Foreign direct investment (FDI) represents capital invested in a country that provides manufacturing and service capabilities for both native consumers and world markets. FDI is instrumental in bringing goods and services to the global marketplace, and the influx of foreign investment not only displays investor confidence in the business and the geopolitical climate of the host country, such capital also links national economies.

The benefits of FDI flow to both the supplier of capital as well as to the host region. China is one country that has stepped up to capitalize on these benefits. According to China's commerce ministry, FDI in 2010 surpassed $100 billion for the first time. Over the entire year ending December 2010 inbound FDI increasded 17.4% to $105.74 billion. Let's take a look at the factors that drive foreign investment in China, and examine what this means for investors - and the Chinese economy. (International investors need to be aware of the staggering correlation between tax rates and economic performance; see How International Tax Rates Impact Your Investments.)

FDI In China

Several factors affect the amount of FDI that pours into China:

1. Capital Availability

In the early 2000s, China overtook the United States as the world's largest recipient of foreign capital. FDI is comprised of capital that an outside investor is willing to place (and risk) within a local region. Conditions in the global capital markets and general economic environment play a role in determining the flow of FDI into China. A thriving global economy, capital markets and business environment create large swaths of investable capital, a portion of which is converted to FDI. Large amounts of investable capital that proportionately overwhelm the number of sound local investment ideas can cause institutional, company and individual investors to invest their wealth in emerging and developing markets. (Learn more in Understanding Capital And Financial Accounts In The Balance Of Payments.)

2. Competitiveness

China's attractiveness as a destination for investment capital rests on its development of infrastructure, resource availability (physical and labor), productivity and workforce skills, and the development of the business value chain. The level of maturation of these elements can make China more attractive for FDI relative to other nations, such as India, that compete and vie for the same investment capital. A growing and developing economy requires infrastructure and resources in order to facilitate the sale of goods and services. Lower transaction costs, due to the maturation of these elements, enables investors to earn returns on their investments as their enterprises are able to generate profits. Roads, highways, bridges and other forms of physical infrastructure should be present, maintained and provide sufficient safety for the transportation of goods as well as for the commute of employees. (For more on the importance of infrastructure, see Build Your Portfolio With Infrastructure Investments.)

Another component for attracting FDI involves the availability of low-cost, skilled employees who possess the necessary aptitudes, experience and proficiencies to create, manufacture, and provide goods and services that can compete in global markets. (Learn how the Bretton Woods system got the ball rolling for world trade, read Global Trade And The Currency Market.)

3. Regulatory Environment

When a national government enacts and enforces rules and policies aimed at favoring state entities at the expense of privately held firms, such an environment can be detrimental to initiatives that aim to attract FDI. As such, the regulatory environment can either encourage or impede foreign direct investment in China. Excessive regulations tend to hinder entrepreneurial and commercial activities, as managers and employees must spend more time and money to comply with rules and regulations. If an investor wants to set up a manufacturing facility in China, high start-up costs, legal exposure and other cumbersome compliance items may encourage that investor to set up the facility elsewhere, where the business climate is more conducive to industry. (For a counterpoint to this articles, see Free Markets: What's The Cost?)

Other types of regulations include mandatory joint venture partnerships in which, together with the foreign investor, the business is required to have a Chinese government agency or local company as a partner. A judicial system that is biased toward protecting Chinese locals - who conduct what are sometimes perceived as unfair, illegal, or unethical business practices - can also contribute to making China a less favorable investment destination. (Investing overseas begins with a determination of the risk of the country's investment climate, read Evaluating Country Risk For International Investing.)

Another regulatory determinant involves the government's promotion of investment activities by providing attractive financial incentives in the form of tax breaks, grants, low-cost government loans and subsidies. Government-sponsored financial inducements provide the possibility of making a business more profitable and in a shorter amount of time.

4. Stability

Political and economic stability can facilitate an influx of FDI. Stability represents predictability and the opportunity for enterprises to gain better foresight into the future. Alternatively, constant social unrest, rioting, rebellions and social turmoil are settings not conducive to business. Economic instability can also contribute to hyperinflation, which can render the currency virtually obsolete. To encourage FDI, citizens/workers as well as businesses should have a reasonable basis for respecting Chinese law and order. Violence, criminal activity, blackmail, kidnappings, and counterfeit currency and products have all been problems in China that serve to undermine the efficacy of conducting trade activities. The justice system should also have effective mechanisms for reducing, or altogether eliminating, rogue and corrupt elements of law enforcement agencies. (Hedging against currency risk can add a level of safety to your offshore investments. Check out Protect Your Foreign Investments From Currency Risk.)

5. Local Chinese Market and Business Climate

The most glaring aspect of China is the sheer size of its population and market, and the prospects for growth that result from this size. The ability of enterprises - backed by foreign capital - to sell to a sizeable local market makes China an attractive destination for FDI. As the Chinese economy continues to prosper, evolve and mature, higher-end industries such as healthcare, information technology, engineering, robotics and luxury goods, among others, can gain a bigger footprint in China as its local conditions, resources and other FDI determinants are enhanced. Additionally, economic growth and FDI can start a "success domino effect." The more the region attracts FDI, the more it grows. The more it grows and matures, the more investors are willing to provide FDI. This point underscores the advantage of China's sizeable market, which presents growth opportunities in current and prospective commercial activity. The more FDI flows into the country, the greater the economic chain reaction, providing a positive effect to sustain such growth. (Find out how these worldly offerings can spice up your portfolio, see Go International With Foreign Index Funds.)

6. Openness to Regional and International Trade

Market openness serves several important roles in attracting FDI. Of critical importance is a business' ability to sell its products and services to both local and foreign markets. If Chinese-based enterprises have limited or no access to foreign customers - particularly the United States, Western Europe, Japan and others - then the local market may not be enough to warrant a significant investment in money and energy. Trade barriers such as tariffs are typically viewed as disincentives by other nations. An American product that is subject to high tariffs in China will be less in demand in the Chinese market due to the artificially inflated price. Such actions typically prompt retaliatory tariffs from the U.S. on Chinese products, or in certain extreme cases, an outright ban on certain goods and services. (For more insight, read The Basics Of Tariffs And Trade Barriers.)

Export-friendly policies, then, can play a major role in deciding whether to invest in China, especially for enterprises that have a large portion of their anticipated market shares located outside of the local market. In efforts to create a more business-friendly environment, regional and international free trade agreements are typically initiated by market-progressive governments as reasonable mechanisms for inducing economic activity and growth.

The Bottom Line

For a developing economy like China's, foreign investment is a key way to spur development and pull the country's economy toward a competitive spot in the global marketplace. However, in order for FDI to occur, certain conditions must be in place.

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