fter more than two decades as the world's destination of choice for FDI, a recent string of regulatory changes by China's central government should cause investors to reconsider their China investment strategies.
   Currently 80 percent of China's GDP is composed of exports and fixed investment. Stephen S. Roach, the chief economist at Morgan Stanley, describes this current economic structure as a "massive investment boom that … supports an all- powerful export machine." Hyperbole aside, his characterization is exactly the economic model Chinese Premier Wen Jiabao has called "unstable, unbalanced, uncoordinated, and unsustainable."
   During the recent investment boom, China's lack of strong regulatory enforcement, decentralized decision making and a "look the other way" policy towards local interpretations of laws and regulations successfully promoted investment to a level where the negative impacts can no longer be ignored. Environmental degradation of all kinds has run rampant, wage inflation and pressures on the labor pool are increasing, and social tension has risen as a large percentage of China's agrarian and working class feel that they have been taken advantage by unscrupulous officials and their network of business associates.
   Acknowledging the shortcomings of the current economic model, the central government has set out on a far- reaching and ambitious effort at economic readjustment. For investors in China, this signals a tightening regulatory atmosphere that includes a new tax policy and stricter controls on the country's land, environment, and resources.    For nearly 30 years, China's staggering economic success has been primarily a result of foreign capital funded investments in manufacturing assets and its accompanying export- led growth. With close to double- digit growth rates over the past two decades, few complained that the system lacked tangible benefits. Real GDP in 2005 was about 12 times the level in 1978 when reforms began.
   Yet policy makers have become keenly aware of the drawbacks of this system. China's economy is now excessively reliant on the manufacturing sector. Industrial production currently accounts for 52 percent of China's GDP compared to 37 percent in other low and middle income countries and 32 percent in developed economies. China's economic structure is one of the most lopsided in modern history.
   Since 1978 when China first opened its doors to foreign investors, export- oriented companies rushed to set up shop in China's low cost coastal cities to take advantage of the region's excellent logistics and human capital and the relative ease of investing. Today, such concentrations of manufacturing capacity have resulted in large income disparities between China's coast and its interior and between urban centers where foreign companies congregate and the rural areas investors have traditionally avoided.
   A heavily manufacturing- based economy is inherently resource intensive. China's historically inefficient manufacturing base now faces problems of environmental degradation, the inefficient use of scarce resources and growing labor market shortages. Beijing's policy makers are keenly aware of this, and as shrewd decision makers with a long- term focus have recently begun to set in motion regulatory changes and implement the enforcement that they believe will transform the economy.    Policy makers hope to create a new economy based on protecting the environment, reducing resource consumption, energy conservation and moving away from the export- led growth to growth based on domestic consumption and investment, and addressing the growing social inequalities of the country.
   In order to create this new economic structure, policy makers have chosen to rely on the power of the center to push through top- down changes. The brand of dictatorial capitalism that was employed so effectively to quickly build the infrastructure required to fuel the growth is now making a major philosophical change.
   In the past the central government set policies that included "gray areas" which allowed provincial- and municipal- level decision makers the latitude to interpret these policies to the advantage of local developments. This is evident in the use of measures such as eminent domain to acquire land for industrial and commercial development, and a project approvals process that required very little documentation and even less evidence of the actual feasibility of the planned investments.
   Today the central government is again using policy as a means to transform the economy. However, it is a far cry from the liberal minded days of the past. On almost a monthly basis new policies are being announced that are making the approvals process for new investments a more difficult task. For investors, this means a tightening regulatory atmosphere in many sectors and an increased vigilance on enforcement of these policies.    Traditionally the governments of developing economies have used tax breaks and incentives as one of the key factors in attracting FDI. Foreign manufacturing enterprises were afforded generous tax holidays and reductions and other preferential fiscal policies in an attempt to lure them into China. Foreign direct investors were offered an attractive 2+3 scenario whereby the first two years of profitable operations were exempt for corporate income tax and during the next three years they received a 50- percent reduction on a reduced income tax rate. This coupled with several other tax incentives such as one for "advanced technology" firms, companies that invested in Western provinces (the "Go West" program), discretionary subsidies and sizable rebates on the municipal and provincial governments' portions of tax revenues, made China an even more attractive destination for global manufacturers.
   One of the most significant regulatory changes is the recently announced Enterprise Tax Law. Approved in March 2007, the new law, which officially begins January 1, 2008, but is retroactive to March 16, 2007, unifies all corporate tax rates in China. Now all foreign enterprises approved after March 16, 2007, will be subject to a 25- percent corporate income tax rate, the same rate to be levied on domestic enterprises. With the passing of this law, China has clearly changed its course in an effort to wean the economy off its reliance on foreign, export- oriented industries and toward giving a boost to domestic companies, which for the past two decades, had been forced to pay higher corporate taxes than their foreign counterparts.
   In line with their economic rebalancing, policy makers will also use exemptions in the new tax law to help stimulate the economic rebalancing they seek. High tech enterprises across China, even those enterprises established outside of the country's many economic development zones (EDZs), will pay only a 15- percent rate in their corporate income taxes. (Investors, pay attention: The criteria for "high tech" status should be clarified later this year, and are likely to be much more stringent requirements than those associated with the past High Tech or Advanced Technology designations).
   There will also be a tax credit for investment in equipment for environmentally friendly, energy- saving projects and a bonus deduction for venture capital engaged in start- up investments.
   Although many of the law's details have yet to be worked out, it is widely speculated that the Central and Western regions of China will continue to receive some preferential treatment. Such policies aim to direct investment away from the saturated coasts and inward in an effort to address mounting development disparities.    Land in China is also under the central government's radar. In the words of the former head of the Ministry of Land and Resources, China has begun implementing its "toughest land management system." China's well- documented transfer of farmland for industrial development has forced its leaders to place land management at the top of their agenda.
   Investors should take note. In years past, industrial land in China was considered cheap because EDZ officials often sold land at below market prices. Large industrial plots at below market values acted like inexpensive fuel for China's export oriented economy. A report issued by the State Council of China revealed that from 2003 to 2005, 60 EDZs transferred over 8.4 billion sq. ft. (780 million sq. m.) of land at prices below the official base. Some transactions involved shady land transfers of agricultural land and led to excessive investment in already overdeveloped areas. Much of that reclaimed industrial land has been inefficiently developed by local leaders trying to increase investment in their localities and polish their resumes. More pressing for the government, the reclamation of agricultural land has infuriated the poorer rural populations already at odds with the country's current economic imbalances.
   In order to combat these losses and steer the country away from such growth, the government recently set new minimum land usage rights price standards by dividing the municipalities and counties of China into 15 categories and setting minimum prices for industrial land use rights for each grade.
   Shanghai's Puxi district is the only Grade I classified area in the country. Grade II land consists of Beijing and Shanghai Pudong. Grade III includes Guangzhou and Shenzhen. Many second- tier cities fall under Grade IV. At the other end of the scale, Tibet and Xinjiang are categorized as Grade XV.
   The government also has hiked rates for a new urban land use tax from which foreign investors were previously exempt. Additionally, the government has set aside a minimum of 296 million acres (120 million hectares) of agricultural land that is not being developed until 2020. For the past few years, and much to the chagrin of the central government, the country's yearly limits on industrial land developments have all been surpassed. A new policy requiring all industrial land to be auctioned to the highest bidder went into effect in December 2006. To- date enforcement has not been strict, but that is set to change on July 1, 2007, when it will become mandatory for all industrial land sales to use the new auction system. Vigilance from the center should only increase, and cheap land to feed investment will become scarcer.    China today remains highly skewed towards a pollution- and energy- intensive economy. China's services sector remains in its infancy, and so the economy thrives off of a growth model that requires excessive output of machinery and equipment and a constant input of raw materials, energy, and resources. China's leaders are set on moving the economy away from these resource- heavy industries in order to halt environmental degradation and cool the country's voracious appetite for resources.
   Premier Wen has been hammering this point home for months now. In recent speeches he has admonished his countrymen about their current energy woes: China is currently using 15 percent of the energy consumed in the world to produce 5.5 percent of the global GDP. And while the economy grew 11.1 percent in the first quarter of 2007, power consumption surged 14.9 percent.
   For investors, this signifies a new concern from the Government's approval authorities about the energy and resource conservation methods to be used by investors. Energy- and pollution- intensive industries will now face higher hurdles for approval, and many will not be allowed to proceed without the addition of costly pollution control or energy conserving equipment. Many potential investors in these categories are likely to be turned down. Investors in the developed coastal areas will encounter the most scrutiny as officials in those areas will be under the most pressure to reign in energy consumption and clean up the environment.
   All new investment projects are now subject to a newly initiated assessment prior to approval. Known as the Energy Conservation Assessment, this approval is similar to the more well known Environmental Impact Assessment required of most large- scale investors. The energy assessment is undertaken by a group of experts who will review the project's equipment, facilities, and application documents in order to verify the investment will implement energy saving technology and will attempt to reduce its resource consumption.    Despite the changing regulations, investors should not expect an immediate 180- degree reversal on all fronts. There is the economy that China's government wants, and the economy that exists today. Any time change is pushed down from above in a place as big as China, results will be mixed. That said, investors experiences in the first half of this year have shown that vigilance is increasing.
   The central government has tried many times to set minimum prices and control land development, only to fail. On recent projects however, land bureaus have paid close attention to these new regulations and pricing guidelines. These changes to the land policy have caused EDZ officials consternation and in some cases, the local EDZ officials have had to lobby hard behind the scenes to successfully transfer land for industrial projects.
   EDZs will likely try to continue to find creative ways to transfer land at below market prices by drafting agreements that include subsidies and other "outside of the box" compensation measures. Some EDZs have even created third party private real estate development companies in an attempt to circumvent the new regulations. But our experience tells us stricter land enforcement is here to stay.
   On the resource conservation side, an increasing number of companies, including our clients, have already had to jump through the Energy Conservation Assessment hoop. While the program is still new and lacks the sometimes more onerous requirements of the Environmental Impact Assessment, the Energy Assessment adds another step to the investment process. We also foresee a not so distant future when the Energy Assessment will be just as strict as its environmental cousin, and investors will need to hire a government- licensed firm to compose a written report and defend their project to approval authorities.
   The central government is not the only one getting involved in enforcement. Just this past May, the government of Xiamen was forced to halt construction on a chemical plant 10 miles (16 km.) outside the city center because of social activism. Local residents sent more than 1 million text messages protesting the plant and expressing their concerns about the possibility of hazardous pollution.
   The ability to leverage the guanxi (relationships) of an investor's local business partner or the economic development zone officials and their relationships with other government officials to structure a deal that is quickly approved and maximizes incentives is rapidly disappearing.    Quite simply the answer is "yes." Despite changing regulations and higher costs, China still has a lot to offer investors and should be considered as a major part of any company's global strategy. Even as the measures to slow the economy take effect, China will continue to experience robust growth in both exports and a burgeoning domestic demand. Even at half of the current growth rate, opportunities will abound at all levels of the value chain.
   But the economics of investing in China are changing. Prudent investors would be wise to take a hard look at their project plans. After evaluating their energy requirements and pollution outputs, investors need to be more careful in choosing their investment location. No longer will a generic location in China meet the majority of an investor's requirements. China's coastal areas are generally no longer low cost locations of choice for manufacturers, and most of the current opportunities in these areas are those that fill existing gaps in the supply chain. Investors should expand their China location searches to include more central and western locations. These areas will retain greater bargaining power than the coastal regions and remain attractive with their lower costs and continued preferential policies.
   EDZs subsist on investment and will continue to find ways to attract it. As EDZ officials and investors create increasingly complex agreements that take advantage of existing legal loopholes, investors will need to seek seasoned real estate and legal advice to ensure that they do not expose themselves to any unnecessary risks and are able to craft dependable and enforceable investment agreements. Finding the optimal site that will minimize regulatory constraints, meet the highest percentage of an investor's requirements and maximize the return on investment is paramount. Our advice to investors in China is this: Take the time to do it right, as location decisions are irrevocable once made.
   We also advise that investors broaden their searches beyond China and also look at south and southeast Asia as locations for their Asian investments. Vietnam has already seen FDI worth about US$ 4 billion rush into their economy in the first five months of 2007. India is rapidly improving its infrastructure and already is more competitive than China on labor costs. Often it is not about one location to serve the globe or even serve the Asian markets, but several locations in Asia to serve the region and global demand.
   We believe that looking at China as an investment destination is still the right choice as long as it is part of an overall integrated Asian investment strategy. In the end, all decisions should be based on the numbers and how quickly an investor will get its targeted return on that investment. China does and will continue to offer investors opportunities of competitive returns on investment for years to come.

   This article was authored by Matt Livingston, a consultant based at the Shanghai offices of Tractus Asia Ltd. For further information please contact him at matt bounce@tractus-asia.com or log onto www.tractus-asia.com.