested Venture Capital Firms: A new regulation that took effect March 1, 2003, replaced earlier provisional regulations permitting the establishment of foreign-invested venture capital firms, including WFOEs, aimed at funding high-technology and new technology startups in industries open to foreign investment. The new regulation lowers capital requirements, allows these firms to manage funds directly invested from overseas, and offers the option of establishing venture capital firms under an organizational form similar to the limited partnerships used elsewhere. An April 2001 regulation barred securities firms (including foreign-invested firms) from the private equity business. Chinese laws concerning foreign private equity firms set limits on corporate structure, share issuance and transfers, and investment exit options. Investment exit problems, especially the difficulty of listing on China's stock exchanges, coupled with the bureaucratic approvals required to list overseas, have limited interest in establishing China-based venture capital and private equity investment. As a result, most foreign venture capital and private equity investments in China are actually housed in offshore investment entities, which, as with other offshore FDI, can be transferred without Chinese Government approval.

Tendering and Government Procurement Laws: Concerns over the WTO consistency of the draft tendering law led the National People's Congress, on April 9, 1999, to make a surprise announcement that it had decided to move key sections relating to government procurement into a separate law. The tendering law (which now governs only state administered capital construction and infrastructure projects) was finalized in 1999, and the State Council issued "Provisions for the Administration of Government Purchases." The NPC approved the new government procurement law in June 2002; the law took effect January 1, 2003, replacing the "Provisions."

The new Government Procurement Law (like its interim predecessor) establishes rudimentary criteria for the qualification of domestic and foreign suppliers and various categories of procurement, as well as broad standards for publicity, notification, bid scheduling, sealed bidding and bid evaluation. Initial foreign reactions to the new law have been mixed. The law is aimed at implementing one of China's WTO entry commitments by clarifying that purchases by SOEs do not constitute government procurement, thereby removing the bulk of commercial value from this procurement system. However, the legislation mandates domestic procurement unless the goods or services cannot be procured on reasonable commercial terms within China. In 2004, China began drafting a more specific government software procurement regulation that is intended to promote domestic software development.

Investment Screening Procedures: Potential investment projects usually go through a multi-tiered screening process involving the foreign investment department at MOFCOM or a provincial equivalent. The process frequently also involves the development planning department, the National Development and Reform Commission (NDRC), or a provincial equivalent and the department responsible for the industrial sector of the project.

The first step is approval of the project proposal. The central government has delegated varying levels of approval authority to local governments. Until a few years ago, only the Special Economic Zones (SEZs) and open cities could approve projects valued at up to $30 million. Such approval authority has now been extended to all provincial capitals and a number of other cities throughout China. The approval process for projects over $30 million has become less of an obstacle than in the past. Furthermore, the State Council issued regulations on July 29, 2004 that significantly raised the dollar limits of foreign investments requiring central government approval. Projects proposals in "encouraged" and "permitted" sectors valued above $100 million and those in "restricted" sectors valued over $50 million require NDRC approval. Subsequently, NDRC released follow-on rules October 9 that clarified that only projects valued over $500 million in "encouraged" and "permitted" categories, and those valued above $50 million in "restricted" sectors require NDRC review and State Council approval. The NDRC rules also require local authorities to report to NDRC for recordation purposes investment projects they have approved valued above $30 million. Even with clearly delineated investment approval criteria, sometimes the political relationship between China and the home country of the foreign investor influences the approval process.

Research and Development: Poor links among government, university and industry researchers make it very difficult for China to efficiently utilize its many brilliant scientists and engineers. Much of China's top scientific talent is not in universities but in a government bureaucracy, the Chinese Academy of Sciences, modeled after the USSR Academy of Sciences. Young scientific and engineering talent often flows to the information industry and biotechnology sectors. Since the late 1980's, China has directed an increasing proportion of government research funds through peer review mechanisms at the National Natural Science Foundation of China (www.nsfc.gov.cn) and the Ministry of Science and Technology (www.most.gov.cn) in order to achieve better results from research funding. Some Chinese government programs such as "Torch" promote scientific research and its commercial applications, yet the investment return on research and development, especially in the state sector, remains low. The central and local Chinese governments have also strongly promoted science parks, which, in actuality, often just serve as low-tech assembly centers.

Despite efforts since the early 1990's to push technical institutes towards the market, the political and economic structures of the old "planned economy" are still important obstacles. Lack of familiarity with or confidence in intellectual property protections discourage Chinese companies from investing in research although an increasing and record number of domestic patents were requested in 2003 and 2004. Patent, copyright, and trademark infringement often prevent companies from recapturing their investment in product research and development. Furthermore, technology utilized by SOEs tends to lag far behind that of the growing private sector, in part because SOEs lack incentives to conduct research and development activities. There is a broad consensus among Chinese scientists and Chinese leaders that more reform and greater IPR protection are needed. China continues to reform its science and technology system in order to create incentives for innovation and to link science and technology research work more closely to the needs of the market.

Foreign companies' research and development centers in China have often focused on product localization or development of new products for the Chinese market. More recently, several companies, including Microsoft, Motorola, and Intel, have established research centers in China aimed at product development for regional or global markets. The Chinese government has welcomed the establishment of these centers although some Chinese critics worry that the centers will create an "internal brain drain" of talent away from Chinese companies and research institutions to foreign companies.

In periods when foreign currency was relatively scarce in China, profits that were not generated in foreign exchange could only be repatriated with great difficulty. Since 1994, however, China's foreign exchange reserves have grown rapidly (nearly $600 billion by the end of 2004), and FIEs have generally enjoyed liberal access to foreign exchange. On December 1, 1996, China announced the full convertibility of its currency on the current account (for trade in goods, services and remittance transactions, including profits). To prevent rampant fraud, in 1998 China tightened the scrutiny of underlying documentation. Bureaucratic procedures as authorities implemented the new regulations created difficulties for many foreign and domestic companies requiring hard currency to complete their transactions. Foreign bank branches are allowed to engage in foreign currency business according to the same rules as Chinese banks. Under the terms of China's WTO entry, foreign bank branches and foreign-invested banks will become eligible to engage in local currency operations in stages over several years. As of the end of 2004, foreign banks were able to engage in local currency operations in 18 cities. China committed to lift all geographic and client restrictions by the end of 2006.

There have been no cases of outright expropriation of foreign investment since China opened to the outside in 1979. However, the Department of State believes that there are several cases that may qualify as expropriations under Section 527 of the FY94-95 Foreign Relations Authorization Act.

Arbitration: Although China is a member of the International Center for the Settlement of Investment Disputes (ICSID) and has ratified the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (a.k.a. the New York Convention), it places strong emphasis on resolving disputes through informal conciliation and mediation. If it is necessary to employ a formal mechanism, most parties prefer arbitration to litigation. The authorities greatly prefer arbitration through institutions in China. Most foreign investors consider arbitration as a last resort and have found it to be time-consuming and unreliable. Most Chinese parties and form contracts propose arbitration by the China International Economic and Trade Arbitration Commission (CIETAC). During the past few years, some foreign parties have expressed satisfaction with and obtained favorable rulings from CIETAC. Difficulties in other cases have led several Western participants and panel members in CIETAC proceedings to raise concerns about CIETAC's procedures and effectiveness. In one instance, a respected American member of an arbitration panel threatened to resign from CIETAC over alleged procedural irregularities during consideration of a case. For contracts that involve a purely foreign party (i.e., not an FIE), offshore arbitration may be adopted. If CIETAC arbitration is chosen, a panel with a foreign arbitrator is also possible, although not for FIEs. Provinces and municipalities also have their own arbitration institutions. Some foreign investors have been favorably impressed with the Beijing Commission despite its lack of foreign arbitrators.

Enforcement of arbitral awards is sporadic. Sometimes, even when a foreign company wins in arbitration in China, the local court may delay or fail to enforce the decision. Even when the courts do attempt to enforce a decision, local officials often ignore court decisions with impunity.

There have also been investment dispute cases in which local authorities have intervened on the part of a Chinese company in a manner considered unfair and capricious by the foreign investor. For example, local courts have occasionally intervened to prevent the sale or transfer of foreign-owned assets, pending resolution of a commercial dispute between a foreign company and a Chinese company. In general, most cases have been resolved through negotiation between the commercial parties and/or intervention of central authorities.

Legal System: Chinese society is in transition from rule by man to rule of law. Most laws are general; details are specified in implementing regulations. Many foreign businesses report that Communist Party and government officials at times interfere in court decisions. China's top leaders undoubtedly play a major role in deciding sensitive political cases. China's legal system is civil law in origin but now includes some common law elements, although it places relatively less emphasis on legal precedent.

The 1979 "Organic Law of the People's Courts of the People's Republic of China" authorized establishment of economic courts at China's Supreme People's Court and three levels of provincial courts. The economic courts are given jurisdiction over contract and commercial disputes between Chinese entities; trade, maritime, intellectual property and insurance; other business disputes involving foreign parties; and various economic crimes including theft, bribery, and tax evasion. In 1994, the lowest level of provincial courts started to try economic cases involving foreign parties. Foreign lawyers cannot act as attorneys in Chinese courts, but may observe proceedings informally. Over the past four years, the United States has been working with China on projects relating to commercial and economic law under the umbrella of the U.S.-China Joint Committee on Commerce and Trade.

Bankruptcy and Creditors' Rights: China's provisional bankruptcy law, passed in December 1986 and applicable only to SOEs, provides for creditors' meetings to discuss and adopt plans for the distribution of bankrupt property. The resolutions of creditors' meetings, which are binding on all creditors, are adopted by a majority of the attending creditors, who must account for more than half of the total amount of unsecured credit. Other laws govern bankruptcy by non-SOEs, but bankruptcy law as a whole is incomplete, inefficient, unprofessional, and subject to gross inequities. Even Chinese officials contemplating broad enterprise reforms recognize the inadequacy of China's current provisional bankruptcy law. A unified enterprise "Bankruptcy Law" is in draft but is still in relatively rough form, in part because the authorities remain reluctant to address the social consequences of bankruptcy.

A major problem for Chinese commercial banks is the formal and informal constraints on liquidating the assets of non-performing SOE loans. Notably, local political leaders, through the ubiquitous apparatus of the Communist Party, continue to control or to influence not only the courts but also the state-owned banks themselves and can effectively block efforts to dispose of SOE assets. The November 2002 Sixteenth Congress of the Chinese Communist Party mandated the creation of a new paradigm for the management of state-owned enterprises and other assets designed to clarify the ownership rights and responsibilities of central, provincial, and local authorities over state property located under their respective jurisdictions. The establishment in March 2003 of the State Asset Supervision and Administration Commission (SASAC) to replace the State Economic and Trade Commission as the leading institution with respect to China's state-owned industrial sector, is one manifestation of this new system, the significance of which has yet to be fully clarified.

In October 1995, China put into effect a "Security Law," the first national legislation covering mortgages, liens, pledges, and guaranties. The Law defines debtor and guarantor rights and provides for mortgaging of property, including land and buildings, as well as other tangible assets such as machinery, aircraft, and other types of vehicles. While some areas of the Law remain unclear -- such as how the transfer of property under foreclosure is affected -- the law represents an important step forward. Chinese commercial banks have successfully repossessed vehicles from delinquent borrowers. Although mechanisms have been created for foreign investors to take over non-performing debt from the domestic banking system (generally through the asset management companies established by the major state-owned banks in 1999), numerous bureaucratic hurdles remain in the process of acquiring and liquidating these assets.

China agreed to implement the WTO Agreement on Trade-Related Investment Measures (TRIMs) upon WTO accession. China has committed to eliminate and cease enforcing trade and foreign exchange balancing requirements and local content and performance requirements. It has also agreed not to enforce contracts imposing these requirements. China has also committed to enforce laws or provisions relating to the transfer of technology or other know-how only if they are in accordance with WTO rules on protection of intellectual property rights (IPR) and TRIMs. Export Performance Requirements: Export performance requirements are inconsistent with WTO principles. China has said it will not enforce export performance requirements in private contracts. However, in the past, MOFCOM's predecessor, the Ministry of Foreign Trade and Economic Cooperation, and the NDRC have strongly encouraged contractual clauses stipulating export requirements.

Local Content: Chinese regulations grant FIEs freedom to source inputs both in China and abroad, though priority is given to Chinese products when conditions are equal. Chinese regulations forbid "unreasonable" geographical, price, or quantity restrictions on the marketing of a licensed product. FIEs thus retain the right to purchase equipment, parts, and raw materials from any source. Chinese officials, however, still encourage localization of production.

Technology Transfer: FIEs often involve the transfer of technology through a licensing agreement, the transfer of technology from a third party, or the transfer from the foreign partner as part of its capital contribution. China has committed to enforce only those laws or other provisions relating to the transfer of technology or other know-how if they are in accordance with WTO provisions on protection of IPR and TRIMS, including a prohibition on technology transfer as a condition to approval. Regulations promulgated in 2001 have generally improved the regulatory environment for foreign technology providers. Despite these commitments, foreign investors may still encounter pressure to transfer technology.

Employment of Host-Country Nationals: Rules for hiring Chinese nationals depend on the type of establishment. Although FIEs are not required to nominate Chinese nationals to their upper management, in practice, expatriate personnel normally occupy only a small number of managerial and technical slots. In some ventures, there are no foreign personnel at all.

The amended EJV Law provides that the joint venture partners will determine, by consultation, the Chairman and Vice-Chairman. If the foreign side assumes the chairmanship, the Chinese party must have the vice-chairmanship, and vice-versa.

FIEs are free to recruit employees directly or through agencies. While FIEs have the right to manage the administrative requirements for employees, such as registration, taxes and records, directly with government offices, most choose to work through approved "labor services companies." Foreign companies may choose from an array of services from paying the full compensation package to the employee to the minimalist service of handling necessary paperwork with the government.

China increasingly is moved from its old command economy toward one that runs on market principles. Upon accession to the WTO, China committed to reduce over time many restrictions on the private sector. In 1999 and 2004, China codified some of these principles by amending its constitution to provide a legal basis for the protection of private property. These constitutional amendments are intended to encourage the healthy development of China's domestic private sector. In recent years, domestic private investment has also been allowed to enter many new sectors, but the level of investment is still limited in sectors such as: banking, railways, natural resource monopolies, and airlines. Domestic private enterprises are also restricted from entering these sectors, with very few exceptions made by the Chinese government. Similar restrictions and limits on FIEs are listed in the Catalogue of Foreign Investment. While there are no regulations that prohibit banks from lending to private enterprise, in practice banks have continued to send most their credit to state-owned enterprises. Consequently, many local private enterprises often turn to informal lending networks and face difficulties reaching maximum efficient size and scale because of the credit crunch.

Land: Chinese law provides that all land is owned by "the public," and individuals cannot own land. However, consistent with the policies of reform and opening to the outside, legal and natural persons, including foreigners, can hold long-term leases for land use. They can also own buildings, apartments, and other structures on land, as well as own personal property. Intellectual Property Rights (IPR): Overview

In spite of significant progress in improving its legal framework for intellectual property, IPR protection in China remains weak. IPR violations are blatant and widespread. Chinese leaders acknowledge that China needs effective protection of patents, trademarks, copyrights, and other intellectual property rights such as trade secrets, plant varieties and domain names to promote a "knowledge-based economy". In addition, China committed to full compliance with the Agreement on Trade-Related Aspects of Intellectual Property (TRIPS) upon accession to the WTO. Chinese officials increasingly have brought their IP laws and regulations into compliance with the TRIPS Agreement and international standards. Chinese officials also have increased enforcement efforts, but their actions and legal remedies have not been strong enough to effectively deter intellectual property pirates and counterfeiters. As a result, IPR violations, including growing exports of counterfeit products, continue to outpace enforcement. Furthermore, protection for copyrights over the Internet has been particularly weak.

Since WTO accession, China's IPR offices (patent, trademark and others) have increased their pace of activity. China's Trademark Office is now the most active office in the world. China also receives more design patent applications than any other country in the world. Chinese rights holders increasingly have become more active in protecting their own intellectual property, but also in abusing the rights of others. U.S. companies complain that Chinese companies are unfairly squatting on U.S. designs, trademarks or other rights, as well as proprietary information, and that Chinese companies may also be seeking to abuse standards setting and use other non-tariff barriers to restrict the fair exercise of IP rights held by foreigners. These other emerging issues have compounded the concerns of U.S. businesses, even as they continue to struggle to fight the high rates of infringement in China today.

Membership in International IPR Organizations: In addition to its WTO TRIPS Agreement obligations, China holds membership in the World Intellectual Property Organization (WIPO), Paris Convention for the Protection of Industrial Property, Berne Convention for the Protection of Literary and Artistic Works, Madrid Trademark Convention, Universal Copyright Convention, and Geneva Phonograms Convention, among other conventions. China's amended copyright law does not fully comply with the WIPO Copyright Treaty and the WIPO Performances and Phonograms Treaty.

IPR Enforcement: Despite the enforcement efforts of Chinese officials, the Chinese government needs to increase its effectiveness and coordination in enforcement in order to successfully reduce persistent high levels of piracy and counterfeiting. Local interests often impede consistent and even enforcement of IPR regulations. Many of China's largest markets continue to openly sell pirated and counterfeit goods, despite repeated requests that China shut down and prosecute vendors of infringing goods. However, local officials have made notable initial progress in certain larger markets on specific brands, particularly in Beijing and Shanghai.

Industry associations representing computer software, entertainment, and consumer goods industries report high levels of piracy and counterfeiting of all types of products. The Business Software Alliance estimates that more than 90% of business software used in China is pirated. Consumer goods companies report that, on average, as much as 20% of their products in the Chinese marketplace are counterfeits. Chinese companies experience similar, or greater, problems with piracy and counterfeits.

Both local produced and imported pirated products continue to flood the Chinese market. The levels of optical media piracy (CDs, VCDs, and DVDs) in China remain at extremely high levels. Furthermore, China remains a center for entertainment software piracy and the production of pirated cartridge-based video game products. The black market for audiovisual products is due in part to excessive market access restrictions, as China tightly controls the distribution of films, books, and music. End-user piracy of business software within the government continues unabated despite issuance of directives to government ministries to use only legitimate software. In addition, the piracy of journals and books, which has moderated in recent years, may be worsening again. The counterfeiting of goods bearing American trademarks runs rampant.

Despite enforcement efforts against such activities, IP pirates continue to produce, sell, and export counterfeit goods. An increasing number of Internet sites offering pirated products have appeared in China. U.S. Customs and other customs authorities' seizures of Chinese-origin goods violating IPR continue at high levels. In medicines, companies registering legitimate medicines and other patented products in China often find the that confidential data they are required to submit to the relevant government agencies is compromised, leading unscrupulous local generic producers to produce unauthorized imitations, sometimes with poor quality or content standards, resulting in unhealthful products.

While industries report improved cooperation with administrative enforcement agencies in regard to raids, the administrative penalties for IPR violations, often no more than confiscation of the counterfeit final products or nominal fines, are generally insufficient to deter counterfeiters. Although China has recently announced new lower thresholds to prosecute IPR crimes, it is too early at this time to determine what the effect of these reduced thresholds will be, including whether corresponding changes in China's administrative enforcement, police and prosecutors will enable more cases to be tried. China's criminal sanctions against IPR violations are seldom used, in part because of restrictions on types of admissible evidence and unclear mandates for law enforcement authorities with little experience in prosecuting IPR violations.

Combating IPR violations in China is a long-term, multifaceted undertaking. China has established special IPR civil courts in all provinces and major cities. Judges in Chinese courts are charged with fact-finding and have greater discretion in the adjudication of cases than those in the United States. However, rules on gathering evidence are more restrictive. The lack of specialized legal training of many trial court judges undermines the effectiveness of these courts. Moreover, criminal IPR cases are likely to be heard in the criminal division of the courts, where the lack of expertise in intellectual property matters is even more severe. A December 2004 judicial interpretation on criminal prosecution of IPR violations issued by the Supreme People's Court and Supreme People's Procuratorate did not fully address longstanding criticisms of China's ability to use criminal sanctions to better enforce IPR. Similar institutional challenges exist in other areas as well. China's police, the Ministry of Public Security, handles all IPR crimes through the Economic Crimes