China should review and alter its policies for attracting foreign direct investment so that it taps the potential of service sector

According to the latest data from the Ministry of Commerce, there has been a shift in foreign direct investment (FDI) in China from manufacturing to the service industry the most important industry for China's future.

In the first 11 months of 2011, the domestic service industry absorbed $48.8 billion of FDI, or 47 percent of the total FDI in China, surpassing the $47.3 billion of FDI in manufacturing.

For a long time the percentage of FDI in the service industry remained low, around 25 percent from 1999 to 2005, lagging far behind its development potential. It was not until 2006 when the industry was opened-up according to World Trade Organization agreements that the percentage began to rise dramatically.

Since then, foreign investments in China's service industry have seen not only huge increases (18.54 percent in 2011), but also some deeper tendencies. The first is the rise of the research and development sector. For example, according to public data, the foreign investment in science, technology and geological explorations in China has risen from $340 million in 2005 to $1.97 billion in 2010. And a McKinsey and Company report in 2010 found that multinational corporations are investing more in R&D in China. Microsoft's China R&D base, for example, became its biggest overseas R&D facility in 2010.

Also to be noted are the investments in retail and the realty market, both of which have increased more than four times in five years. Besides, the channels for FDI to enter China are also expanding, and more multinationals enter China through mergers and acquisitions, thus changing the total industry chain.

China's use of foreign investment is entering a period of service-industry-led growth, with many new characteristics that distinguish it from the manufacturing boom.

International competition to attract investment in the service sector is so fierce that China does not enjoy as many advantages in the service industry as its manufacturing industry does. For example, with people older than 60 accounting for 13.3 percent of the total population, much higher than those of neighboring India and Vietnam, it lacks competitiveness in human resources.

Moreover, it has become a common practice for many countries opening their domestic markets to attract foreign investment. India passed a long-debated bill in 2011 that allowed Walmart and other international supermarkets to take 51 percent of the share of joint ventures, while Brazil cut the transaction tax for foreign investment in infrastructure from 6 percent to zero on Dec 1. All intensified the competition for attracting investment.

Another change has occurred within the service industry itself. Of China's expanding service industry, the sectors that provide direct services to manufacturing are growing the fastest, while their importance is also increasingly emphasized. That echoes China's need to upgrade its economic structure by making its economy more like that of developed countries, where such manufacturing-related industries as telecommunications, finance and transportation account for a significant part of the whole service industry.

Of course, to make this upgrading a reality, China needs to review and alter its policies for attracting foreign investment, which has long focused on manufacturing. It should also improve the domestic investment environment to attract more high-quality investments. The service industry relies more on soft elements such as transparent governance and high-quality public services than the manufacturing industry; this requires China promote social justice, better protect intellectual property rights, and further open-up certain sectors.

This new period will also see the rise of some fresh problems that demand urgent solutions.

First, attention should be paid to national economic security on which the service industry casts a greater and deeper influence than its percentage in GDP. For example, credit rating is a very small sector of the industry, but it is directly related to the stability of the macroeconomy; also if China's high-end auditing market is wholly controlled by foreign enterprises, its data will no longer be safe.

So China needs a more flexible and positive policy regarding its economic security. A comprehensive and complete regulating mechanism must be established in the long run.

Second, the domestic service industry might suffer under the current conditions. A truly fair environment should be open to both international and domestic investors alike. China's entry into the WTO has guaranteed foreign investors' access into the Chinese market, but private investors at home still do not enjoy such treatment. The State is still running some monopolistic giants while private capital is not allowed to enter profit-making service sectors.

So we expect in the future China will give domestic investors equal treatment through policy arrangements, so that they can survive in the increasingly intensified competition.

The authors are researchers at the National Economic Strategy Institute, Chinese Academy of Social Sciences.