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Foreign capital inflows and trade policy change: The automotive and consumer electronics industries in Brazil and China

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Foreign capital inflows and trade policy change: The automotive and consumer electronics industries in Brazil and China

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Content FOREIGN CAPITAL INFLOWS AND
TRADE POLICY CHANGE:
THE AUTOMOTIVE AND
CONSUMER ELECTRONICS INDUSTRIES IN
BRAZIL AND CHINA
by
Feng Xu
A Dissertation Presented to the
FACULTY OF THE GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
DOCTOR OF PHILOSOPHY
(INTERNATIONAL RELATIONS)
May 2001
Copyright 2001 Feng Xu
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UMI Number: 3 0 2 7 8 0 6
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UNIVERSITY OF SOUTHERN CALIFORNIA
TH E GRADUATE SCHOOL
UNIVERSITY PARK
LOS ANGELES. CALIFORNIA 90007
This dissertation, written by
FEtJfr £ W L .
t
under the direction of h.x.A Dissertation
Committee, and approved by all its members,
has been presented to and accepted by The
Graduate School, in partial fulfillment of re
quirements for the degree of
DOCTOR OF PHILOSOPHY
C T N / t r
Dean o f Graduate Studies
Date
DISSERTATION COMMITTEE
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Feng Xu Abraham F. Lowenthal
John S. Odell
ABSTRACT
FOREIGN CAPITAL INFLOWS AND TRADE POLICY CHANGE:
THE AUTOMOTIVE AND CONSUMER ELECTRONICS INDUSTRIES
IN BRAZIL AND CHINA
This dissertation seeks to explain why foreign capital inflows in various forms
perpetuate the restrictive import regime in some instances but facilitate trade policy
opening in others.
The author identifies two variables that might shift trade policy in one direction or
the other: (1) the ratio of foreign direct investment (FDI) to external debt, and (2) the
inward/outward-orientation of foreign investors.
His hypotheses are that the more foreign capital inflows are associated with FDI
rather than commercial bank loans, and the more outward-oriented the foreign investors,
the lower the level of tariffs. As two distinct forms of foreign capital inflows, FDI and
external debt can have very different impacts on government decision whether to use the
exchange rate or tariffs for current account adjustment. A higher level of external debt
relative to FDI gives the government less incentive to devalue its currency for external
adjustment because devaluation increases the local currency value of a debt denominated
in foreign currency. A higher level of FDI relative to external debt gives the government
more incentive to do so, since a rise in FDI shifts foreign exchange risks more onto
foreign investors, and devaluation therefore works against foreign investors rather than
the debtor country by lowering the value (in dollars) of fixed foreign assets. A real
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devaluation, which makes imports cheaper and exports more competitive, is conducive to
import liberalization.
To evaluate these two hypotheses, the author selects two pairs of contrasting,
sector-specific episodes: the Brazilian government decisions to raise automobile tariffs in
the late 1960s and lower them in the 1990s; and the Chinese government decisions to
lower tariff protection for consumer electronics while at the same time raising it for
automobiles during the 1990s. As the evidence shows, two significant reasons for the
variations were changing levels of FDI relative to external debt, and a changing
orientation of foreign investors as between domestic sales and exports. These cases
therefore provide support for both hypotheses.
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II
Table of Contents
List of Tables and Figures IV
Chapter One
Toward a Theory of Foreign Capital Inflows and Trade Policy
Change
1. Introduction 1
2. An Overview of the Literature on the Linkage of Foreign Capital
Inflows and Trade Policy Change 2
3. Hypotheses and Case Selection 10
4. Alternative Explanation 16
Chapter Two
The Brazilian Automotive Industry during the 1960s and 1990s:
Types of Foreign Capital Inflow, FDI Orientation, and Trade
Policy Change
1. Background to the Installation of the Brazilian Automotive Industry 19
2. The Surge in FDI under the Auto Program 23
3. Debt Financing and Its Impact on Foreign Exchange Policy 30
4. The Inward Orientation of FDI, the Lower FDI/Debt Ratio, and Trade
Policy Closure 32
5. From the BEFIEX Program to the Debt Crisis: The Shift to Export
Production 44
6. Debt Rescheduling and Reduction 54
7. The Outward Orientation of FDI, the Higher FDI/Debt Ratio, and
Trade Policy Opening 58
Chapter Three
The Chinese Automotive and Consumer Electronics Industries
during the 1990s: FDI Orientation and Trade Policy Change
1. FDI in the Context of China’s “Open Door” Policy 71
2. The Inward Orientation of FDI and Trade Policy Closure in the
Automotive Industry 88
3. The Outward Orientation of FDI and Trade Policy Opening in the
Consumer Electronics Industry 102
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Chapter Four
Conclusions: Limitations and Applicability of the Hypotheses
Bibliography
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IV
List of Tables and Figures
Table 1 Import Exchange Rates by Categories, 1953-57 22
Table 2 Domestic Content Requirements, 1956-60 24
Table 3 Firms Undertaking Vehicle Production in 1960 28
Table 4 Structural Change in the Brazilian Automotive Industry 29
Table 5 Brazil’s Average Tariff Rates by Sector, 1966-69 39
Table 6 Export Engagement under the BEFIEX Program (1973-85) 48
Table 7 China’s Passenger Car/Jeep Joint Ventures 83
Table 8 China’s Electronics FIE Exports as a Percent of Total Output
and Sales, 1993-96 106
Table 9 China’s Electronics FIE Exports as a Percent of Total Sectoral
Exports, 1993-96 107
Figure 1 Brazil’s Average Tariff Rates for Transportation Equipment,
1966-77 34
Figure 2.1 Brazil’s Real Exchange Rates, 1963-70 41
Figure 2.2 Brazil’s Real Effective Exchange Rates, 1970-80 42
Figure 3 Ratio of FDI Stock to Debt with Commercial Banks, 1970-80
43
45 Figure 4 Brazil’s Balance of Payments, 1950-80
Figure 5 Brazil’s Vehicle Exports as a Percent of Total Production,
1970-87 54
Figure 6 Ratio of FDI Stock to Debt with Commercial Banks, 1980-93
65
66 Figure 7 Brazil’s Real Effective Exchange Rates, 1987-95
Figure 8 Brazil’s Average Tariff Rates for Motor Vehicles, 1990-95 69
Figure 9 China’s Simple and Trade-Weighted Average Tariff Rates for
Passenger Cars and Jeeps, 1985-1996 72
Figure 10 China’s Trade-Weighted Average Tariff Rates for Electronics
and T elecommunication Products, 1987-1996 73
Figure 11 China’s Annual Exports of Passenger Cars and Jeeps, 1983-
92 82
Figure 12 China’s Imports of Passenger Cars and Jeeps, 1983-90 93
Figure 13 China’s Imports of Passenger Cars and Jeeps as a Percent of
Total Output, 1985-90 94
Figure 14 Localization of the Shanghai VW Santana, Beijing Jeep
Cherokee, and Guangzhou Peugeot Model 505 Sedan, 1985-
93 95
Figure 15 China’s Real Effective Exchange Rates, 1987-93 100
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Chapter One
Toward a Theory of Foreign Capital Inflows and Trade Policy Change
While foreign capital inflows in various forms are a common phenomenon in the
process of less developed country (LDC) economic development, such inflows seem
to perpetuate the restrictive import regime in some instances but contribute to trade
policy opening in others. Why?
In countries or industrial sectors where foreign capital inflows are large and FDI
predominant, trade policy, or the level of tariffs more specifically, is likely to be
affected by two factors: the type of foreign capital inflows and the inward/outward-
orientation of FDI. In other words, the more foreign capital inflows are associated
with FDI rather than commercial bank loans, and the more outward-oriented the FDI,
the lower the level of tariffs.
1. Introduction
With the opening of the capital account in LDCs and the globalization of the
world economy, the flow of foreign capital to the developing world has increased
tremendously. Four asset types with respect to foreign capital inflows can be
identified—foreign direct investment (FDI), commercial bank loans, foreign bonds,
and foreign equity shares.1 At the start of the 1980s, LDCs, taken as a group, had
come to rely heavily on borrowing from banks. In 1981, commercial bank loans
made up nearly half of all gross long-term foreign capital inflows. In the 1990s,
1 Sylvia Maxfield, Gatekeepers o f Growth (Princeton: Princeton University Press, 1997), p. 36.
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2
however, FDI replaced bank loans to become the predominant instruments of foreign
capital inflows.2 Compared with bonds and equity shares (or the so-called portfolio
investment), FDI and bank loans usually have a lasting effect on recipient country
economic policy due to the relatively low liquidity.
Despite the fact that foreign capital inflows have grown faster than ever before,
the way they are related to trade policy change remains largely unexplored. Most
literature on the international capital movement focuses on the impact of FDI on
economic restructuring, trade performance, and employment, or, conversely, on the
determinants of FDI. On the other hand, the literature on trade rarely sees policy
change in the light of foreign capital inflows. Given the fact that foreign capital
inflows can affect the recipient country’s current account and real exchange rate, and
alter the composition of domestic interests if FDI is involved, an attempt to bridge
these two bodies of literature will help us better understand trade policy change. At
least, it could open up a new field for further research.
2. An Overview of the Literature on the Linkage of Foreign Capital
Inflows and Trade Policy Change
There is no linear relationship between foreign capital inflows and trade policy.
Foreign capital inflows, especially commercial bank loans, affect trade policy by
way of the exchange rate. As Jeffry Frieden has noted, foreign capital inflows
increase local availability of foreign currency, and cheapen its price. In other words,
2 Anonymous, “Capital Flows to the Third World: From Bank to Market,” Economist, April 24, 1993,
p. 84.
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3
the local currency appreciates against foreign currencies.3 A real appreciation, as it
makes imports cheaper and helps fuel the excess demand for imports, is often
followed by import restrictions or higher tariffs in order to reduce the effects of the
currency appreciation on the worsening balance-of-payments (BOP) situation.
Unlike Frieden, who focuses on debt financing, the configuration of domestic
interests, and their impact on the overall economic development and political
democratization in major Latin American countries, Donald Coes takes a step further
to link foreign capital inflows directly to trade policy change. Coes’s study begins
with a conventional model of trade liberalization that suggests a reduction in tariffs
should lead to a real depreciation. Export response to the real depreciation, as the
model goes on, will absorb the factors released by the contraction of import-
substituting production. According to Coes, however, this model is flawed because it
implicitly ignores the capital account or at least assumes it to be unchanged. If trade
liberalization occurs concurrently with the opening of the capital account, Coes
argues, any effects import liberalization may have in forcing a real depreciation tend
to be offset by a real appreciation due to foreign capital inflows. Thus, the
simultaneous opening of the capital account could disrupt the trade liberalization
process if (a) import liberalization is modest, (b) part of trade liberalization is on the
export side, through the reduction of anti-export bias, and/or (c) foreign capital
3 Jeffry Frieden, Debt, Development, and Democracy: M odem Political Economy and Latin America,
1965-1985 (Princeton: Princeton University Press), 1991, pp. 67-70.
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4
inflows are large in relation to the current account.4 For Coes, a case in point is the
reversal of earlier liberal trade policies in Brazil in the late 1960s.
Coes is not the only one who is aware of the effects of capital account opening
on trade policy. Economists including Rudiger Dombusch and Jacob Frenkel have
long argued that the capital account should not be liberalized until a real depreciation
is achieved. One theoretical base for such a delay is that asset markets will respond
more quickly than goods markets to new price signals.5
The above summary implies that foreign capital inflows are prompted by
domestic financial deregulation so that only investment in financial assets increases.
As the foreign currency is readily available, the net effects of such inflows are a real
exchange rate appreciation. However, if foreign capital inflows are used not to
finance domestic consumption or BOP deficits but to finance capital accumulation in
the form of FDI, these inflows tend to enhance the productivity of the economy. In
such a case, the orientation of FDI toward the domestic or international market is of
critical importance to the real exchange rate movement. Generally, a high degree of
export orientation promotes a real depreciation.
The literature on FDI is far richer than that dealing with foreign capital inflows in
general. Nevertheless, a small number of studies that link FDI-related variables to
trade policy change are confined to developed countries, especially the United States.
For example, Helen Milner identifies the level of export dependence and
4 Donald Coes, “Brazil,” in Demetris Papageorgiou, Michael Michaely, and Armeane M. Choksi, eds.,
Liberalizing Foreign Trade, Vol. 4, The Experience o f Brazil, Colombia, and Peru (Cambridge,
Mass.: Basil Blackwell, 1991), pp. 12, 68-69.
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multinationality as two determinants of firms’ trade policy preferences, drawing on
case studies of U.S. and French industries.6 On the premise that inward foreign direct
investment (IFDI) can change the configuration of domestic interests for and against
trade barriers, John Goodman, Debora Spar, and David Yoffie argue that the
aggregate demand for protection over time is likely to decrease if IFDI is import-
complementing and to increase if it is import-substituting. Again, their conclusions
come from a probe into five U.S. industries. Although not a single study on FDI is
devoted to trade policy change in LDCs, some do point to that direction.8
Apart from the analysis of the financial and BOP effects of FDI, the FDI theory
as it is commonly known falls into two categories. The first is an aspect of the more
general subject of the theory of factor mobility in international trade. It is intended to
explain not only the circumstances in which capital moves abroad but also the
5 Rudiger Dombusch and Jacob Frenkel, “Panel Discussion on the Southern Cone,” IMF S taff Papers,
no. 30, March 1983.
6 Helen Milner, Resisting Protectionism: G lobal Industries and the Politics o f International Trade
(Princeton: Princeton University Press), 1988.
7 John Goodman, Debora Spar, and David Yoffie, “Foreign Direct Investment and the Demand for
Protection in the United States,” International Organization 50, no. 4 (Autumn 1996), pp. 565-591.
8 For example, Jagdish Bhagwati suggests that the capital movement can include changes in both the
patterns o f trade and the volume o f trade, and it is these combined with changes in relative factor
prices that can create a loss in national welfare. Anne Krueger and Ian Malcolm David Little argue
that tariff barriers and consequent investment can be counterproductive in terms o f overall growth.
Charles Kindleberger, on the other hand, focuses more on the role o f multinationals in world trade
rather than their effects on national economic development. On a sector basis, Theodore Moran
presents an excellent case study o f resource-extracting FDI in Chile and the dominance o f social
groups tied to exports and foreign finance. While Raymond Vernon’s “product cycle theory”
hypothesizes about the reasons for multinational investment, the stories told rely, to some degree, on
the existence o f market imperfections for their explanations. See Jagdish Bhagwati, Essays in
International Economic Theory, Vol. 2, The Theory o f International Factor M obility (Cambridge,
Mass.: MIT Press, 1983); Anne Krueger, Liberalization Attem pts and Consequences (Cambridge,
Mass.: Bollinger, 1978); Ian Malcolm David Little, Economic Development: Theory, Policy, and
International Relations (New York: Basic Books, 1982); Charles Kindleberger, The Multinational
Corporations in the 1980s (Cambridge, Mass.: MIT Press, 1983); Theodore Moran, M ultinational
Corporations and the Politics o f Dependence: Copper in Chile (Princeton: Princeton University Press,
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welfare consequences of such movements. The second type of FDI theory is
concerned with the activities of multinational corporations (MNCs), analyzing why
firms prefer to integrate their operations across national boundaries.9 Two most
popular approaches to FDI in the latter category stress the exploitation of firm-
specific advantages (also known as intangible assets, which include technological
superiority, marketing expertise, large firm size, brand names, and differentiated
products) or location-specific advantages. Taken together, the FDI theory has
identified two types of FDI-—import substituting and export promoting.
As far as the theory of factor mobility is concerned, the Heckscher-Ohlin model
of international exchange contends that differences in comparative advantage or
relative factor endowments provide the basis for international production and trade.
Since the model assumes that productive factors are internationally immobile, it has
been extended to analyze the implications of capital mobility. And the standard
argument is that capital tends to flow to relatively capital-poor, labor-abundant
countries to maximize its expected return. So if the local market is large, FDI usually
takes place for market-penetration purposes. If the local market is small, foreign
production can be used as an export base. This view of the relationship between trade
1974); Raymond Vernon, Sovereignty at Bay: The M ultinational Spread o f U.S. Enterprises (New
York: Basic Books, 1971).
9 Richard Eckaus, “A Survey o f the Theory o f Direct Foreign Investment in Developing Countries,” in
Richard Robinson, ed., Direct Foreign Investment: Costs and Benefits (New York: Praeger, 1987), pp.
111-128.
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and factor mobility also suggests that tariff barriers could motivate import-
substituting FDI.1 0
Although the theory of MNC activities is not as rigorous as the theory of factor
mobility, it also offers important insights. More recently, there is a clear tendency in
the FDI literature to focus on the exploitation of firm-specific or location-specific
advantages as the major motive for FDI. The effective exploitation of firm-specific
advantages in an oligopolistic market structure sometimes requires firms to
“internalize” their international operations by establishing foreign affiliates to
maximize returns or reduce transaction costs. The trade policy orientation of FDI in
this case depends on the prevalence of market imperfections, including tariff barriers,
export subsidies, and exchange rate movements that affect the relative prices of
traded goods.1 1 While tariff barriers facilitate tariff-jumping FDI, other market
imperfections have opposite effects. For example, if export subsidies are large
enough to compensate for the high costs of local production and the exchange rate is
biased toward exports, other things being equal, export-promoting FDI could
emerge.
On the other hand, FDI often occurs when domestic firms consider themselves to
be in a comparatively disadvantageous position due to, say, rising domestic wage
rates. The reason they venture abroad is to exploit location-specific advantages of the
1 0 Magnus Blomstrom and Ari Kokko, Regional Integration and Foreign D irect Investment, NBER
Working Paper Series, no. 6019 (Cambridge, Mass.: National Bureau o f Economic Research, 1997),
p. 3.
1 1 Louka Katseli, Foreign Investment and Trade Linkages in D eveloping Countries (New York:
United Nations, 1993), pp. 30-31.
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1 0
host country, such as low-cost labor. If the host country happens to favor export
production, relocational FDI will do what it is supposed to do and become export
promoting. Thus, differences in relative factor endowments—which are a source of
differences in competitive advantage— combined with the specific conditions in
which FDI takes place help explain both the gravitation of FDI to the developing
world as well as its trade policy orientation.
Another classification of FDI divides it into four categories: resource-extracting
» 1T
FDI; component-outsourcing FDI; labor-seeking FDI; and market-seeking FDI.
Resource-extracting FDI is usually driven by the need to secure raw materials. It is
both pro-trade in the sense that it gives rise to new trade flows and export promoting.
Component-outsourcing FDI consists of intra-firm trade, where locally-produced
components are shipped abroad, usually back to the home country, for assembly.
Such FDI also creates trade and is export promoting. Labor-seeking and market-
seeking FDI are more complicated. Assuming that government policy is neutral and
biased neither toward imports nor toward exports, the trade policy orientation of
labor-seeking FDI depends largely on the size of the local market. The larger the
market, the more likely FDI is to be geared toward domestic production. Market-
seeking FDI is generally import substituting. But if it is involved in the manufacture
of differentiated products, such as automobiles, consumer durables, and
1 2 Kiyoshi Kojima and Terutomo Ozawa, Japan's General Trading Companies: Merchants o f
Economic Developm ent (Paris: OECD, 1985), Chapter IV.
Ij Katseli, Foreign Investment and Trade Linkages in D eveloping Countries, pp. 39-46.
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pharmaceuticals, that require international exchange, or if it aims to obtain scale
economies at a later stage, it could turn into export promoting.
Building upon the existing literature, I will explore the effects of foreign capital
inflows on trade policy at both macro and micro levels. At the macro level, I will
look at the aggregate of foreign capital inflows to find out how the mix of external
debt and FDI affects trade policy. At the micro level, I will examine how the trade
policy orientation of FDI contributes to trade policy change. Inspired by the interest
group approach, the micro-level analysis is intended to apply the interest-driven
argument to MNCs operating in developing countries.
This study goes beyond the existing literature in two aspects. First, Coes does not
distinguish between external debt and FDI in his study when talking about foreign
capital inflows (see above). He focuses mainly on the impacts of capital account
opening and the accumulation of external debt on trade policy. I will pick up what
Coes leaves behind to examine how the combination of external debt and FDI (not
just external debt alone) affects trade policy. This emphasis takes me directly to the
trade policy orientation of FDI. Second, much of the existing literature concentrates
on the effects of government policy on FDI flows.141 will go the other way around.
1 4 See, for example, Pimam Chuhan, Stijn Claessens, and Nlandu Mamingi, Equity and Bond Flows to
Latin America and Asia: The Role o f G lobal and Country Factors (Washington, D.C.: World Bank,
1993); Stijn Claessens and Moon-Whoan Rhee, The Effects o f Barriers on Equity Investment in
Developing Countries (Washington, D.C.: World Bank, 1994); Edward Coyne, Targeting the Foreign
D irect Investor: Strategic Motivation, Investment Size, and D eveloping Country Investment-Attraction
Packages (Boston: Kluwer Academic Publishers, 1995); Martin Gilman, The Financing o f Foreign
D irect Investment: A Study o f the Determinants o f Capital Flows in M ultinational Enterprises (New
York: St. Martin's Press, 1981); Harinder Singh and Kwang Jun, Some N ew Evidence on
Determinants o f Foreign D irect Investment in D eveloping Countries (Washington, D.C.: World Bank,
1995); United Nations Centre on Transnational Corporations (UNCTC), The Determinants o f Foreign
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That is, I seek to explain how the trade policy orientation of FDI, though a function
of government policy, helps to shift trade policy in one direction or another.
3. Hypotheses and Case Selection
The dependent variable of this study is the degree of trade policy opening on the
import side, defined as the level of tariffs. Broadly speaking, trade policy reform
“comprises exchange rate policy and commercial policy affecting the export and
import regimes and the domestic sector.”1 5 It includes such measures as exchange
rate devaluation that helps reduce the anti-export bias and reduce the excess demand
for imports, the elimination of export controls, the removal of quantitative import
restrictions, and the reduction of import tariffs. Since devaluation and the elimination
of the anti-export bias are a move toward neutral incentives between exportables and
importables, tariff reduction is at the core of trade liberalization. That is why I have
chosen tariffs as the focus of the study. Moreover, by emphasizing commercial
policy or tariffs more specifically, I hope to pinpoint the dependent variable so that
the relationships between the dependent and independent variables can more easily
be established.
The explanatory variables are (a) sources of finance for the accumulated foreign
capital, that is, FDI versus commercial bank loans, and (b) the inward/outward
orientation of FDI. The first variable is expressed in terms of the ratio of FDI stock
D irect Investment: A Survey o f the Evidence (New York: United Nations, 1992); UNCTC,
Government Policies and Foreign D irect Investment (New York: United Nations, 1991).
1 5 Vinod Thomas, Kazi Matin, and John Nash, Lessons in Trade Policy Reform (Washington D.C.:
World Bank, 1990), p. 2.
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to debt with commercial banks. The second variable is measured by the share of
exports in the total output of MNCs.
I offer two hypotheses:
(a) In the event o f BOP difficulties, a higher FDI/debt ratio is likely to lead to the
devaluation o f an overvalued exchange rate, which in turn is likely to
increase the openness o f trade policy.
(b) The outward orientation o f FDI leads to trade liberalization by shaping the
trade policy preferences o f MNCs in favor o f trade openness.
These two hypotheses will be evaluated at the macro and micro levels,
respectively. At the macro level, the unit of analysis is the aggregate of foreign
capital inflows. What interest me here are interactions between capital and current
accounts as they relate to the exchange rate movements and trade policy. Assuming a
country is experiencing BOP difficulties, different types of foreign capital inflows
could have different effects on foreign exchange and trade policy choice. A large
external debt tends to discourage a country to devalue its currency because such a
move will inevitably increase the local currency value of a debt denominated in
foreign currency. Instead of devaluation, a tariff hike is more likely to be used as an
external adjustment tool. If FDI is a major form of foreign capital inflows, on the
other hand, the chances for devaluation will increase because it is now the foreign
investor rather than the host government who bears the risk of devaluation, which
lowers the value (in hard currency) of the assets acquired through foreign
investment. This is especially true for fixed assets (production facilities) as opposed
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to liquid assets (stocks and bonds) due to the former’s specific use in certain
activities and the cost of switching from one activity to another.1 6 Thus, it is
expected that the incentive for the host government to devalue its currency in the
face of rising BOP deficits is positively related to the FDI/debt ratio. The higher the
FDI/debt ratio, the larger the incentive to devaluate. A real devaluation in turn will
create a favorable condition for trade policy opening.
At the micro level, FDI is disaggregated. The unit of analysis is the firm. Here,
the emphasis is on the trade policy preferences of MNCs. It is expected that outward-
oriented firms are likely to press for trade policy opening, if they rely on imported
inputs or the restrictive import regime gives rise to retaliation from abroad. On the
other hand, inward-oriented firms, fearing that lower tariffs will increase foreign
competition, tend to be supporters of protectionism, thus contributing to the
sustenance of higher tariffs and other restrictions on imports.
A lingering question here is: If foreign investors are to suffer from devaluation,
why would they not come forward to pressure the government not to devalue? One
1 7
reason for the lack of action is the technical complexity of monetary issues. Many
monetary decisions are made to address macroeconomic imbalances (including
inflation), and thus are beyond the expertise of special interests or hard for them to
take a stand. Another reason is that, for export-oriented MNCs, a real devaluation
1 6 Jefffry Frieden uses the notion o f asset specificity to identify firms that are more motivated to
influence government policy toward their industries. Usually, lobbying efforts increase with asset
specificity up to the point where it would make more sense for owners o f assets to find another use for
their resources. See Frieden, Debt, Development, and Democracy, pp. 19-22.
1 7 John Odell, “The U.S. and the Emergence o f Flexible Exchange Rates: An Analysis o f Foreign
Policy Change,” International Organization 33, no. 1 (Winter 1979), p. 80.
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may sufficiently increase their revenue so that their overall profitability will be
enhanced despite the loss of fixed assets.
Based on the independent variables, I have selected two pairs of contrasting
episodes, one time-series and the other cross-sectional, for this study. The first pair is
drawn from the Brazilian automotive industry during the 1960s and 1990s, and the
second pair, from the Chinese automotive and consumer electronics industries during
the 1990s. In each pair of episodes, I will contrast trade policy opening with closure
by focusing on the underlying conditions stated above.
I use three criteria to select these episodes. First, there should be some degree of
variation or contrast on the dependent variable. Second, the episodes selected should
allow for the control of other variables (except the explanatory variables) so that they
are comparable. Third, because the explanatory variables are related to international
capital movements, I look for countries with large, accumulated foreign capital
(external debt and FDI combined) and sectors where FDI is predominant.
The selected episodes, or trade policy changes more specifically, are ideal for
comparison exactly because they let the dependent variable vary. This meets the first
requirement that the selection of observations “should allow for the possibility of at
least some variation on the dependent variable.”1 8 Without the variation on the
dependent variable or without taking into account other instances where the
dependent variable takes on other values, any causal inferences reached are likely to
be biased.
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In terms of comparability, the two Chinese episodes are drawn from two different
sectors in the same country at about the same time. So all other variables are held
constant except the independent variables. The two Brazilian episodes are more than
twenty years apart. Without question, not everything involved is perfect for
comparison. Most noticeably, a change toward trade policy closure in the late 1960s
occurred under the authoritarian regime, whereas a shift from closure to opening did
not take place until after the country returned to democracy in the mid-1980s. But I
will show below that the actual variation in the outcomes is exactly the opposite of
what the state autonomy argument would suggest.
Moreover, foreign capital inflows (external debt and FDI) into Brazil and China
have been tremendous. This allows me to evaluate the explanatory variables based
on international capital movements. By 1983, Brazil was the largest debtor country
in the world.1 9 China’s external debt was small, but FDI in China accounted for
about 25 percent of the total domestic capital formation in the mid-1990s. Speaking
of FDI, in all the sectors in question there was a high degree of foreign domination.
Both Brazil and China experienced heavy foreign investment in the automotive and
consumer electronics industries over the years. In Brazil, the “deepening” of import-
substituting industrialization (ISI) was characterized by rapid domination of MNCs
in key sectors. Between 1956 and 1962, FDI averaged more than $100 million per
1 8 Gary King, Robert Keohane, and Sidney Verba, Designing Social Inquiry: Scientific Inference in
Qualitative Research (Princeton: Princeton University Press, 1994), p. 129.
1 9 Pedro-Pablo Kuczynski, Latin American D ebt (Baltimore: The Johns Hopkins University Press,
1988), p. 13.
20 United Nations, World Investment R eport (New York: United Nations, 1996).
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year.2 1 The lion’s share of FDI in manufacturing went to the automotive industry, in
which Ford, General Motors (GM), and Volkswagen (VW) held 100 percent, 100
percent, and 80 percent of their Brazilian subsidiaries, respectively. By the late
1960s, these three firms alone controlled 89 percent of the domestic vehicle market
99
through acquisitions and mergers. FDI in the Chinese automotive and consumer
electronics industries was not as predominant as FDI in Brazil. Foreign ownership in
9 9
automobile joint ventures ranged from 30 percent to 50 percent. No data is
available as to the percent of foreign ownership in the consumer electronics industry,
but consumer electronics joint ventures and foreign-invested enterprises together did
contribute over 70 percent of the sector’s total exports by the mid-1990s.2 4 Given the
role of FDI in domestic capital formation, technology transfer, labor and managerial
training, as well as export market access, it is not surprising that foreign firms
usually get more attention from the government and thus have more influence on
sector-specific trade policies than average domestic firms.
While the country choice of Brazil and China for the study of the episodes makes
it possible to isolate even the cross-country peculiarities, such as domestic market
size, level of industrialization, factor endowments, and historical development
patterns, it raises the question of whether the hypotheses in this study are applicable
if smaller countries are selected. Here, two variables come to mind: domestic market
2 1 Joel Bergsman, Brazil: Industrialization and Trade Policies (London: Oxford University Press,
1970), p. 77.
2 2 Helen Shapiro, “Automobiles: From Import Substitution to Export Promotion in Brazil and
Mexico,” in David B. Yoffie, ed., B eyond Free Trade: Firms, Governments, and G lobal Competition
(Boston: Harvard Business School Press, 1993), p. 204.
2’ Zhongguo Qiche Gongye Nianjian (China Automotive Industry Yearbook), Beijing, various issues.
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16
size and factor endowments. Many have argued that relatively small countries with
limited domestic markets and few natural resources tend to pursue a more open trade
policy than relatively large countries because of the structural constraints. But sector-
specific trade policies are not unambiguously given by domestic market size. If they
were, there would be no disparity in tariff rates. Other factors have to be considered.
Also, similarly endowed countries have pursued very different trade policies. If
factor endowments are constraining, a political explanation of policy will be able to
account for their importance by tracing the pressure from the owners of different
factors seeking to maximize their returns. In short, there is no reason to believe that
the evidence will go against the hypotheses if smaller countries are selected.
4. Alternative Explanation
The hypotheses proposed in this study originate from interest-driven and rational
choice arguments. One alternative explanation that stands out and must be
considered is a perspective emphasizing the role of the state as both actor and
institution. Among the several dimensions of the state,2 5 two dimensions relevant to
this study are the degree of state autonomy from societal forces and the policy
instruments available to state elites in pursuing their political and substantive goals.
The first dimension attributes policy choice to the degree of state autonomy. In
this dimension, the state by itself is an institution. The role of the state depends on
the degree of insulation from societal forces, which in turn is a function of the
2 4 Zhongguo D ianzi Gongye Nianjian (China Electronics Industry Yearbook), Beijing, 1997, p. 234.
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institutional arrangements linking state and society. The more the state is insulated,
the more likely policy choice is to hinge upon the state. While authoritarian regimes
may be extensively penetrated by societal forces and allow significant independent
political organization, they nevertheless are more insulated than democracies and
26
similar polities organized on the basis of popular elections.
The second dimension suggests that policy choice is influenced by the range of
policy instruments the state commands. Especially during times of economic crisis,
the state is positioned to act independently—to construct, rather that merely reflect,
emergent coalitions. This view is exemplified by Susan Shirk’s seminal work The
Political Logic o f Economic Reform in China. In the book, Shirk raises two
important questions: Why could China carry out economic reform without political
reform; and how exactly were the Chinese able to introduce market reforms through
the existing and presumably hostile institutions of a Communist Party and a socialist
state bureaucracy? To answer these questions, Shirk emphasizes the strategy of
“playing to the provinces” employed by reformists within the general institutional
framework. She argues that many of the early policy initiatives (such as
administrative decentralization and the introduction of profit contracting and tax-for-
profit systems ) were designed to appeal to local governments and state-owned
enterprises. As reformists won the support of localities, they were able to use them as
2 5 See Stephan Haggard, Pathways from the Periphery: The Politics o f Growth in the Newly
Industrializing Countries (Ithaca: Cornell University Press, 1990), pp. 42-46.
2 6 Haggard, Pathways from the Periphery, pp. 44-45.
2 7 According to profit contracting, enterprises promise to deliver to the state a base amount o f profits
and retain a preset proportion o f all profits above that amount. Tax-for-profit is a more flexible form
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an effective counterweight to conservatives holding power at the Center. Over time,
'ja
the balance of power began to shift in favor of reformists. For Shirk, the success of
China’s economic reform had much to do with the building of a “clientalistic support
network” that mobilized the groups who would benefit from the reform and rendered
ineffective the groups who would lose as a result of the reform.
To summarize, the state-centric perspective implies that different institutional
arrangements linking state and society will result in differences in trade policy. Trade
policy changes with changes in institutional arrangements. Institutional change can
be a change in the degree of state autonomy or as a result of top-down coalition
building. Although this perspective brings to our attention the importance of the role
of the state, it is not sufficient to explain trade policy change by itself. Most
noticeably, it is still unclear why some policies are adopted rather than others under
this perspective. The degree of state autonomy does not automatically lead to either
an open or closed trade policy. Nor does any attempt at top-down coalition building.
This problem aside, the evidence in this study does not seem to support a state-
centric explanation—a point I will illustrate in detail when I get to the specific
episodes.
o f profit sharing. After paying taxes, enterprises achieve complete financial autonomy and are
responsible for their own profits and losses.
2 8 Susan Shirk, The Political Logic o f Economic Reform in China (Berkeley: University o f California
Press, 1993), Chapters 1-8.
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Chapter Two
The Brazilian Automotive Industry during the 1960s and 1990s: Types
of Foreign Capital Inflow, FDI Orientation, and Trade Policy Change
The Brazilian government maintained high tariff protection against automobile
imports beginning in the 1950s and raised tariffs in the late 1960s, and then it
dramatically cut auto tariff protection in the 1990s. This chapter will show that two
significant reasons for both decisions were changing levels of FDI relative to
external debt and a changing orientation of foreign investors as between domestic
sales and exports. These two Brazilian episodes therefore provide support for both
hypotheses proposed earlier.
1. Background to the Installation of the Brazilian Automotive Industry
After World War II (WWII), the Brazilian government adopted an import-
substituting industrialization (ISI) strategy, in which the automotive industry played
a central role. The Brazilian automotive industry started with assembly operations.
The decision to upgrade the existing assembly operations and install a domestic
automotive industry emerged in response to chronic BOP problems. Later, the
industry took on strategic implications as it was expected to be a leading sector to
attract foreign capital and generate production linkages.
As is the case with all less developed countries (LDCs), Brazil’s automotive
industry grew out of the assembly operations that relied on imported “completely
knocked-down kits” (CKDs) and “semi-knocked-down kits” (SKDs). The earliest of
such operations dates back to 1919 when the Ford Motor Company opened its
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Brazilian branch and installed the first vehicle assembly line in the country, followed
in the mid-1920s by General Motors (GM) and International Harvester.1 Other
multinational corporations (MNCs) that joined the American firms in similar
operations over the years included Volkswagen (VW) and Mercedes-Benz. Despite
these assembly operations, imports of assembled vehicles, especially passenger cars
not available in Brazil at the time, were still large and came exactly from the same
foreign assemblers.
Although some of the MNCs chose to source simple automotive parts locally
after the construction of the original assembly lines, the parts sector took shape only
dining WWII in response to the demand for the replacement parts. Between 1940
and 1945, the number of registered firms increased from 11 to 3 8.2 Almost all of
these firms were Brazilian-owned. They would more accurately be characterized as
small workshops with artisan-type production methods and primitive technologies.
Nevertheless, they were producing nearly 2,000 out of a vehicle’s 15,000-odd parts,
■ 2
ranging from radiators to pistons and springs.
For many years, the Brazilian government followed a relatively loose import
policy, leaving the door wide open for imports of parts, components, and assembled
vehicles. During World War II, however, automotive imports were virtually cut off;
1 Headquartered in Chicago, International Harvester pioneered in motorized trucks and used to be one
o f the largest manufacturers o f earth-moving equipment. Chrysler bought out its truck facilities in
1966.
2 Helen Shapiro, Engines o f Growth: The State and Transnational Auto Companies in Brazil
(Cambridge: Cambridge University Press, 1994), p. 40.
3 With the implementation o f the auto plan in 1956 that required a high rate o f local content for
vehicles produced in Brazil, the parts sector became increasingly under foreign control either through
vertical integration by the terminal producers or through independent foreign direct investment.
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only a trickle of commercial vehicles came in. This war-induced shortage generated
a postwar international spending spree. From 1946 to 1948, automotive products
topped the import bill, surpassing even the traditionally dominant imports of
petroleum and wheat.
As the BOP situation deteriorated, the government imposed a full import
licensing scheme in February 1948 that discriminated against “nonessential”
consumer durables while favoring intermediate and capital goods considered
essential for the rehabilitation of the Brazilian economy. Limits were especially strict
on automotive imports, which immediately fell from the top of the import list. As a
result of deep cuts in imports, Brazil had a trade surplus in 1949. This, coupled with
the outbreak of the Korean War and the fear of yet another import shortage,
facilitated the temporary relaxation of import restrictions. Automotive imports
therefore surged again, with vehicle imports alone to reach an unprecedented level of
109,502 units in 1951.4 By 1952, a huge trade deficit reappeared in the current
account.
In August 1952, the government issued a decree banning imports of some 104
groups of automotive parts that were produced domestically. Another decree, issued
in April 1953, went a step further by prohibiting imports of assembled cars. From
then on, all vehicles had to be imported as CKDs and SKDs. In January 1954, this
4 Eduardo Augusto de Almeida Guimaraes, “Industry, Market Structure and the Growth o f the Firm in
the Brazilian Economy” (Ph.D. diss., University o f London, 1980).
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22
restriction tightened so that only CKDs stripped of those parts for which a
domestically produced counterpart existed could be imported.5
Meanwhile, the government increasingly relied on foreign exchange-related
instruments to reduce imports. A foreign exchange auction system replaced the
licensing scheme in 1953. Under the new system, imports were divided into five
categories according to their degree of essentiality. A minimum premium was set for
each of these categories, with the ultimate price established through auction (see
Table 1). The cruzeiro exchange rate for Category 5 (containing imports considered
“least essential”) was much higher and thus more expensive than those for the rest
categories. Passenger cars occupied Category 5 whereas commercial vehicles were in
Category 3. Certain other goods were sold at special auctions where the rate was kept
low, such as agricultural machinery. The rate applicable to these items represented a
substantial subsidy to their import.
Table 1
Import Exchange Rates by Categories, 1953-57
(Cruzeiro per US dollar)
Year Category 1 Category 2 Category 3 Category 4 Category 5
1953 31.19 37.82 43.97 48.82 81.49
1954 41.78 44.88 57.81 68.30 110.84
1955 63.80 66.00 82.42 86.32 171.65
1956 73.76 81.29 103.15 115.56 222.36
1957 58.29 74.51 100.60 138.03 299.07
Source: J. T. Winpenny, Brazil - M anufactured Exports and Government Policy: B razil’ s Experience
since 1939 (London: Latin American Publications Fund, 1972), p. 73.
5 Shapiro, Engines o f Growth, p. 33.
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Clearly, BOP concerns dictated Brazil’s policy initiatives in the postwar years.
Import licensing and, later, differential foreign exchange premiums rather than tariffs
were used as major devices to alleviate the pressure on the current account. Although
the 1957 tariff reform restored the importance of customs duties for the control of
imports, the cost of foreign exchange was retained as a vital supplement. In the
context of chronic BOP difficulties, the idea to establish a domestic automotive
industry emerged during the administration of Getulio Vargas (1951-54). A
subcommission headed by Admiral Lucio Meira was created to study all the
possibilities. But it was not until 1956, the year when Juscelino Kubitschek took the
presidency (1956-61), that the idea was put into action.
2. The Surge in FDI under the Auto Program
The auto program (1956-60) launched by the Kubitschek government required
participating foreign firms to increase the level of domestic content. Firms that failed
to meet the program’s requirements faced the risk of being driven out of the
Brazilian market. As part of the program, the incentive structure was also designed to
ensure that firms made large, up-front commitments to their projects. This strategy
proved effective enough to entice increasing amount of FDI in the terminal sector,
which came under total foreign control by the late 1960s. With more investment in
the terminal sector, firms not only found it difficult to exit without incurring heavy
losses, but also had an interest in keeping the domestic market closed so as to
maximize sales and protect their investment against import competition.
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The initiation of the auto program in 1956 marked the beginning of the modem
Brazilian automotive industry, as it established the conditions for a major
transformation from assembly operations to manufacturing. Overseeing the auto
program was the Executive Group for the Automotive Industry (GEIA), composed of
members from all the government agencies involved and granted a life span of five
years (equal to the implementation phase of the program). Through a series of
executive decrees, GEIA set up the guidelines for nationalizing the content of
vehicles produced in Brazil. Firms that chose to participate in the program were
required to meet the progressive domestic content requirements measured by weight
(see Table 2). The method by which the domestic content levels were increased was
left to each firm’s discretion, and detailed plans had to be submitted for approval.
Implicit in the program was the prospect that nonparticipating firms would be
excluded from the Brazilian market, perhaps for all time.6
Table 2
Domestic Content Requirements, 1956-60
(Percent)
Deadline Trucks Jeeps Utility vehicles Cars
12/31/1956 35 50 40
7/1/1957 40 60 50 50
7/1/1958 65 75 65 65
7/1/1959 75 85 75 85
7/1/1960 90 95 90 95
6 That the Brazilian government would display the will or the means to implement the auto program
was by no means obvious at the time. Since Brazil was setting a precedent in the region, it could not
benefit from the experience o f neighboring countries. As a result, the threat o f market closure was less
credible than it would later be in Argentina and M exico, which followed Brazil’s example. This
explains why Ford and GM did not participate in domestic car production until the late 1960s.
7 Utility vehicles are defined as mixed-service vehicles and include vans, station wagons, and pickups.
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Source: Lincoln Gordon and Engelbert L. Grommers, United States Manufacturing Investment in
Brazil: The Impact o f Brazilian Government Policies, 1946-1960 (Boston: Harvard University Press,
1962), p. 49.
In order to attract foreign investment into vehicle production, GEIA offered a
number of foreign exchange and fiscal incentives. First, under Instruction 113,8
participating firms were allowed to import machinery and equipment without
deposits of foreign exchange so that they could bypass the auction system and avoid
paying foreign exchange premiums involved in transactions as long as these imports
were registered as FDI. Second, in case firms sought debt financing for imported
equipment, loans proportional to Brazilian capital, with a minimum term of five
years, were available and could be repaid at the favorable cost-of-exchange rate,
usually lower than the free rate. Third, in addition to foreign exchange benefits, firms
were exempt from import duties and sales tax on equipment imported. Fourth, in the
process of attaining 90 to 95 percent domestic content levels, firms were allowed to
import those parts not yet locally produced free of import duties. Fifth, since the
automotive industry was classified among “basic industries,” firms were eligible for
credits and financial guarantees directly from the National Bank of Economic and
Social Development (BNDES). All these incentives amounted to substantial
government subsidies that considerably reduced the costs involved in the original
round of investment. According to one study, the government provided 89 cents in
8 This policy instrument was issued by SUMOC (Superintendencia da Moeda e do Credito) in 1955 to
encourage foreign investment considered desirable to the Brazilian economy. It was later incorporated
into the Tariff Law o f 1957.
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foreign exchange and fiscal subsidies for every dollar invested in the industry in
1956-619
The reactions of MNCs to the auto program were mixed. While none of them
liked the idea of local production despite the incentives, the European firms,
especially VW, seemed more willing to compromise than the American firms. The
potential loss of market access prompted VW to submit a proposal for a Brazilian
van factory as early as August 1956, two months after the announcement of the auto
program. When GEIA’s car decree was issued in February 1957, VW was the first
MNC to submit a proposal, for the Beetle. By contrast, Ford’s first response to the
auto program was to try to figure out how to appear to be in compliance while
investing as little as possible.1 0 Like GM, Ford initially committed itself only to truck
production.
As locally manufactured European cars were about to roll off the production
lines, Ford became increasingly concerned with preserving dealer loyalty and
retaining its option to enter the car market at a later date. From late 1958, Ford began
to submit proposals for a mid-sized passenger car that would eventually reach a
maximum of 73 percent (instead of 95 percent) local content. GEIA rejected them
all. When Ford was forced to comply with the local content schedules, GEIA did not
question the project but refused to grant Ford foreign exchange and import benefits
9 Kenneth S. Mericle, “The Political Economy o f the Brazilian Motor Vehicle Industry,” in Rich
Kronish and Kenneth S. Mericle, eds., The Political Economy o f the Latin American M otor Vehicle
Industry (Cambridge, Mass.: MIT Press, 1984), p. 6.
1 0 In a letter to Chairman Ernest Breech dated on October 3, 1956, A. J. Wieland, vice-president o f
Ford International, suggested that Ford let GEIA know the steps the company was taking to keep its
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on the ground that the proposal was submitted after the deadline. GEIA feared that
any special consideration given to Ford would break its pledge of consistency and
encourage other assemblers to follow suit. Ford finally had its proposal accepted by
the military regime that took power in 1964. GM’s decision to produce passenger
cars in Brazil was largely contingent upon Ford’s. For GM, Ford’s entry into the
Brazilian Passenger car market substantially increased its costs of not investing.
Prior to 1956, FDI in Brazil was relatively insignificant. The annual inflows
averaged $16.67 million in 1947-55,1 1 whereas the total value of investment in the
automotive sector as of 1956 was only $19.47 million,1 2 largely due to the low
capital cost of the early assembly operations. This situation changed dramatically in
1960, when a total of 11 firms had begun vehicle production under the auto program
(see Table 3 for a list of these firms, including their ownership and the types of
vehicles they proposed to produce locally). Discounting Ford’s and GM’s car
projects implanted several years later, FDI in the terminal sector of the automotive
industry totaled $156 million—an increase of more than eight times the total value of
investment before 1956. In 1956-61, FDI in the automotive industry accounted for
1T
53 percent of total investment in Brazil.
place in Brazil without following the executive decrees and make as little capital investment as
possible. Ford Industrial Archives, AR-67-6, Box 2.
1 1 Joel Bergsman, Brazil: Industrialization and Trade Policies (London: Oxford University Press,
1970), p. 76.
1 2 Mine Sadiye Eder, “Crises o f Late Industrialization: A Comparative Study o f the Automotive
Industry in Brazil, South Korea and Turkey” (Ph.D. diss., University o f Virginia, 1993), p. 87.
1 3 Bergsman, Brazil: Industrialization and Trade Policies, p. 77.
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Table 3
Firms Undertaking Vehicle Production in 1960
Firm Ownership Percentage Type o f Vehicles Produced
FNM* 96% Brazilian state-owned Trucks, cars
Vemag 82% Brazilian privately-owned Jeeps, cars
Ford 100% US Trucks, utility vehicles
GM 100% US Trucks, utility vehicles
Int’l Harvester 100% US Trucks
Willys Overland 45% US Jeeps, utility vehicles, cars
VW 80% German Utility vehicles, cars
Mercedes Benz 50% German Trucks
Simca 23% French Cars
Scania Vabis 33.3% Swedish Trucks
Toyota 100% Japanese Jeeps
* Fabrica National de Motores
Sources: Adapted from Mine Sadiye Eder, “Crises o f Late Industrialization: A Comparative Study of
the Automotive Industry in Brazil, South Korea and Turkey” (Ph.D. diss., University o f Virginia,
1993), p. 91, Table 2.1; Lincoln Gordon and Engelbert L. Grommers, United States Manufacturing
Investment in Brazil: The Im pact o f Brazilian Government Policies, 1946-1960 (Boston: Harvard
University Press, 1962), p. 54, Table 9.
After a strong beginning in the early 1960s, the Brazilian automotive industry
entered a period of stagnation due largely to the downturn in overall economic
activity in 1963-64 and the implementation of an austerity program after the 1964
coup. The firms best equipped to compete during the stagnation period were the
larger producers with solid foreign connections and easy access to low-cost credit.
Smaller, financially weaker firms, which saw sustained losses, barely survived these
years. As a result, a number of structural changes occurred in the industry. In a
matter of several years since 1966, Chrysler acquired the parent corporation of Simca
do Brasil and purchased the truck production facilities of International Harvester.
Again in 1966, VW gained control over Vemag. A year later, Ford took over Willys
to jumpstart its passenger car operations in Brazil. The state-owned firm, Fabrica
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Nacional de Motores (FNM) was sold to Alfa Romeo, which later was acquired by
Fiat. A final change came in 1969 when Saab merged with Scania and renamed the
Brazilian affiliate Saab-Scania in accordance with the parent’s new structure (see
Table 4 for a summary of these structural changes). A major consequence of the
shakeout was virtually total denationalization of the terminal sector as the three firms
with the most significant Brazilian participation (FNM, Vemag, and Willys) all
passed to foreign control. By the late 1960s, VW, Ford, and GM alone controlled
almost the entire domestic vehicle market.
Table 4
Structural Change in the Brazilian Automotive Industry
Original Firms The 1960s 1979 /A T
VW
VW
VW
Auto Latina
Vemag
Simca
Chrysler
Int’l Harvester
Ford
Ford Ford
Willys Overland
FMN Alfa Romeo Fiat Fiat
GM GM GM GM
Mercedes Benz Mercedes Mercedes Mercedes
Scania Vabis Saab-Scania Saab-Scania Saab-Scania
Toyota Toyota Toyota Toyota
Having participated in domestic production under the auto program, foreign
investors became increasingly inward-oriented. In order to maximize their
investment returns in an already crowded market, they favored high tariffs or other
import restrictions that would protect them from import competition.
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30
3. Debt Financing and Its Impact on Foreign Exchange Policy
Before the early 1960s, Brazil’s long-term investment financing came almost
exclusively from FDI or such multilateral lending institutions as the World Bank.
After the 1964 coup, this form of investment financing gradually lost its prominence,
as the military government adopted a number of expansionist policies that were
directly or indirectly tied to big projects to tap the burgeoning Eurocurrency market
(or Euromarket for short). With foreign debt growing rapidly against FDI, the
government became increasingly inclined toward the use of commercial policy
instead of currency devaluation for current account adjustment.
Brazil’s turn to borrowing from foreign banks started in 1967 and became
pronounced by the early 1970s. Between 1967 and 1973, net FDI inflows averaged
$278 million a year, whereas net foreign bank lending averaged $2.2 billion a year.
The country’s foreign debt, expressed in constant (1982) dollars, went from $9.2
billion in 1967 to $27.8 billion in 1973.1 4
The external borrowing was done under two statutes—Law 4131 and Resolution
63, and the borrowers were everyone including state enterprises, MNC affiliates, and
locally-owned private firms. Law 4131, originally enacted in 1962 and reinforced
after the coup, permits firms to borrow directly from foreign banks. Yet Law 4131
tended to favor MNC affiliates and state enterprises over local private firms because
the former had easy access to the Euromarket due to the size and creditworthiness of
the ultimate guarantor of the loan (i.e., the parent firm or the Brazilian government).
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In an attempt to take care of local private firms, Resolution 63 was introduced in
1967 to allow domestic banks to borrow abroad and pass the cruzeiro equivalent of
the foreign currency on to the domestic borrowers that could not benefit from Law
4131.
Although the Brazilian government tried to make foreign bank loans available to
both public and private sectors, it pushed state enterprises even harder to borrow
abroad in order to leave room in the domestic capital market for local private firms.
As a result, the majority of foreign debt (more than two-thirds in 1982) was owed by
public sectors, including state enterprises and the government itself.1 5 To encourage
external borrowing, the government also created some mechanisms for borrowers to
transfer foreign exchange risk to the Banco Central. Unused foreign funds borrowed
under Law 4131 and Resolution 63 could be deposited with the Banco Central,
where they did not earn interest but were secure against a cruzeiro devaluation. By so
doing, the government absorbed some of the foreign exchange risk previously borne
by MNC affiliates and local private firms, not to mention state enterprises.
What is the impact of external borrowing, as distinct from FDI, on foreign
exchange policy? Both external borrowing and foreign investment involve exchange
risk: in the case of external borrowing, foreign exchange risk is borne by the ultimate
borrower, whereas in the case of FDI, the same risk is borne by the foreign investor.
Thus if a country has a low FDI/debt ratio, there will be disincentive for the
1 4 Jeffry A. Frieden, Debt, Development, and Democracy: Modern P olitical Economy and Latin
America, 1965-1985 (Princeton: Princeton University Press, 1991), p. 116.
1 5 Jeffry A. Frieden, “The Brazilian Borrowing Experience: From Miracle to Debacle and Back,”
Latin American Research Review 22, no. 1 (1987), p. 103.
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32
government to devaluate its currency in the face of BOP difficulties. This is because
devaluation directly increases the local currency value of a debt denominated in
foreign currency. In other words, devaluation inflates a debt as the local currency
cheapens against foreign currencies. Disincentive is likely to turn into incentive if the
FDI/debt ratio increases and foreign exchange risk begins to shift from the ultimate
borrower to the foreign investor.
As we will see below, the change in the sources of finance for domestic projects
prompted the Brazilian government to rely on import tariffs rather than the exchange
rate for external adjustment.
4. The Inward Orientation of FDI, the Lower FDI/Debt Ratio, and Trade
Policy Closure
In the late 1960s, automobile import tariffs rose sharply from the previous levels.
I attribute this change in trade policy to two factors: the inward orientation of foreign
auto producers and an increase in the level of external debt relative to FDI. The
inward orientation—a function of the implementation of the auto program—changed
the trade policy preferences of foreign auto producers and prompted them to exert
pressure on the Brazilian government for more protection. A higher level of external
debt, which would make exchange rate devaluation too costly, forced the Brazilian
government to use tariffs as an external adjustment tool.
As mentioned earlier, tariffs were never an effective protective device in Brazil
before 1957. Previously, the last revision had occurred in 1934, when the former ad
valorem duties were changed to specific ones in response to the price fall during the
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33
Great Depression. When prices began to rise again toward the end of the Great
Depression, tariffs gradually lost the importance. (The higher the price, other things
equal, the smaller the percentage tariff rate.) Until 1957, first import licensing and
then differential exchange rates through auctions fulfilled the tariffs restrictive
function.
With the reintroduction of ad valorem tariffs in August 1957—the first major
postwar tariff reform, tariff protection was restored. The tariff rates thus established
varied from zero to 150 percent. Since a 150-percent maximum tariff was considered
inadequate to restrict imports, the import exchange rate categories, now reduced
from five to two, were retained. Of the two new categories, the Special Category was
more prohibitive than the General Category and comprised mostly finished consumer
goods or capital goods that were domestically available. This new system remained
in effect with only minor changes until 1967.
After March 1967, there was a brief period of import liberalization (I will discuss
this further below), in which tariffs were reduced and a single import exchange rate
instead of two was adopted. The nominal tariff rate for transportation equipment fell
from 108 percent to 57 percent.1 6 But this change in tariffs proved to be politically
unsustainable as tariffs were quickly revised upward in 1968. By January 1969, the
tariff rate for transportation equipment again stood at 91 percent and kept moving
higher in the following years (see Figure 1).
1 6 Bergsman, Brazil: Industrialization and Trade Policies, p. 42.
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34
Figure 1
Brazil’s Average Tariff Rates for Transportation Equipment, 1966-77
(Percent)
Sources: William G. Tyler, Manufactured Export Expansion and Industrialization in Brazil (Mohr,
Germany: Tubingen, 1976), p. 239; Mauricio Mesquita Moreira, Industrialization, Trade and Market
Failures (New York: St. Martin's Press, 1995), p. 198.
Then, what accounted for the sharp reversal in trade policy?
One possible explanation focuses on lesser insulation of policy making from
societal pressure. Brazil’s military regime after 1964 is best characterized as
“authoritarian” versus “democratic,”1 7 meaning that it was a government in which
authority was centered in one person or in a small group not constitutionally
accountable to the people. It might be argued that the repressive measures adopted
after 1964 stifled any overt political opposition to the efforts to stabilize the economy
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35
and liberalize the trade regime. But when Brazil’s trade policy reversed its course in
late 1968, the same national political institutions were still in place. According to the
logic of this argument, the earlier period of trade liberalization would have been
sustained, other things being equal, as long as the state of affairs remained
unchanged. As a matter of fact, political repression escalated rather than diminished
after 1967, culminating in December 1968 with Institutional Act 5 (AI-5), aimed to
eliminate what little political opposition had survived since the coup.
As the Brazilian experience shows, although a centralized authoritarian regime
may have greater freedom to make significant policy changes, these changes do not
necessarily have deep roots and may be easily reversed by the very same
authoritarian regime. This calls us to look beyond the state-centric variables, since
they merely provide the institutional setting in which trade policy is made. By
themselves, they do not lead to trade policy changes in either direction.
To account for the trade policy reversal in late 1968, we must have some ideas of
why liberalization had occurred in the first place.
Between April 1964, when the military government assumed power, and March
1967, when it took steps to liberalize the trade regime, the cruzeiro was devalued
twice. The first devaluation, of 21 percent, occurred in November 1965, and the
second, of 23 percent, occurred in February 1967. These devaluations were part of a
stabilization program launched in 1964 to stimulate exports and improve the
1 1 See Guillermo O’Donnell, Bureaucratic Authoritarianism: Argentina, 1966-1973 (Berkeley:
University o f California Press, 1988); Lawrence Graham and Robert Wilson, eds., The Political
Economy o f Brazil: Public Policies in an Era o f Transition (Austin: University o f Texas Press, 1990).
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36
country’s balance of payments. Where a currency is overvalued, some kind of
protection is necessary to compensate for the artificial cheapness of imports.
Likewise, when a currency is devalued, the same protection will have to be adjusted
downward for the devalued currency. That is exactly what happened in Brazil in
early 1967.
Originally, the new maximum tariff in the 1967 liberalization scheme was
intended to be 120 percent, down from 150 percent established in 1957 and in
accordance with the first devaluation. With another devaluation in February 1967,
the military government decided to reduce all tariffs by a further 20 percent, making
100 percent the maximum.1 8 At first sight, the subsequent tariff cuts seemed to
reflect the devalued exchange rate at the time. In reality, however, these cuts were
still considered too deep and resulted in strong repercussions across sectors.
The automotive industry was one of those sectors hurt badly by the tariff cuts.
Before the implementation of the auto program, foreign auto firms operating in
Brazil were essentially assemblers. As assemblers, they relied on imported CKDs
and SKDs. So it is no surprise that they favored an open trade policy. Because of
their liberal trade policy preferences, they were constantly at odds with the Brazilian
government on issues such as import restrictions and domestic content requirements.
But by the time the military government decided to liberalize the import regime,
these former assemblers had turned into manufacturers. Following VW, Ford started
passenger-car production in the mid-1960s and rolled out the Galaxie, the largest car
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37
ever made in Brazil, in 1967. At the same time, GM made its debut in the passenger-
car field with a Brazilian Opel.1 9 The large, up-front commitments foreign auto firms
had made to Brazil in order to penetrate the domestic market changed their trade
policy preferences toward closure. They did not want to see their sunken investment
threatened by import competition as a result of the tariff cuts.
It is true that changes in economic policies were more likely to come from
initiatives within the government, or from the pressure of economic events, than
from any organized political opposition during the period. The authoritarian regime,
however, was not impervious to outside influence. Businessmen, particularly those in
the manufacturing sectors, maintained close contact with the major policy makers,
such as then Planning Minister Antonio Delfim Neto. Communication was both
informal and organized. Among the major associations with a voice in policy making
were the Federation of Industries of Sao Paulo State (FIESP), the National
Confederation of Industry (CNI), and the exporters’ association. In the automotive
industry, the National Association of Motor Vehicle Manufacturers (ANFAVEA)
earned itself a reputation as a most effective lobbyist. Its president Wolfgang Sauer,
a former president of VW’s local subsidiary and later president of Autolatina,
reportedly “controlled” sector-specific government policy during the years of
military rule.2 0
1 8 J. T. Winpenny, Brazil - Manufactured Exports and Government Policy: B razil’ s Experience since
1939 (London: Latin American Publications Fund, 1972), p. 77.
1 9 Brazilian Business, September 1966, p. 16.
2 0 Latin American Weekly Report, March 12, 1992, p. 8.
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The information about how foreign auto producers exerted influence on the
government is rather sketchy. But some circumstantial evidence is available.
After its original decision to stay out of the Brazilian automotive industry, Fiat
looked on several occasions for a way to get in. Its intention, however, met strong
2 1
opposition from the auto firms that had already established their presence in Brazil.
These earlier starters—VW, Ford, and GM in particular—had spent millions of
dollars for new production facilities in the fight for sales, especially of smaller cars.
The entry of Fiat would make things worse in an already saturated small car market.
If Fiat was considered a threat, so was tariff reduction, since the latter would open
the door for imports from not only Fiat but also everyone else. Fiat finally got into
Brazil in the 1970s amid the country’s export promotion drive. To be qualified, Fiat
agreed to export its production in the annual range of $30 million to $40 million in
exchange for a list of fiscal incentives.2 2
Another way to identify the influence of foreign auto producers, though less
conclusively, is to analyze the pattern of import response by sector after the tariff
cuts and their subsequent reversal. If the intention were to placate sectors that had
lost protection in the original cuts, the reversal would be concentrated in those
sectors. Donald Coes compared this interest-driven hypothesis with one that
emphasized the growth rate of imports. But he quickly pointed out that the two
hypotheses were not mutually exclusive. If imports happened to grow more rapidly
in sectors subject to the largest cuts, they could reinforce each other. According to
2 1 Business Latin America, April 12, 1973, pp. 114-116.
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39
his finding, a simple correlation of the growth rate of imports by sector with the size
of the reversal yielded a coefficient of 0.18. Although positive, the coefficient was
not significant (prob Hq = 0.207). By comparison, the interest-driven hypothesis
received stronger support from the data. The correlation of the hardest-hit sectors
with the size of the reversal yielded a coefficient of 0.35, which was moderately
significant (prob Hq — 0.055).2 3
Table 5 gives a further illustration of the point. The tariff rate for transportation
equipment dropped by 47.22% in 1967, and then it increased, albeit on a lower base,
by 59.65% in 1969. In terms of percentage change, transportation equipment ranked
No. 13 (out of 21) in the 1967 tariff cuts and No. 6 in the subsequent reversal. Except
for chemicals, pharmaceutical products, perfumery, plastic goods, and printing and
publishing, the 1969 tariff increases in most sectors were in proportion to their
earlier reductions.
Table 5
Brazil’s Average Tariff Rates by Sector, 1966-69
(Percent)
Sector
1966 1967
Down
from
1966
%
change
ranking 1969
Up
from
1967
%
change
ranking
Non-metallic 79 40 -49.37 9 51 27.50 12
Metallurgy 54 34 -37.04 16 47 38.24 8
Machinery 48 34 -29.17 19 44 29.41 10
Electrical & comm. 114 57 -50.00 8 71 24.56 13
Transport equip. 108 57 -47.22 13 91 59.65 6
Lumber & wood 45 23 -48.89 10 67 191.30 1
2 2 Business Latin America, April 12, 1973, p. 115.
2 3 Donald Coes, “Brazil,” in Demetris Papageorgiou, Michael Michaely, and Armeane M. Choksi,
eds., Liberalizing Foreign Trade, Vol. 4, The Experience o f Brazil, Colombia, and Peru (Cambridge,
Mass.: Basil Blackwell, 1991), pp. 50-51.
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Furniture 132 68 -48.48 11 87 27.94 11
Paper 93 48 -48.39 12 58 20.83 14
Rubber 101 78 -22.77 21 94 20.51 15
Leather 108 66 -38.89 15 86 30.30 9
Chemicals 53 34 -35.85 17 29 -14.71 n.a.
Pharmaceutical 48 37 -22.92 20 29 -21.62 n.a.
Perfumery 192 94 -51.04 7 29 -69.15 n.a.
Plastic 122 81 -33.61 18 29 -64.20 n.a.
Textiles 181 48 -73.48 1 122 154.17 2
Apparel & shoes 226 103 -54.42 5 176 70.87 5
Food 82 27 -67.07 2 40 48.15 7
Beverages 205 83 -59.51 4 183 120.48 3
Tobacco 193 78 -59.59 3 167 114.10 4
Printing 122 59 -51.64 6 44 -25.42 n.a.
Miscellaneous 104 58 -44.23 14 60 3.45 16
n.a. = Not applicable.
Source: Adapted from William G. Tyler, M anufactured Export Expansion and Industrialization in
Brazil (Mohr, Germany: Tubingen, 1976), p. 239.
At Ford’s Brazilian subsidiary, there was a lot of opposition to the tariff cuts.
Top executives were frustrated because they were tied up to the stringent domestic
content requirements and unable to take advantage of lower tariffs to import cheap
parts and components. On the contrary, they would have to rely on domestic
sourcing to compete with imported vehicles of superior quality. At the time of tariff
cut, Ford had already achieved an 80-85 percent domestic content level for its
Brazilian-made passenger cars. Notwithstanding the sunk investment it had made,
Ford probably would have been more open to the tariff cuts, had the domestic
9 4
content requirements been relaxed.
In addition to the sectoral influence that weighed in favor of the reversal, changes
in the capital account also shifted trade policy in the same direction. Although the
24 Interview with David Shelby, former CFO o f Ford do Brasil, July 23, 1999.
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official rhetoric of the military government welcomed FDI, the structure of policies
tended to favor borrowing from commercial banks rather than financing through
FDI. As a result, external borrowing quickly outpaced FDI, which in the post-1964
period rarely exceeded 20 percent of gross borrowing. An immediate impact of
massive external borrowing was that it increased local availability of foreign
currency and cheapened its price. The cruzeiro thus appreciated against foreign
currencies (see Figures 2.1 and 2.2).
Figure 2.1
Brazil’s Real Exchange Rates, 1963-70
(Cruzeiro against US dollar at 1961 constant prices, calculated by deflating the
nominal exchange rate by the wholesale price index)
260.00
240.00
220.00
200.00 -
180.00
160.00
140.00
120.00
1963 1964 1965 1966 1967 1968 1969 1970
Year-end rate Average annual rate
Source: William G. Tyler, M anufactured Export Expansion and Industrialization in Brazil (Mohr,
Germany: Tubingen, 1976), pp. 343-344.
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Figure 2.2
Brazil’s Real Effective Exchange Rates, 1970-80
(1970=100)
140 r
130
120
1 1 0 -------
100 -
1970 1971 1972 1973 1974 1975 1976 1978 1979 1980 1977
Source: Benedict J. Clements, Foreign Trade Strategies, Employment, and Income Distribution in
Brazil (New York: Praeger, 1988), p. 16.
When the BOP situation worsened and sectoral pressure mounted, the
government began to consider ways to adjust. At first, devaluation was seen as an
option to attain external balance. But this idea quickly gave way to a tariff hike due
9 ^
to concerns over growing external debt. In the face of a declining FDI/debt ratio,
the government feared that devaluation would have a devastating effect on its debt
service. From a macroeconomic point of view, the use of commercial policy instead
of devaluation for external adjustment ignores the fact that a real devaluation would
improve the current account and thus reduce a debt denominated in foreign currency
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43
if the foreign funds had been borrowed to finance the current account. But the
decision makes sense in that it was an attempt by the borrower to avoid foreign
exchange risk. In the late 1970s and the early 1980s when the overvaluation of the
cruzeiro reached a point where there was nothing the government could do but
devalue, the government as the largest debtor was indeed squeezed.
Figure 3
Ratio of FDI Stock to Debt with Commercial Banks, 1970-80
1.80
1.60
1.40
1.20
1.00
0.80
0.60 -
0.40
0.20
0.00
1971 1972 1974 1975 1977 1978 1980 1970 1973 1976 1979
Source: Source: World Bank, G lobal Developm ent Finance 1997 (on CD-ROM).
Systematic data on debt owed to commercial banks by Brazil prior to 1970 is not
available. But the trend of a declining FDI/debt ratio over the years is unmistakable
(see Figure 3). If we go back to Figures 1, 2.1, and 2.2, we can find a clear pattern of
how the FDI/debt ratio affects the tariff rate by way of the exchange rate: When the
2 5 Papageorgiou, Michaely, and Choksi, eds., Liberalizing Foreign Trade, Vol. 4, pp. 38-39.
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FDI/debt ratio declined, the real exchange rate appreciated or remained constant (as
the government was unwilling to devalue the currency in the face of BOP
difficulties), which in turn forced the tariff rate to go up accordingly. This trend was
consistent with the inward orientation of foreign auto producers at the time. But if
the trade policy preferences of MNCs and the FDI/debt ratio changed, so would the
tariff rate. That is the point I want to elaborate in the sections below.
5. From the BEFIEX Program to the Debt Crisis: The Shift to Export
Production
After the early 1970s, foreign auto producers became increasingly outward-
oriented. Likewise, their trade policy preferences were also undergoing a drastic
change. While this change toward outward orientation again originated from or
coincided with government policies, its impacts on trade policy change toward
opening were unexpected by the government that promoted export production in the
first place.
The turning point in the outward orientation of foreign auto producers came as a
reaction to the BOP problems created by the first oil shock in 1973. Historically
Brazil was successful in maintaining surpluses in its balance of trade. Between 1946
and 1970 exports exceeded imports in all but three years (1952,1960, and 1962).
This situation, however, changed dramatically after the first oil shock in the early
1970s, as deficits became the norm (see Figure 4). Concerned with the balance of
trade, the government looked to the automotive industry as a potential source of
foreign exchange. It lifted all incentives granted earlier with the exception of those
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available under the Special Fiscal Benefits for Exports (BEFIEX) program in order
to shift the incentive structure toward export promotion.
Figure 4
Brazil’s Balance of Payments, 1950-80
(Millions of US dollars)
1000
El.. a . . ea . . m g, E l r , tl
c # . < # ^ c # c #
-1000
-2000
-3000
-4000
-5000
Source: Mauricio Mesquita Moreira, Industrialization, Trade and Market Failures (New York: St.
Martin’s Press, 1995), p. 203.
To qualify for BEFIEX, firms had to commit to targeted dollar values of exports
and net foreign exchange earnings. The incentives they received in return included
exemptions from the federal and state sales taxes (known as the IPI and ICM taxes)
on exports; exemptions from duties on imported capital goods, components, and raw
materials; and various drawback schemes that allowed firms to obtain a refund of
duties and taxes paid on imports of inputs whenever these inputs were used in the
production of exportable goods. In addition to the IPI and ICM taxes waived on
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46
export sales, firms also received a credit equal to these waived taxes that could be
used toward taxes due on goods produced for the domestic market. For example, if a
firm exported $100 million worth of automotive products whose combined IPI and
ICM tax rate was 30 percent, taxes equal to $30 million would be waived on the
export sales, and the firm would receive another $30 million credit against taxes due
on domestic sales.2 6 In terms of duty-free imports, a limit was set to tie exemptions
to export contributions. Firms could import up to one dollar worth of duty-free goods
for every three dollars of goods exported. In keeping with the relaxation of parts and
components imports, the government also lowered the local content requirements
97
from 98 to 80 percent for trucks and from 99 to 85 percent for cars.
In addition to these attractive incentives, there are other reasons for foreign auto
producers to go with the export promotion policies. First, almost all firms invested
heavily in the late 1950s and throughout the 1960s. Given the lumpy nature of auto
investment, export would overcome the scale disadvantage by extending the size of
the market and serve as an outlet for excess capacity until the domestic market grew.
In fact, some firms even expanded their facilities in response to the BEFIEX
program. Ford’s new plant built after the BEFIEX program was capable of producing
255,000 four-cylinder motors for which the demand in Brazil in the later 1970s was
about 120,000 units. Once these facilities were in place, the firms had no choice but
2 6 The IPI tax credit was abandoned in 1979 as a result o f pressure from the United Sates and the
General Agreement on Trade and Tariffs (GATT), which charged that it amounted to subsidies.
However, it was revived in 1981 as a less inflationary means than a hefty one-shot devaluation to
regain export competitiveness. Again the United States criticized the incentive mechanism and forced
its elimination in 1983.
2 7 Latin America Economic Report, December 16, 1977, pp. 244-245.
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47
to export. Second, from the standpoint of cost efficiency it was in the interest of the
firms to reduce the local content level and replace the more expensive, locally-
produced parts and components with imported ones. In order to achieve this goal, the
firms would have to develop export capability to pay for increased imported content.
According to one estimate, international production and the exchange of parts and
components would reduce the average resource cost for the Brazilian automotive
industry by 35 percent (equivalent to 16 percent of vehicle value).2 8 Third, when
engaged in production for the domestic market under protection, the firms found it
unnecessary to adhere to international standards in design and specifications.
Consequently, they lagged technologically behind their parent companies. Export
thus would narrow the technological gap or at least assure that the gap was not
widening since technical requirements on export products were more stringent than
those on products sold domestically.
By 1977, all major auto producers had signed export contracts under the BEFIEX
program.2 9 Ford, GM, and VW each committed to $1 billion in exports over a period
of around ten years (see Table 6 for a list of participating firms). BEFIEX
participation meant that firms were not able to alter export targets regardless of the
fluctuations of foreign demand and exchange rate, but were bound to fulfill export
commitments by a given date.
2 8 Jack Baranson, Autom otive Industries in D eveloping Countries, World Bank Occasional Staff
Papers, no. 8 (Washington, D.C.: World Bank, 1969), p. 69.
29 These contracts were extended in the 1980s, but the range o f benefits became narrower than before
as the Brazilian government was under pressure from industrialized countries to phase out export
incentives.
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Table 6
Export Engagement under the BEFIEX Program (1973-85)
Firm Export in million $ Duration Products
Ford 1,355.4 1974-83 Engines, parts, electronic components
VW 1,069 1974-82 Assembled vehicles, V-8 engines
GM 1,009.5 1976-86 Assembled vehicles, diesel engines
Fiat 550 1976-85 Assembled vehicles, engines, parts
Mercedes 500 1975-84 Not specified
Saab-Scania 415.4 1976-85 Not specified
Chrysler 314.5 1974-83 Assembled vehicles
Source: United Nations Center on Transnational Corporations, Transnational Corporations in the
International Auto Industry (New York: United Nations, 1983), p. 117.
In the first few years of the BEFIEX experiment, export was simply a sideline to
supplying the domestic market. Some export projects, such as the one proposed by
Fiat, merely served as a lateral entry into the market the government considered as
having already been crowded. Between 1974 and 1979, despite high gasoline prices,
rationing, the slowdown in production activity, and recurrent credit tightening for
vehicle purchase, the growth of domestic sales averaged over five percent per year in
real terms.3 0 Nevertheless, the second oil shock in 1979 and the ensuing debt crisis
had a devastating effect on domestic demand. Vehicle sales slumped by 42 percent in
1981.3 1 By 1987, domestic sales were still 10 percent below the 1981 level.3 2 With
the fall-off in domestic sales, export activity was greatly enhanced. As a MNC’s
spokesperson put it, “Today exporting may be the key to keeping a Brazilian
investment alive. With the shrinkage of the market here and growing excess
30 Winston Fritsch and Gustavo Franco, Foreign D irect Investment in Brazil: Its Im pact on Industrial
Restructuring (Paris: Development Centre, Organization for Economic Cooperation and
Development, 1991), p. 115.
3 1 Latin Am erica Weekly Report, March 12, 1982, p. 8.
3 2 Fritsch and Franco, Foreign D irect Investment in Brazil, p. 115.
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49
capacity, the only alternative for many firms is to push sales abroad. For them,
exporting is just as important as it is for the country.”
Of the four leading auto producers, GM exported components for assembly to its
plants in Chile and Uruguay, and vehicles to Bolivia, Paraguay and Central America.
Some of its automotive exports also made their ways to Africa and Middle East.
Compared to GM, Ford followed more of an international sourcing strategy,
exporting engines and other components back to the United States or shipping them
to Canada for installation in vehicles that ultimately would be sold in the U.S.
market. Engines were preferred over CKDs or finished vehicles due largely to lower
transportation costs and simpler quality control. Contrary to Ford’s practice, VW
used Brazil as an offshore base to export finished vehicles to other Latin American
countries. The models it produced included the Beetle, which had been discontinued
in Germany. Brazil also accounted for a larger share of VW’s global production than
Ford’s, and was the company’s primary low-cost production site before its
investments in Spain. As a latecomer, Fiat entered the Brazilian market in 1973 on
condition that it would export part of its production. It started manufacturing in 1976.
Although Fiat was unsuccessful in capturing a larger slice of the domestic market,
the growth of its exports was spectacular. Like GM, Fiat produced a substantial
amount of components for export to other Latin American countries, but its vehicle
3 3 Business Latin America, February 8, 1984, p. 42.
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50
sales were destined for the low price end of European markets. In 1981, Fiat’s 147
model, the cheapest on the Italian market, accounted for 62 percent of its exports.3 4
When Latin American markets collapsed during the 1980s as a result of the debt
crisis, the direction of exports began to change. GM and VW both shifted their
exports first to the oil-exporting nations in Africa and the Middle East, and then to
industrialized countries after more and more LDCs began to feel the impact of the
debt crisis. In 1987, VW do Brasil introduced the Fox, a compact passenger car, and
exported it almost exclusively to the United States and Canada. In the 1970s, nearly
90 percent of finished vehicle exports went to other Latin American countries. By
1984, this share was reduced to 60 percent. And by 1989, 60 percent of vehicle
exports were shipped to the United States, Canada, and Europe.3 3
The approach these firms adopted to facilitate export production also differed
from the earlier period and was exemplified in the development of the “world car.”
Based on the notion of the world car, all models are produced for sale anywhere in
the world, with only small regional/country design variations. Production of key
components—engines, transmissions, suspension systems, safety devices,
computerized ignition systems and so on—can be located wherever cost advantages
are greatest. By and large, U.S. firms—Ford and GM in particular—promoted the
world car to a greater extent than their less internationalized European counterparts.
Among the many variants of the world car, The Ford Escort was the best known. As
3 4 Latin American Weekly Report, March 12, 1992, p. 9.
3 5 Shapiro, “Automobiles: From Import Substitution to Export Promotion in Brazil and M exico,” p.
215.
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51
part of the $3 billion Erika project, Ford do Brasil introduced a modified version of
the Escort in 1983, both to replace the Corcel in the domestic market and for export
to Europe to compete with Japanese cars. To facilitate the global sourcing of
components for the Escort, Ford demanded, though unsuccessfully, that the local
content requirements be reduced. Ford initially planned to produce 190,000 Escorts
by 1990, of which 40,000 would go to Europe.3 6 However, the cruzeiro
overvaluation in the mid-1980s, which made exports from Brazil less competitive,
forced Ford to cancel the plan and turn its attention to East Asia as a potential export
base. Other world cars introduced during the same period included GM’s J-car or
Monza as it was called in Brazil, launched simultaneously in Brazil, North America,
and Europe. In a global sourcing arrangement, Brazil was assigned the role of
exporting J-engines, mainly to Germany and the United States.
A question that follows is the ability of the industry to compete in world markets.
Comparing Argentina, Brazil, and Mexico with the United States, Jack Baranson
noted that “production costs of the three leading automotive manufacturing countries
in Latin America in 1965 ranged between 60 and 150% more than in the United
States. A vehicle that costs approximately $1,660 to manufacture in Detroit averages
about... $3,000 in Brazil.”3 7 The cost differentials were mainly a function of local
content requirements imposed by the government. In all three countries, production
costs rose with the increase in domestically produced inputs as the national parts
3 6 Latin Am erica Weekly Report, March 12, 1982, p. 9.
3 7 Jack Baranson, “Will There Be an Auto Industry in the LDC’s Future,” Columbia Journal o f World
Business 3, no. 3 (1968), p. 52.
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52
industry was simply not prepared to provide its products at internationally
competitive prices.
After 1965, the cost effectiveness of Brazil’s automotive production improved
remarkably. By the early 1970s, Brazil’s cost differential with U.S. production was
narrowed down to 35 percent, which compared favorably with Mexico’s differential
-IQ
of 45 percent to 53 percent. Recent studies have given more attention to price
comparisons to address the issue of cost effectiveness. Direct price comparisons by
the World Bank in 1980-82 indicated that the prices of Brazilian vehicles were lower
than those of similar foreign models.3 9 According to implicit-tariff calculations,
international prices exceeded domestic prices by 23 percent on average. For
commercial vehicles, the difference was even twice as high.4 0
Brazil’s price advantage in the 1980s could be attributed to low labor costs, low
raw material, energy and environmental costs, generous investment and export
incentives, more efficient local parts supplies, as well as the relaxation of local
content requirements 4 1 Moreover, the export drive since the mid-1970s produced a
situation in which most firms began to achieve reasonably high levels of production
in terms of the minimum requirements for technical efficiency. For example, car
production reached 512,946 units at VW, 164,729 at GM, 124,656 at Ford, and
3 8 Bernhard Fischer et ah, Capital-Intensive Industries in N ew ly Industrializing Countries: The Case
o f the Brazilian Automotive and Steel Industries (Mohr, Germany: Tubingen, 1988), p. 55.
3 9 World Bank, Brazil: Industrial Policies and M anufactured Exports (Washington, D.C.: World
Bank, 1983), p. 122.
4 0 It should be pointed out that some o f the local vehicles selected for comparison were not strictly
comparable to foreign vehicles and that quality-adjusted price differences were not taken into account.
4 1 Traditionally, Brazil had its greatest cost advantage in machined castings and forgings because of
their high labor content and the country’s low wage rates. That’s why Brazil was considered
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53
97,302 at Fiat in 1978.4 2 Given the fact that production costs per unit level off at
about 120,000 units per year on car assembly operations,4 3 these firms clearly were
reaping or about to reap the benefits of scale economies. When combined with other
factors such as low-cost labor, this implies a cost structure that was quite competitive
by any standards.
In 1970, Brazil exported no vehicles. By 1987, however, the share of vehicle
exports in total production rose to a stunning 39.93 percent, thanks to export
promotion (see Figure 5). Notwithstanding the incentives associated with export
production, foreign auto producers had their own reasons to go along with
government policies: overseas expansion to overcome the scale disadvantage;
development of export capability necessary to pay for increased imported content;
and elimination of the technological gap between Brazilian-made vehicles and
foreign vehicles. Facilitated by an increase in the competitiveness of Brazilian-made
products, automobile exports finally took off after the debt crisis. As I will show
below, the switch of foreign auto producers to export production led to a change in
their trade policy preferences, which eventually affected Brazil’s sector-specific
trade policy in a fundamental way.
competitive in engines and transmissions, whose production involved basically labor-intensive
activities, but not in plastic, glass, and electronics components.
42 Mericle, “The Political Economy o f the Brazilian Motor Vehicle Industry,” pp. 31-32.
4j Baranson, Automotive Industries in D eveloping Countries, p. 29.
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Figure 5
Brazil’s Vehicle Exports as a Percent of Total Production, 1970-87
45
40
35
30
25
20
15
10
5
0
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987
Source: Winston Fritsch and Gustavo Franco, Foreign D irect Investment in Brazil: Its Im pact on
Industrial Restructuring (Paris: Development Centre, Organization for Economic Cooperation and
Development, 1991), p. 116.
6. Debt Rescheduling and Reduction
Complementing the shift of foreign auto producers to export production was the
improvement of Brazil’s capital account. Toward the late 1980s, the country’s
ballooning external debt was finally under control thanks to debt rescheduling and
reduction. The net inflows of FDI also returned to the pre-1982 level. Although such
inflows turned flat after 1988, in relative terms the FDI stock (net inflows plus
reinvestment of profits) actually grew against the debt. For the first time in more than
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55
a decade, the decline in the FDI/debt ratio began to reverse. The debt rescheduling
and reduction thus eliminated a major obstacle to exchange rate devaluation.
By the time the debt crisis erupted, Brazil’s outstanding external debt stood at
$83.2 billion. Most of the debt consisted of floating-rate loans from commercial
banks, which accounted for 75 percent of the total.4 4 With the debt crisis came a new
phase of Brazil’s international financial relations. The previous system of debt
service by means of essentially voluntary lending was replaced by debt rescheduling
and the extension by bank creditors of “forced” loans to ensure interest payments in
exchange for the acceptance of an IMF adjustment program. It was in this context
that Brazil negotiated two financial packages with commercial banks in 1983-84,
which involved two “jumbo loans” totaling $10.9 billion.
These rescue loans, however, did not help pull Brazil out of its indebtedness. In
1984, Brazil’s interest payment rose from $9.6 billion to $10.8 billion, whereas its
total debt went from $92 billion to $99 billion. Although Brazil was forced to reopen
talks with commercial banks on its private liabilities in 1985, the tension between the
two sides was growing. The cause of the tension was a proposed IMF austerity
program. The IMF wanted the country to do more to cut government spending. But
Brazil found the IMF’s demand on its budget unacceptable.
The inauguration of Jose Samey as the first civilian president of the “new
republic” further hardened Brazil’s position on the debt issue. Amid the general
sentiment among Brazilians that opposed any compromise with the IMF, in February
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56
1987 the government declared what would become a ten-month-long moratorium on
further debt service to commercial banks. In hindsight, President Samey admitted
that the moratorium was “the worst error we have yet committed.”4 5 But ironically
this action ended with a new round of debt rescheduling and, most importantly, some
major breakthroughs in debt reduction.
After the moratorium took effect, both commercial banks and Brazil favored
reconciliation over continued confrontation. The banks preferred to do so, not
because of the suspension of interest payments, but because of the potential risk they
faced with their Brazilian loans.4 6 Meanwhile, the moratorium did not do any good
for Brazil either. Except for satisfying the nationalist sentiment at home, the strategy
backfired. The banks successfully manipulated the international credit situation to
isolate Brazil. While Brazil was posturing against the banks, private creditors were
cutting deals with more cooperative debtor countries, such as Mexico, Argentina,
Venezuela, and Chile. The period saw a distinct reduction in interest rates for
debtors, and Brazil obviously missed the boat. As time passed by, Brazil began to
regret what had happened.
44 Carlos Geraldo Langoni, The Developm ent o f Crisis: Blueprint fo r Change (San Francisco:
International Center for Economic Growth, 1987), p. 39.
4 5 Financial Times, February 4, 1988.
46 In the United States, the Interagency Country Exposure Review Committee (IACERC) downgraded
the banks’ Brazilian portfolios to “substandard” in April 1987, and was threatening to drop it further
to “value-impaired.” Had the next step been taken, the banks would have had to write off their
Brazilian loans. The IACERC, established in the late 1970s, is made up o f members o f the Federal
Reserve, the Comptroller o f the Currency, and the Federal Deposit Insurance Corporation (FDIC). Its
goal is to advise U.S. banks and help them achieve “sufficient diversification among countries to
reduce lending risks.” Among other things, the IACERC recommends that banks be required to write
off portions o f loans to countries that apparently cannot meet their interest payments.
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In November 1987, the banks and Brazil worked out an interim agreement to end
the moratorium. Attempting to get Brazil to clear up its interest arrears, the banks
made a series of short-term bridge loans of $3 billion. Brazil itself put up $1 billion
of its own money from its reserves and paid $1.5 billion in December as its first
interest payment since the beginning of the year. At Brazil’s insistence, the banks did
not seek to tie the deal to an IMF austerity program this time. Considering the status
of their Brazilian loans, the banks figured that the best they could do was to get
Brazil to agree to IMF negotiations.
With interest payments trickling out of Brazil, negotiations on another financial
package for the country started in February 1988. The new package, completed by
June, rescheduled $62 billion in debt over 20 years and allowed Brazil to receive
another $5.2 billion in new money for interest payments. Brazil’s finance minister
Mailson Fereira da Nobrega hailed it as “the best debt accord any Third World
country ever had.” Besides being the most generous deal the country had received,
the package also created various debt-reduction mechanisms, including debt/equity
swaps and “exit bonds.” While the debt/equity conversion schemes took a longer
time to implement, exit bonds were immediately available. Exit bonds in fact were
U.S. Treasury zero-coupon bonds Brazil purchased and then auctioned for its debt.
To buy exit bonds, the banks would incur a loss proportionate to the discount of
loans they would sell, but in return they would be able to strengthen their portfolios
with more secure assets and become exempt from future forced lending or
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rescheduling. Within months, over 100 banks quickly bought up $1 billion exit
bonds at 6 percent interest.4 7
As a result of the new package, especially those measures aimed to provide a
permanent solution to the debt problem, Brazil’s private debt—debt owed to
commercial banks—fell by nearly one-fourth in 1987-90, from more than $70 billion
to less than $53 billion. At the same time, the net inflows of FDI rose from $1,225
million in 1987 to $2,969 million in 1988.4 8 With the increase in the FDI/debt ratio,
the Brazilian government now found it less painful and more acceptable to devalue
its currency if necessary.
7. The Outward Orientation of FDI, the Higher FDI/Debt Ratio, and
Trade Policy Opening
In the 1990s, Brazil’s automotive industry experienced deep, multi-year tariff
cuts. This change in trade policy occurred along with a shift in the orientation of
foreign auto producers from domestic sales to exports and a decrease in the level of
external debt relative to FDI. Just as the inward orientation of foreign auto producers
and an increase in the level of external debt relative to FDI contributed to higher
tariffs in the earlier period, a change in these conditions made it possible for the
government to reverse the course in the 1990s.
47 Ernest J. Oliveri, Latin American D ebt and the Politics o f International Finance (Westport, Conn.:
Praeger, 1992), pp. 155-156.
4 8 World Bank, G lobal Developm ent Finance 1997 (on CD-ROM).
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Another change that could make a difference is Brazil’s return to democracy in
the 1980s.4 9 One would argue that it was the democratic transition that made trade
policy opening possible. But the state-centric perspective implicitly suggests that the
authoritarian regime is more conducive to liberal trade policies due to the insulation
of the decision-making process from societal pressure.5 0 If this is true, Brazil’s trade
policy under democracy should have been more closed rather than more open. In
fact, the only difference brought about by the democratic transition was rather
technical. Before democratization, businesses defended their interests mainly
through negotiations with the members of the cabinet. Now the erosion of the power
of the executive shifted the clashes of interests to the public arena.5 1
Then, how did the outward orientation of foreign auto producers and a decreasing
level of external debt relative to FDI contribute to the sector-specific trade policy
opening?
The liberal trade policy preferences of foreign auto producers were a function of
their outward orientation. These preferences, however, would not necessarily
translate into pressure for trade policy opening unless the restrictive import regime
hurt. In the 1980s, foreign auto producers rose to confront the Brazilian government
because of three new developments: (1) The Ford-VW merger of their South
American operations that required exchange of vehicle models between the Brazilian
49 Some scholars characterize Brazil in the 1980s as transitional democracy next to established
democracy. See Joan Nelson, ed., Economic Crisis: The Politics o f Adjustment in the Third World
(Princeton: Princeton University Press, 1990), p. 23.
5 0 Barbara Stallings and Robert Kaufman, eds., D ebt and Democracy in Latin America (Boulder,
Colo.: Westview Press, 1989), pp. 205-212.
5 1 Latin America Regional Reports-Brazil, June 1, 1984, p. 7.
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60
and Argentine plants to reduce the costs, (2) the passing of the 1984 Informatics Law
that prevented the introduction of high-tech components to vehicles and the use of
new technology in production, and (3) the fear of trade sanctions threatened by the
United States due to informatics and pharmaceuticals disputes.
The Ford-VW merger of their car manufacturing activities in Brazil and
Argentina was announced in November 1986. The new company that emerged from
the merger was called Autolatina, in which Ford had a 49 percent stake and VW 51
percent. At the time of the merger, Autolatina employed 67,000 workers and
♦ S '?
controlled almost 60 percent of all vehicle sales in Brazil (over 500,000 in 1985).
Apart from catering for the domestic market, Autolatina’s Brazilian plants, to be
reorganized around VW, would concentrate on the production of cheaper cars for
export to Argentina, whereas its Argentine plants, to be reorganized around Ford,
would give priority to the production of luxury cars for the Brazilian market. This
division of labor was designed to address the problems of idle capacity faced by Ford
and VW and the overlapping of their product lines. For example, Ford needed a more
powerful engine than it had produced for its Del Rey car, and VW was producing
exactly the type of engine Ford wanted for its Santana model. The grand plan to
exchange vehicle models between Brazil and Argentina, however, would breach
Brazil’s “market reserve” for Brazilian-made cars. Thus for the merger to work, as
5 2 Latin America Weekly Report, July 3, 1986, p. 10.
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61
one observer pointed out, the market reserve enjoyed by major auto producers so far
had to be lifted.5 3
The market reserve had been around for sometime. But it came to be in the
spotlight after 1984 when Brazil passed the Informatics Law. The law reaffirmed the
government’s commitment to the protection of infant industries such as
microcomputers, with a specified period of at least eight years up to 1992.5 4 In
contrast to the auto program, the domestic market in microcomputers was reserved
only for national firms by prohibiting imports and restricting foreign investment in
that market segment. Although the controversy that followed focused primarily on
microcomputers, the impact of the market reserve policy extended far beyond this
market segment, as microelectronics had served as important industrial inputs with
ramifications for the entire manufacturing sector.
To be sure, MNCs were not monolithic and unified on the informatics issue.
Some dominant, profitable companies in the Brazilian computer industry such as
IBM chose not to irritate Brazil, hoping for an eventual policy turnaround. They
believed that the Informatics Law was more a codification of existing practice and
still left room for maneuver on a company basis.5 3 But others, especially those
outside the computer industry but adversely affected by the law, did come forward to
5 3 Latin American Regional Reports-Brazil, January 8, 1987, p. 5.
5 4 Manuel Castells, Lisa Bomstein, Katharyne Mitchell, Rebecca Skinner, and Jay Stowsky, The State
and Technology Policy: A Com parative Analysis o f the U.S. Strategic Defense Initiative, Informatics
Policy in Brazil, and Electronics Policy in China (Berkeley Roundtable on the International Economy
[BRIE], Working Paper #37, June 1988), pp. 80-81.
5 5 John Odell and Anne Dibble, Brazilian Informatics and the United States: Defending Infant
Industry Versus Opening Foreign M arkets (Washington, D.C.: Institute for the Study o f Diplomacy,
Pew Case Study Center, Georgetown University, 1992), Case 128, Part A, pp. 6-7.
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speak out. Helmut Vervuert, president of the German company Siemens, complained
about what he regarded as “nationalist tendencies” in Brazil after his company’s
latest project to manufacture a new type of private branch exchange (PBX)5 6 was
vetoed because of the law. Siemens’s experience was shared by other industries.
Werner K. Lechner, president of Mercedes Benz, saw the new “wave of nationalism”
affect other sectors, including the automotive industry.5 7 The executive vice
president of ANFAVEA Wagner Bouker believed that the Informatics Law was to
blame for the lack of high-tech components for vehicles and the use of outdated
technology in production. Matas Ola Palm, managing director of Volvo do Brasil
(the country’s largest exporter of heavy vehicles), was brave enough to predict that
trade barriers would make the export industry uncompetitive for the next 10-20
r o
years. Speaking of why Brazilian-made cars were often referred to as “crude little
carts,” the president of ANFAVEA Jacy de Souza Mendon?a pointed to the policy
that closed Brazil to the world economy and its technology. “If the manufacturers
who are already here continue to be prohibited from equipping their vehicles with
imported electronic equipment,” he said, “it is all over for Brazil.”5 9 The conflict
between the multinationals and the Brazilian government eventually sent the main
directors of Ford, VW, and GM on frequent business trips to Brazil for lobbying
activities.6 0
56 These are private telephone switching systems used by business such as hospitals, hotels, and other
multi-line locations.
51 Latin America Regional Reports-Brazil, January 4, 1985, p. 6.
5 8 Latin American Weekly Report, May 19, 1988, p. 7.
5 9 Sao Paulo ISTOE, May 9, 1990, pp. 16-18.
60 Latin America Weekly Report, March 25, 1995, pp. 8-9.
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The controversy on informatics soon spilled over to other areas. This time it was
the refined chemicals/pharmaceuticals industry that was in dispute. For years, MNCs
dominated the production of raw and intermediate refined chemicals for the
pharmaceuticals industry. The only area in which local firms had a hold was the
manufacture of finished refined chemicals, where they controlled formulation
technology. The Brazilian government was determined to reverse the imbalance. The
new policy, hammered out in closed-door sessions and leaked to the press thereafter,
reportedly included such criteria for approval of new investment in the industry:
local ownership, local technological control, and high levels of local value added.6 1
This policy intention amounted to adding fuel to the fire and further angered foreign
investors. Under the pressure of U.S. multinationals, the United States decided to
retaliate, threatening to impose trade and other sanctions if Brazil did not back off.
Thus, the skittish battles between the United States and Brazil over informatics
quickly developed into a potential trade war, with MNCs caught in the crossfire.
The United States started an investigation into the activities of the Brazilian
computer industry in September 1985 under Section 301 of the 1974 Trade Act. In
November 1987, a Brazilian decision to ban imports of Microsoft computer software
into the country prompted the U.S. action. As a first step, the office of the U.S. Trade
Representative (USTR) released a list of products to be subject to surtaxes. On top of
the list were footwear, cars, trucks, ceramics, furniture, telephones, industrial
6 1 Business Latin America, June 30, 1986, pp. 193-194.
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64
machinery, airplanes, etc.6 2 Orange juice, coffee, gasoline, and textiles were
excluded from the list and cars and trucks were included because the United States
wanted to prevent Brazil from exporting industrial products that usually generated
more foreign exchange earnings. Again in July 1988, following a petition by the
powerful Pharmaceutical Manufacturers’ Association (PMA), which accused Brazil
of pharmaceutical patent piracy, the USTR proposed another action against Brazil—
a 100 percent retaliatory duty on about 60 Brazilian products, including cars and
trucks, valued in 1987 at $200 million.6 3 Although the Reagan administration never
actually imposed the informatics and pharmaceutical sanctions, it made a credible
threat that haunted Brazil for the next few years.
With their exports facing U.S. retaliatory measures, foreign auto producers now
had to pick a side. Had the Ford-VW merger not taken place or had imports of
electronic components not been an issue, foreign auto producers would have sought
to accommodate themselves to the existing policy—exactly like what IBM did in the
controversy. However, the fear of retaliation forced foreign auto producers to embark
on a journey of “no return.” They joined the force of other multinationals in an effort
to pressure the Brazilian government to abandon protectionist policies and lobby the
Brazilian congress to block bills that proposed counter-retaliatory measures. Because
of this experience, the president of ANFAVEA Jacy de Souza Mendonthat “no one cried out more loudly in opposition to that [trade policy] closure than
6 2 Latin American Weekly Report, December 3, 1987, p. 11.
6 3 Latin American Weekly Report, August 11, 1988, pp. 10-11.
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65
we did.”6 4 When the Brazilian government announced in May 1988 a new industrial
policy that called for the “gradual liberalization of the Brazilian economy,” one
observer noted that, while the government would not admit it, the decision to change
direction owed a great deal to pressure from multinationals and abroad.6 5
Figure 6
Ratio of FDI Stock to Debt with Commercial Banks, 1980-93
0.80
0.70
0.60
0.50
0.40
0.30
0.20
1980 1981 1992 1993
Source: Source: World Bank, G lobal Developm ent Finance 1997 (on CD-ROM).
Meanwhile, as the FDI/debt ratio reversed its downward trend toward the end of
the 1980s (see Figure 6), the government became more flexible about devaluation. In
the early 1980s, Brazil’s exports grew strongly due to real cruzeiro devaluations
under an IMF stabilization program. From 1985 onwards, however, nominal
6 1 Sao Paulo ISTOE, May 9, 1990, pp. 16-18.
6 5 Latin American Regional Reports-Brazil, July 7, 1988, p. 6.
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exchange rate adjustments did not keep pace with domestic inflation, allowing the
currency to appreciate in real terms. A direct consequence of the real exchange rate
appreciation was a decline in trade surplus. Beginning in 1990, the Brazilian
government, in a bid to improve export performance, introduced a series of
corrective devaluations, which brought the real exchange rate down (see Figure 7)
and paved the way for trade liberalization.
Figure 7
Brazil’s Real Effective Exchange Rates, 1987-95
(1987=100)
180
160
140
120 -
100 -
1987 1988 1989 1990 1991 1993 1994 1992 1995
Sources: GATT, Trade P olicy Review: Brazil 1992 (Geneva: GATT, 1993), p. 30; WTO, Trade
Policy Review: Brazil 1996 (Geneva: WTO, 1997), p. 5.
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67
In theory, devaluation hurts foreign investment by reducing the value (in hard
currency) of fixed assets,6 6 but makes new investment in the recipient country more
attractive (more assets for less hard currency). This, however, may not be the case if
the foreign investor is outward-oriented. For an export-oriented firm, the benefits of
devaluation are greater than its costs. Simply put, a real devaluation can boost the
firm’s export revenue so that the loss of fixed assets will be offset by the overall
profitability. In fact, foreign auto producers operating in Brazil during the period not
only welcomed devaluation but also exerted pressure to make it happen.
In the 1980s, there was a strong contraction of the domestic market. Therefore,
exports helped prevent auto producers from losing money for some years. With
exports now taking a front seat in the firms’ profit and loss statements, the
overvaluation of the cruzeiro became a sore point. For example, VW saw the United
States and Canada suspend imports of 20,000 units of its Fox model because of the
relatively high price in April 1988.6 7 Immediately after the incident, foreign auto
producers jointly called for devaluation of the cruzeiro of over 30 percent to regain
competitiveness. Andre Beer, president of ANFAVEA and GM, complained that the
current exchange rate was at the root of the industry’s present difficulties.6 8 “We are
actually losing money on the exports,” claimed Wolfgang Sauer, president of
Autolatina.6 9 For auto producers, trade policy opening and devaluation
complemented each other. Concerned with falling exports in 1989, the president of
66 Vinh Quang Tran, Foreign Exchange M anagement in M ultinational Firms (Ann Arbor, Mich.: UMI
Research Press, 1980), p. 53.
61 Latin American Regional Reports-Brazil, June 2, 1988, p. 7.
6 8 Latin American Weekly Report, May 19, 1988, pp. 6-7.
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68
ANFAVEA Jacy de MendoiKja demanded that the government do three things to halt
the “free fall” in foreign sales: a large devaluation of the cruzeiro, more competition
70
among local parts supplies, and the opening of Brazil’s closed market.
Following the 1988 announcement of gradual liberalization at the height of U.S.-
Brazilian disputes over informatics and pharmaceuticals, the Brazilian government
finally took concrete steps to honor its words. During his pre-inaugural tour to the
United States, Europe, and Japan in February 1990, president-elect Fernando Collor
de Mello promised that his government would do away with the policy of market
reserve, thus eliminating possible U.S. sanctions that had loomed over Brazil for
years. This statement was followed by an import liberalization plan released in
March. According to this plan and several new decrees and directives, tariff
reductions were scheduled for January 1, 1991. By 1995, the government had
lowered tariffs from 40 percent average level and 105 percent maximum level down
to basic duties of 0-20 percent and a maximum 40 percent for nascent industries.
Within the automotive industry, the average tariff rate for motor vehicles was
reduced substantially from 85 percent in 1990 to 20 percent in 1995 (see Figure 8).
In the immediate postwar years, Brazil encountered chronic BOP difficulties. It was
in this context that the government decided to upgrade the existing assembly
operations and install a domestic automotive industry. Since the Brazilian state’s
fiscal capacity was extremely limited at the time, the government concluded that
direct investment by MNCs would be the only means to transfer the required capital
6 9 Latin American Regional Reports-Brazil, June 2, 1988, p. 6.
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69
and technology. In the 1950s and 1960s, foreign investors were attracted to Brazil
because of the potential of the Brazilian market. That foreign investors sought to
penetrate the Brazilian market through participation in domestic production
suggested their inward orientation.
Figure 8
Brazil’s Average Tariff Rates for Motor Vehicles, 1990-95
90
80
70
60
50
40
30
20
10
0
1990 1991 1992 1993 1994 1995
Source: Avinandan Mukherjee and Trilochan Sastry, “Automotive Industry in Emerging Economies:
A Comparison o f South Korea, Brazil, China and India,” Economic and Political Weekly, November
30, 1996, p. M-77.
On the other hand, Brazil saw its outstanding external debt ballooning in the
1960s. The large amount of external debt relative to FDI increased the cost of
exchange rate devaluation, forcing the government to resort to commercial policy for
current account adjustment. Thus, the increasing level of external debt relative to
7 0 Latin American Regional Reports-Brazil, February 15, 1990, p. 7.
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70
FDI plus the inward orientation of foreign auto producers contributed to higher
automobile tariffs in the late 1960s.
After the late 1960s, however, the orientation of foreign auto producers and the
level of external debt relative to FDI shifted in the other direction. Years of export
promotion since the 1970s reoriented foreign auto producers more toward
international markets, whereas debt rescheduling and reduction in the 1980s
significantly lowered the level of external debt relative to FDI. These changes
eventually led to a reversal in the sector-specific trade policy in the 1990s.
While the outward orientation of FDI and a decreasing level of external debt
relative to FDI contributed to lower automobile tariffs in the 1990s, import
liberalization in turn inspired changes in corporate strategies to adapt to the new
environment. Firms like Ford, VW, GM, and Fiat increasingly sought to integrate
their Brazilian operations into global sourcing networks, standardize certain parts
worldwide to maximize economies of scale, and push import opening further up the
production chain to include parts. Parts producers instead passed on the pressure with
insistence on access to machinery and inputs, thus creating a snowball effect. As a
result of import liberalization, foreign auto producers now faced new competition in
finished products from abroad, but they also enjoyed easier access to imported
components and equipment and deregulation of the domestic market.
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71
Chapter Three
The Chinese Automotive and Consumer Electronics Industries during
the 1990s: FDI Orientation and Trade Policy Change
This chapter deals with two parallel Chinese episodes during the 1990s. In order
to weigh the relative importance of interests versus the capital account situation
(though not conclusive) in trade policy change, I will hold constant the level of
external debt relative to FDI and focus exclusively on the inward or outward
orientation of foreign investors.
Beginning in the mid-1980s, China’s automobile and consumer electronics tariffs
trended in the opposite directions. While the average simple and trade-weighted
tariff rates on automobile imports remained higher in 1996 than in 1985, consumer
electronics tariffs were declining over the years (see Figures 9 and 10 below). This
chapter will show that the divergence in sector-specific trade policy was a function
of the inward or outward orientation of foreign investors. These two Chinese
episodes thus provide additional support for the hypothesis about FDI.
1. FDI in the Context of China’s “Open Door” Policy
In a dramatic shift in foreign economic policy, China announced in 1978 that it
would “open door to the outside world.” As part of the “open door” policy, China
expected to use FDI to revitalize its economy. In incorporating foreign capital into its
development plan, the Chinese government employed a two-pronged strategy: to
upgrade technologies in capital-intensive industries to reduce import needs and to
promote exports in low-tech, labor-intensive industries to generate more foreign
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exchange. The automotive and consumer electronics industries were representative
of these two targeted areas. While this strategy set the terms of firm entry
negotiations and explained why FDI was import substituting in the automotive
industry and export promoting in the consumer electronics industry, it nevertheless
exposed the Chinese government to the pressure of foreign interests. By signing firm
entry agreements, the government found itself contractually obliged to react to
foreign demands.
Figure 9
China’s Simple and Trade-Weighted Average Tariff Rates for Passenger Cars
and Jeeps, 1985-1996
(Percent)
250
200
150
100
1993 1994 1996 1985
H Simple H Weighted
Sources: Correspondence with the Shanghai Customs o f the People’s Republic o f China, May 1996;
General Administration o f Customs o f the People’s Republic o f China, Zhonghau Renmin Gongheguo
Jinchukou Guanshui Tiaoli (Import and Export Tariff Regulations o f the People’s Republic o f China),
Beijing: Law Press, 1995, p. 468; Ta Kung P ao (Hong Kong), December 15, 1993, p. 5; South China
Morning Post (Hong Kong), February 7, 1996, p. 3.
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73
Figure 10
China’s Trade-Weigh ted Average Tariff Rates for Electronics and
Telecommunication Products, 1987-1996
(Percent)
Sources: General Administration o f Customs o f the People’s Republic o f China, Zhonghau Renmin
Gongheguo Jinchukou Guanshui Tiaoli (Import and Export Tariff Regulations o f the People’s
Republic o f China), Beijing: Law Press, 1995, pp. 444-461; Kiichiro Fukasaku and Henri-Bemard
Solignac Lecomte, “Economic Transition and Trade-Policy Reform: Lessons from China” (Paris:
OECD, Technical Paper, no. 112, 1996), p. 20; China D aily Business Weekly (Beijing), January 21-
27, 1996, p. 3.
China’ s Turn to FDI: The Economic Rationale
Up until 1979, China had followed a policy of self-reliance, which, among other
things, restricted foreign investment. Chinese leaders doubted China’s ability to
capture its share of the economic benefits generated by foreign investment. They also
feared loss of state control over the economy, loss of political independence, and the
potential for foreign influences to contaminate socialist values, if foreign investment
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74
was allowed. Although this policy prevented Chine from being dependent on any
other country, China paid a price by isolating itself from the rest of the world.
Because China had long resisted foreign investment, the announcement in 1978
that China would allow foreign firms to invest on its soil came as a surprise to many.
Having realized the limitations of self-reliance, the Chinese government hoped to
revitalize the Chinese economy by tapping into the international capital market.
From 1979 through the late 1980s, China developed a complicated legal system for
the regulation of foreign investment, with more than 50 laws and regulations put in
place.1
China’s turn to FDI originated in the deep economic troubles that China faced in
the 1970s, including low factor productivity, low standard of living, state budget
deficits that hindered domestic funding of infrastructure and industrial projects, low
technical and managerial sophistication in industry, and shortages of foreign
exchange to pay for technology and other imports. These economic problems,
coupled with foreign firms eager to open up the Chinese market or take advantage of
lower costs for labor and land, pushed China toward participation in the world
economy.
Foreign investment, and foreign joint ventures more specifically, would offer
China four things that were lacking in China: new sources of capital, advanced
technology, advanced management skills, and access to international markets. On the
other hand, the prospect of access to what investors had long believed to be a huge
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75
market (the so-called “market of one billion”) made China a highly desirable
location for new investment, although Hong Kong and Taiwanese manufacturers
were also attracted by China’s relatively cheap, proximate labor.
Investment Laws
At the time of opening, China had no body of law capable of providing a viable
framework for foreign investment activity. As a result, China’s planners had to start
all from scratch. Of numerous laws and regulations promulgated thereafter, three
were most important: the Joint Venture Law (1979), the Joint Venture Implementing
Regulations (1983), and the Provisions for the Encouragement of Foreign Investment
(1986).
The 1979 Joint Venture Law, the first of its kind, established the principles of
investment.2 Its significance lay in the signal it sent to foreigners that now it was
legitimate for them to invest and profit—the minimum needed to give some security
to potential investors. But in its 15 short, general articles, the new law fell short of
guiding foreign investors in crucial legal and operational matters. The vagueness of
the law was compensated by gradual addition of supplementary regulations, such as
the 1983 Implementing Regulations.3
1 Michael Moser, ed., Foreign Trade, Investment, and the Law in the P eo p le’ s Republic o f China
(Oxford: Oxford University Press, 1987), p. 90.
2 The formal title o f this law is The Law o f the People’s Republic o f China on Joint Ventures Using
Chinese and Foreign Investment (Zhonghua Renmin Gongheguo Zhong Wai H ezi Jingying Qiye Fa),
adopted at the Second Session o f the Fifth National People’s Congress on July 1, 1979 and
promulgated on July 8, 1979. For an English translation, see Franklin Chu, Michael Moser, and Owen
N ee, eds., Commercial, Business and Trade Laws: P eo p le’ s Republic o f China (Dobbs Ferry, N.Y.:
Oceana Publications, 1982).
3 Formally titled The Implementing Act for the Law o f the People’s Republic o f China on Joint
Ventures Using Chinese and Foreign Investment (Zhonghua Renmin Gongheguo Zhong Wai Hezi
Jingying Qiye Fa Shishi Tiaoli). Translated in Beijing Review, no. 41, October 10, 1983, pp. 1-16.
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The 1983 Regulations were designed to improve the investment environment by
clarifying it in a way that would give foreign investors greater confidence and guide
those who were negotiating joint ventures. In particular, the regulations provided
greater detail about China’s policy on the important issues of profit repatriation,
technology transfer, and foreign exchange.
Between 1983 and 1986, there was a tremendous expansion in Chinese imports
that caused the government to curtail foreign exchange spending by domestic firms,
including joint ventures. Since most joint ventures at the time were unable to export
their products, the reduction of domestic sources of foreign exchange made it very
difficult for them to import parts and components necessary for normal operations.
These problems spurred vociferous complaints and lobbying efforts by foreign
business interests. American Motor Company (AMC, acquired by Chrysler in 1987),
which formed a joint venture with the Beijing Automotive Works to produce jeeps,
became notorious for publicizing these problems that arose during the period. The
1986 Provisions were enacted exactly in response to foreign concerns.4 Unlike the
1979 and 1983 investment legislation, the 1986 Provisions explicitly favored
investment in the two areas that the government wanted to promote most:
technologically advanced and export-capable sectors.5 The government figured that
the transfer of advanced technology could cost China some foreign exchange if
4 Before the announcement o f the new law, the government solicited foreign views on a draft, and the
final version contained a number o f clauses that had been lobbied for by the U.S China Business
Council and by individual fmns. See U.S. Congress, Office o f Technology Assessment, Technology
Transfer to China, OTA-ISC-340 (Washington, D.C.: U.S. Government Printing Office, 1987), p. 33.
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77
exports failed to take off. But with simultaneous investment in export sectors
characteristic of labor-intensive, low-tech activities, foreign exchange receipts thus
generated would be enough to offset the expenditures.
Compatibility and Conflicts between the Goals o f Foreign Investors and Those of
the Chinese Government
FDI in the automobile industry in the 1980s came almost exclusively from U.S.
and Western European firms—AMC/Chrysler, VW, and France’s Peugeot. Even the
unsuccessful Panda Motors Corporation, a wholly foreign-owned enterprise in
Southern China between 1988 and 1992, was established by Korean Americans and
was incorporated in Delaware under an umbrella organization called the Virginia
Business Enterprise Group.6 Compared to the automobile industry, the consumer
electronics industry relied mainly on Hong Kong and Taiwanese investors to raise
foreign capital. These foreign investors of different origins were attracted to China
with different goals, which fit into different government foreign investment schemes
and contributed to different entry agreements.
The foremost goals of U.S. and Western European auto producers investing in
China were the prospects of gaining access to the Chinese market and, reflecting the
oligopolistic rivalry in the structure of these firms, preempting competitors from
gaining a large share of that new market first.7 Since these firms already had strong
5 See The Provisions o f the State Council for the Encouragement o f Foreign Investment (Guowuyuan
Guanyu Guli Waishang Touzi de Guiding), Article 2. An English translation is reprinted in The China
Business Review 14, no. 1, January-February 1987, pp. 14-15.
6 For details about the Panda project, see Eric Harwit, “China’s Elusive Panda,” The China Business
Review 17, no. 4, July-August 1990, pp. 44-47.
7 Access to the Chinese market and market preemption o f competitors were found to be the primary
goals for U.S. firms in a number o f early surveys. See John Daniels, Jeffrey Krug, and Douglas Nigh,
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78
market positions in Asia, they did not want to sell their products from China that
would undercut their existing sales. They knew how inefficient the Chinese
economic structure was and that the domestic market had to be developed before
substantial profits could be made. However, they were willing to forego immediate
profits from joint ventures in exchange for the hope that these ventures would offer
them a foothold in the nascent Chinese market.
Hong Kong and Taiwanese investors entered into the Chinese consumer
electronics industry in the middle of a shift of labor-intensive, low-skill jobs from
Hong Kong and Taiwan to China’s coastal provinces as a result of increasing local
labor costs and the appreciation of local currency that pushed up the price of their
o
exports. While Hong Kong and Taiwanese firms, like Western firms, also wished to
gain a foothold in the Chinese market, their primary goals were to seek low-cost
labor and land. To invest in China, they had to prepare for arbitrary local fees. But
even with these extra charges, wage rates for low-skill workers would be lower than
in Hong Kong and Taiwan. Moreover, Chinese sites would offer more factory space
“U.S. Joint Ventures in China: Motivation and Management o f Political Risk,” California
Management Review 27, no. 4 (Summer 1985), pp. 48-49.
8 In Taiwan, the economic success had led to rising living standards and rising wages. Between 1975
and 1985, the nominal wage rate in Taiwanese manufacturing increased at 13.7 percent annually,
whereas nominal labor productivity grew only half as fast, at 6.8 percent annually. Unit labor costs,
therefore, were growing rapidly. At the same time, the trade surplus Taiwan had been developing with
the United States suddenly exploded and put pressure on the local currency, which was revalued
upward by 40 percent against the U.S. dollar in 1986-87. As the local currency appreciated, the price
o f Taiwanese exports became more expensive. Hong Kong avoided an appreciating currency by
following a flexible exchange rate. But like Taiwan, it was also facing the problems o f high wage
costs and labor shortages. By relocating their export businesses to China, firms in these economies
hoped to regain their competitiveness in the international market. See Barry Naughton, “Economic
Policy Reform in the PRC and Taiwan,” in Barry Naughton, ed., The China Circle: Economics and
Electronics in the PRC, Taiwan, and Hong Kong (Washington, D.C.: Brookings Institution Press,
1997), pp. 81-110.
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79
than was available in crowded, high-rent Hong Kong and Taiwan, allowing
manufacturers to increase their capacity for orders and inventories.
Before the mid-1980s, the foreign investment policy goals of the Chinese
government, among other things, were to have all joint ventures export and open
international markets for China. By doing so, the government hoped to ease foreign
exchange shortages or at least prevent joint ventures from creating a drain on hard
currency. But the difficulties of technologically advanced ventures to export soon
dampened the government’s enthusiasm over this indiscriminate export push. After
the mid-1980s, the government began to seek accommodation with import-
substituting FDI that brought China advanced technology, while at the same time
extended the export production of labor-intensive, low-tech goods from special
economic zones (SEZs) to other coastal areas through the formulation of the Coastal
Development Strategy (CDS).9 By the time the 1986 Provisions were announced, it
was quite clear that China would target foreign investment on both fronts.
Obviously, there were some areas of compatibility between foreign goals for
foreign investment and the Chinese goals of absorbing foreign capital. Both had
interests in import substitution or export promotion. Both hoped that joint ventures
would be economically successful. That foreign firms were willing to go along with
9 Built upon the earlier experiences, the CDS was designed to extend the elements o f the SEZs to
other coastal areas. The CDS policy framework took shape in late 1986 and developed during 1987.
Its objective was to make the Chinese coast a site for the reception o f labor-intensive manufacturing.
The CDS differed from the earlier policies in several ways. First, labor-intensive, low-tech
manufacturing investment was accepted, provided that the completed projects could earn foreign
exchange. Second, export-oriented enterprises were allowed to import raw materials and other
components free o f duties or with lower tariffs for production toward export, thus ending the attempt
to base export potential on domestic inputs. This was the so-called “both ends outside” (liang tou
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80
China’s foreign investment schemes might at first glance suggest a convergence of
interests between the two sides. Yet the goals of foreign investors still conflicted in a
number ways with those of the Chinese government.
One of such conflicts was over the issue of the speed of parts localization in the
automobile industry. Foreign auto producers generally favored a gradual approach to
parts localization. Their major concern was the effect poor-quality local parts would
have on their reputation.1 0 Moreover, profits were greater when local content was
low, as this would give foreign auto producers the chance to export more parts to
China. Foreign auto producers’ support for gradual localization conflicted with the
desire of the Chinese government for speedy localization in order to cut CKD/SKD
imports and preserve foreign exchange.
Another conflict was over the issue of foreign exchange control by the Chinese
government. The requirements that joint ventures meet their own foreign exchange
needs for imports and net income conflicted with a foreign view that foreign
exchange concerns should not hamper production and profit repatriation. Since yuan
was not convertible, these requirements turned out to be a big problem for foreign
auto producers relying on sales in the Chinese domestic market. This problem,
however, was later resolved by allowing foreign auto producers that were given the
import substitute status to convert part of the proceeds from domestic sales into
chao wai) policy— having both supplies and markets outside the domestic economy. Third, following
the 1979 Joint Venture Law, wholly foreign-owned enterprises were legalized.
1 0 For example, The Cherokee kits that AMC shipped to China contained more parts than the kits sent
else in the world, because there were no decent parts available in China. The company even had to put
sandpaper into China’s Cherokee kits for a profit. There was sandpaper in China, but none could be
used at Beijing Jeep. See Jim Mann, Beijing Jeep (New York: Simon and Schuster, 1989), p. 230.
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81
foreign exchange. But foreign investors in the consumer electronics industry were
never allowed to do so.
A third conflict surrounded the issue of high tariffs on imported parts and
components necessary for export production. Before investing in assembly and
processing plants that would produce simple consumer electronics for exports, Hong
Kong and Taiwanese investors wanted to make sure that these tariffs were removed
or waived. While this was an issue mainly between the government and the outward-
oriented consumer electronics manufacturers, foreign auto producers happened to
have similar demands for their SKDs and CKDs before these imports were phased
out in the process of parts localization. Other than that, they would rather see tariffs
go higher rather than lower because of their inward orientation.
Implications o f Firm Entry Negotiations and Agreements
The first three foreign firms that pioneered automotive joint ventures in China
were AMC/Chrysler, VW (with the Shanghai Car Plant in 1984), and Peugeot (with
The Guangzhou Automotive Manufacturing Plant in 1985). While these firms
probably had been eyeing China for some time, ironically, it was the Chinese who
first approached them to ask whether they would be interested in a cooperative
automotive project. Following the initial contacts, in all three cases entry
negotiations lasted for years.
As in all subsequent auto negotiations, parts localization was a prerequisite for
these firms to gain access to the Chinese domestic market. Exports of a certain
percentage of vehicles produced in China were a mandate and were written into the
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82
agreements. Nevertheless, the export requirements were never taken seriously,
especially after China considered import-substituting FDI acceptable.1 1 Because of
the poor quality and high costs associated with parts localization, China’s exports of
cars and jeeps never took off (see Figure 11).
Figure 11
China’s Annual Exports of Passenger Cars and Jeeps, 1983-92
(Unit)
50000
4 5 000
4 0 000
35000
30000
2 5000
20000
15000
10000
5000
0
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
Source: Almanac o f C hina’ s Foreign Economic Relations and Trade, Beijing, various issues.
In addition to the concession of market access, the government also offered some
standardized incentives for these firms to increase local content, calculated by the
cost of the parts manufactured in China. Once a venture reached 40 percent local
1 1 Chinese officials at Beijing Jeep reportedly were not concerned about what would sell on the world
market or how to develop products to meet international standards. They were thinking only about the
domestic market. See Mann, Beijing Jeep, pp. 229-230.
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83
content, its imported parts were no longer considered CKDs and were taxed at a
lower tariff rate as SKDs. Further tariff reductions were available if the venture
exceeded 60 and 80 percent localization levels.1 2 In short, the outcomes of the
negotiations set these firms on the road to import substitution, giving them an
interest in high tariff barriers. Table 7 is a summary of China’s major passenger
car/jeep joint ventures as of 1995.
Table 7
China’s Passenger Car/Jeep Joint Ventures
Venture Year formed Foreign stake Product 1993 output
FAW VW 1991 40% Audi, Golf &
Jetta sedans
20,000
SAW
Citroen
1991 30% ZX model
sedan
Not operational
Shanghai
VW
1984 50% Santana sedan 100,000
Beijing Jeep 1983 31.35% initial,
42% as of 1994
Cherokee jeep 10,400
Guangzhou
Peugeot
1985 34% 504 light truck
& 505 sedan
20,000
Tianjin
Daihatsu
1986 Technology
licensing
Charade mini
car
47,850
Shanghai
GM
1995 50% Buick Century
midsize sedan
Not operational
Note: The list includes the so-called “Big Three, Little Three” o f Chinese automobile manufacturers,
designated by Chinese planners back in 1988. The Big Three were the First Automotive Works
(FAW), the Second Automotive Works (SAW ), and Shanghai VW. Beijing Jeep, Guangzhou Peugeot,
and Tianjing Daihatsu— a technology licensing joint venture between the Tianjin Minibus Works and
Japan’s Daihatsu Motor Company— made up the Little Three. In 1991, the FAW and SAW also
formed joint ventures with VW and France’s Citroen, respectively. Until GM outbid Ford in 1995 to
start a $1 billion joint venture that would produce the Buick Century in Shanghai, the passenger car
segment o f the m odem Chinese automotive industry finally took shape.
Sources: Zhongguo Qiche Gongye Nianjian (China Automotive Industry Yearbook), Beijing, various
issues; Graeme Maxton, The Automotive Sector o f the Pacific Rim and China (London: Economist
Intelligence Unit, 1994), p. 23.
1 2 Eric Harwit, China's Automotive Industry: Policies, Problems, and Prospects (Armonk, N.Y.: M.E.
Sharpe, 1995), p. 102.
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84
Consumer electronics negotiations operated in a manner quite different from auto
negotiations. Foreign investors had to deal with local governments rather than central
authorities. Moreover, the large number of potential investors with small projects
($1-5 million on average) meant that they had to compete with each other for
acceptance. Unlike what was happening to the automotive industry, the Chinese
government rarely granted the import substitute status to consumer electronics joint
ventures. Export promotion was a top priority for the industry.
The most frequently employed means of encouraging joint venture exports was
by formally negotiating contracts that set export targets, ranging from 20 to 100
percent (often over 50 percent) of the joint venture total production. To get the best
export commitments possible, it was not uncommon for the Chinese to contact
several foreign investors at a time and play them against each other. But more often,
the Chinese sought to identify foreign partners by calling for competitive bids for
specific projects. In the process, the Chinese required that proposals specify the level
of exports foreign investors were willing to meet.1 3
Foreign investors were also told that the new venture would be barred from
domestic sales unless it exported a certain quantity of products, and that it would
have to maintain a foreign exchange account sufficient to meet its foreign
obligations, such as payment for expatriate salaries, assembly or processing imports,
1 3 Margaret Pearson, Joint Venture in the P eo p le’ s Republic o f China: The Control o f Foreign D irect
Investment under Socialism (Princeton: Princeton University Press, 1991), pp. 127-128.
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85
distribution of profits, royalties, and interest payment on loans.1 4 These two
measures were mutually reinforcing. Because domestic sales saddled joint ventures
with the nonconvertible Chinese currency, foreign investors could not expect to sell
more in China than they needed. Unless their products were deemed to be import
substitutes, thus making them eligible to convert yuan into dollars (a rare case in
consumer electronics), they had no choice but to export to meet their foreign
exchange needs.
In order to encourage foreign investors to export more, the State Council granted
a number of incentives for export production. Joint ventures designated as export-
oriented enterprises1 5 by local governments were eligible for special treatment in a
variety of areas. Costs, such as land use fees, and certain subsidies to be paid to labor
were lowed,1 6 as were both domestic taxes and taxes on profits remitted abroad.
Priority was given in obtaining water, electricity, and other infrastructural services in
short supply, as well as receiving short-term bank loans.1 7 Most importantly, export-
oriented enterprises were either exempt from tariffs or subject to a lower tariff rate
for their inputs. In 1991, tariff exemptions for export assembly and processing
activities with imported inputs accounted for 78 percent of China’s total concessional
1 4 Jerome Alan Cohen, “Equity Joint Ventures: 20 Potential Pitfalls that Every Company Should
Know about,” The China Business Review 9, no. 6, November-December 1982, p. 27.
1 5 Export-oriented enterprises were designated based on their ability to export at least 50 percent o f
their output and maintain a foreign exchange balance. See John Frisbie, “Balancing Foreign
Exchange,” The China Business Review 15, no. 3, March-April 1988, p. 24.
1 6 These subsidies amount to cash benefits and are paid by foreign investors.
1 7 Moser, ed., Foreign Trade, Investment, and the Law in the P eo p le’ s Republic o f China, pp. ISO-
132.
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86
1 8
imports. The treatment Taiwanese investors got was even better. A 1988 State
Council decree urged the governments of all levels to give Taiwanese investment
projects faster approval and better support services.1 9 All these concessions were
meant to attract foreign firms capable of exports and facilitate firm entry
negotiations. Obviously, as part of the export promotion scheme, consumer
electronics joint ventures that hoped to take advantage of cheap labor and land were
oriented toward international markets from day one.
How would the joint venture agreements affect future sector-specific trade
policy?
First, the agreements exposed the Chinese government to foreign pressure. To be
sure, the inward or outward orientation of the auto and consumer electronics ventures
was largely the work of the Chinese government. If there had been no excessive
restrictions and regulations, the foreign investors would not have done what they
were doing. The foreign auto producers would have opted for imports of parts and
components instead of domestic sourcing. The consumer electronics investors would
have sold their Chinese-made products in China rather than on international markets.
While the Chinese government succeeded in enlisting foreign technology, expertise,
and knowledge of international markets to help simultaneously promote import
substitution and export production, the agreements that established the joint ventures
could backfire. If the market conditions turned against the interests of the foreign
1 8 Christian Bach, Will Martin, and Jennifer Stevens, “China and the WTO: Tariff Offers,
Exemptions, and Welfare Implications,” Weltwirtschaftliches Archiv 132, no. 3, 1996, pp. 419-420.
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87
investors, the government would be the first to blame. As the backer of the
agreements, the government would be contractually obliged to react to foreign
demands.
Second, the progress of parts localization in the automotive industry only
increased the demand for protection. In China, localization was a major cause of
poor export performance in the automotive industry. High costs such as local fees,
low labor productivity, and poor quality of local materials meant that Chinese-made
cars and jeeps, especially in the early years, were uncompetitive in either price or
quality on international markets. If they could not compete on international markets,
nor could they compete at home if imports were allowed. Therefore, high level of
localization was closely correlated to high demand for protection, which would make
any attempt at tariff reduction, for whatever reasons, more difficult, if not
impossible.
Third, tariff exemptions for export production in the consumer electronics
industry rendered some nominal tariffs useless, making their removal all natural and
painless. The success of China’s export drive relied on exporters’ access to
concessional imports. The less exporters had to pay for their inputs, the more
competitive their final products on international markets. As China exported more,
the share of concessional imports in total imports rose accordingly, from a third in
1988 to a half in 1991. This trend was also reflected in China’s duty collection rate.
1 9 Sung Yun-Wing, “Non-Institutional Economic Integration via Cultural Affinity: The Case o f
Mainland China, Taiwan, and Hong Kong,” Occasional Paper, no. 13, Hong Kong Institute o f Asia-
Pacific Studies, Chinese University o f Hong Kong, July 1992, p. 8.
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China’s average nominal tariff rate in 1992 was above 40 percent, but its duty
collection rate at the same time was only between 5 and 6 percent of the c.i.f. value
-yrv
of imports." Unlike the practice of other LDCs, relief from import duties was
allowed at the point of import rather than through refunds of duties paid, as in duty
drawback systems. So any tariff cuts in the export areas would not hurt anybody but
institutionalize an existing practice.
2. The Inward Orientation of FDI and Trade Policy Closure in the
Automotive Industry
After a brief period of import liberalization in 1984-85,2 1 the Chinese
government raised tariff protection against automobile imports at a pace that
paralleled the progress of parts localization, but at the same time gradually reduced
tariffs on consumer electronics imports (see Figures 9 and 10 above). Why did these
trade policy changes occur? What accounted for the variation in these changes?
From a state-centric perspective, the key to understanding China’s economic
reform is the range of policy instruments employed by the state and a changing
central-local relation. It is argued that the weakening of central institutions and the
rise to importance of provinces in Chinese politics changed the balance of power in
20 World Bank, China: Foreign Trade Reform (Washington, D.C.: World Bank, 1994), pp. 57-63.
2 1 During this period, trade reform joined industrial reform at the top o f a reformist agenda. Trade
reform included the relaxation o f import restrictions on automobiles to facilitate tourist trade. But that
liberalization led to a rapid increase in imports and a drawdown o f China’s foreign exchange reserves.
By m id-1985, the Chinese government began backpedaling, reimposing restrictions on the trading
process. See Naughton, “Economic Policy Reform in the PRC and Taiwan,” p. 95.
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89
00
favor of reformist leaders and therefore facilitated economic reform. During the
Cultural Revolution, the normal operations of the central party and government
bodies were severely disrupted. As a result, the central party and state bureaucracies
became a less formidable threat to economic reform as they would have been.
Adding to that was a reformist effort to empower provinces through administrative
decentralization. As provinces gained more power, reformist leaders were able to use
them as a counterweight to the more conservative center.
Applying this argument to the cases (though somewhat a stretch), one would
attribute the variation in trade policy choice to the respective control of the
automotive and consumer electronics industries by the conservative center and
reformist localities. There is some truth in this argument. Local governments did
control the approval of consumer electronics ventures, and they were generally
considered foreign-business friendly. But it is still hard to make a case that the
conservative center was in control of the automotive industry. In fact, the person who
acted as a patron of the automotive industry was then Premier Zhao Ziyang 2 3 During
O A
the 1986 Beijmg Jeep foreign exchange crisis, Zhao sent Zhu Rongji to help
resolve the problems. After the crisis, Zhu was reportedly “virtually running the
2 2 It should be noted that Susan Shirk’s analysis is more comprehensive and not limited to the central-
local relations. See Susan Shirk, The Political Logic o f Economic Reform in China (Berkeley:
University o f California Press, 1993), Chapter 1.
2 3 Harwit, C hina’ s Autom otive Industry, p. 83.
2 4 The crisis broke out when the Chinese side, short o f foreign exchange, tried to pay for the imported
CKD/SKD parts using the non-convertible yuan. But AMC considered the proposal unacceptable.
After a brief confrontation, the central government came to AM C’s aid and helped resolve the crisis.
According to an agreement, the Chinese side would be responsible for raising foreign exchange to pay
for the imported parts, whereas AMC pledged to speed up parts localization.
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90
Chinese automotive industry.” One government bureaucracy that can be labeled as
part of the conservative center is the China National Automotive Industrial
Corporation (CNAIC), which oversaw the automotive industry before the mid-1980s.
But the CNAIC was later forced to surrender its power to the State Council headed
by the premier in the decentralization movement. In 1987, the once ministry-level
agency became merely an association of automotive manufacturers and no longer
had the authority to make policy decisions. The question of who controlled the
automotive industry aside, the institutional approach still stops short of identifying
the sources of trade policy change.
There are still scholars who see China’s economic reform through the lens of the
power struggle among top Chinese leaders. Thus, many of the early reform
initiatives—to decollectivize agriculture, expand foreign trade and investment,
encourage private and collective businesses, decentralize fiscal revenues to local
governments, and allow state-owned enterprises to keep a share of their own profit—
are believed to be power struggle-related with the aim to mobilize support from
below.2 6 The power struggle can be complicated. It includes the struggle between
party factions (rightists or reformists versus leftists, hard-liners or conservatives),
and the struggle for leadership succession, such as the ones between Deng Xiaoping
and Hua Guofeng in 1978-80, between Hu Yaobang and Zhao Ziyang in 1980-87,
and between Zhao Ziyang and Li Peng in 1987-89. While the power struggle is a
2 3 Mann, Beijing Jeep, p. 273.
26 Peter Lichtenstein, China at the Brink: The Political Economy o f Reform and Retrenchment in the
Post-M ao Era (New York: Praeger, 1991), Chapters 6-7; Harry Harding, C hina’ s Second Revolution:
Reform after M ao (Washington, D.C.: Brookings Institution, 1987), Chapters 1-4.
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distinctive feature of Chinese politics, it by itself does not tell us why some policies
are preferred over others. This brings us back to where we were: What accounted for
the variation in trade policy change if it is not the state or power struggle?
I will show below that the inward or outward orientation of foreign investors
mattered. In the automotive industry, the inward orientation of foreign auto
producers was an open secret. This orientation was further strengthened by the low
quality and high costs of locally produced vehicles due to parts localization. Since
their products were unable to compete with foreign imports, they had an interest in
keeping the domestic market closed. So when China’s campaign to joint the
GATT/WTO called for tariff reduction across board, their demand for protection
sustained high tariffs in the automotive industry.
China’s foreign trade regime underwent some substantive changes after the
country opened its door to the outside world. Before 1979, foreign trade planning
was a primary mechanism used by the Chinese government to control imports. The
planning mechanism entailed not only formulating import and export plans, but also
defining the role of China’s foreign trade corporations (FTCs). The objective of
planning was to identify the key raw materials and commodities that were in short
supply and therefore had to be imported, and then ensure that sufficient foreign
exchange was generated through selected exports. For over 30 years, all trade was
monopolized by a dozen of state-owned FTCs, which had the responsibility of
executing import and export plans. Beginning in 1979, the government, in an effort
to decentralize foreign trade authority, encouraged the establishment of autonomous
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92
trading companies. The number of such entities rose to more than 5,000 toward the
97
end of the 1980s. In keeping with the change in the way trade was handled, the
planning mechanism was gradually replaced by import licensing and tariffs.
At the time of the 1984 automotive import binge, import licensing prevailed.
Many government agencies and state-owned enterprises in coastal areas were able to
import cars and trucks because they were exempt from the licensing restrictions. In
1985, the General Administration of Customs of the PRC (or China Customs in
short) promulgated the country’s most comprehensive tariff regulations since 1951
and assigned tariffs a more important role in regulating imports. As part of the 1985
regulations, the new tariff schedule set the average tariff rate for passenger cars and
jeeps in the range of 105 (trade-weighted) to 150 percent (simple),2 8 which
effectively restored the earlier protection through import licensing. Despite the
periodic use of import licenses, the tariff rate went up steadily after 1985 and reached
its peak of 180 to 220 percent in 1993 2 9 Systematic data on annual tariff rates are not
available. But the decline in imports of passenger cars and jeeps, both in absolute
terms (see Figure 12) and relative to output (see Figure 13), suggests an upward
movement. In early 1994, the government lowered the tariff rate to the range of 110
2 7 Nicholas Lardy, Foreign Trade and Economic Reform in China, 1978-1990 (Cambridge:
Cambridge University Press, 1992), p. 39.
2 8 Correspondence with the Shanghai Customs o f the People’s Republic o f China, May 1996. This
rate was among the highest o f all at the time. Other imports that were charged at higher rates included
such luxury items as liquor, cosmetics, tobacco products, and edible delicacies. See Moser, ed.,
Foreign Trade, Investment, and the Law in the P eo p le’ s Republic o f China, pp. 26-27.
29 General Administration o f Customs o f the People’s Republic o f China, Zhonghau Renmin
Gongheguo Jinchukou Guanshui Tiaoli (Import and Export Tariff Regulations o f the People’s
Republic o f China), Beijing: Law Press, 1995, p. 468.
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93
0 A
to 150 percent. This move, however, was not intended to open the domestic market.
It was more of an attempt to trim excessive tariffs due to the yuan devaluation and
discourage car smuggling. Two years later in 1996, the tariff rate again crept up to
the range of 120 to 170 percent, which was higher than that in 1985.
The increase in automobile tariffs paralleled the progress of the localization
process, which was a primary reason for the low quality and high costs of
domestically produced vehicles.
Figure 12
China’s Imports of Passenger Cars and Jeeps, 1983-90
(Unit)
140000 -
120000 - -
100000
80000
60000 -
40000
20000
1983 1984 1985 1986 1988 1989 1987 1990
Source: Xiaohua Yang, Globalization o f the Autom obile Industry: The United States, Japan, and the
P eo p le’ s Republic o f China (Westport, Conn.: Praeger, 1995), pp. 144-145.
3 0 T aK u n gP ao (Hong Kong), December 15, 1993, p. 5.
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94
Figure 13
China’s Imports of Passenger Cars and Jeeps as a Percent of Total Output,
1985-90
500
450
400
350
300
250
200
150
100
1985 1986 1989 1990 1987 1988
Source: Xiaohua Yang, Globalization o f the Automobile Industry: The United States, Japan, and the
P eople’ s Republic o f China (Westport, Conn.: Praeger, 1995), pp. 144-145.
All automobile joint ventures started their operations with assembly of imported
CKD/SKD kits. But they were required by their contracts to localize the vehicles
they produced in exchange for entry into the domestic market. Since each venture
had its own contract, the progress of localization was uneven among major auto
producers (see Figure 14). As we see, despite a slow start at Guangzhou Peugeot,
localization generally proceeded very fast, with Shanghai VW taking the lead to
reach 80 percent local content level for its Santana in only seven years. This speed
was incredible if compared with similar experience of other countries around the
world. Honda, for example, started car assembly in the United States in 1982 with 25
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95
percent ready-to-use American parts. But it was not until ten years later that the
company was near its goal of using 75 percent local American parts.
Figure 14
Localization of the Shanghai VW Santana, Beijing Jeep Cherokee, and
Guangzhou Peugeot Model 505 Sedan, 1985-93
(Percent localized)
90
80
70
60
50
40
30
20
10
0
1985 1986 1988 1989 1990 1991 1992 1993
-e— Shanghai VW — Beijing Jeep —g — Guangzhou Peugeot
Source: Eric Harwit, C hina’ s Automotive Industry: Policies, Problems, and Prospects (Armonk, N.Y.:
M.E. Sharpe, 1995), pp. 78, 100, & 121.
The progress of localization was made at the expense of the quality of locally
produced parts and components. Many Chinese parts suppliers were simply
unfamiliar with high foreign standards and refuse to invest funds to raise quality
unless they were given large, economy-of-scale orders. In the early years of
localization, Chinese parts were scarce. If they were available, the quality was poor
and the prices too high. The Americans at Beijing Jeep found that on average
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96
Chinese-made auto parts cost approximately twice as much as those produced in the
United States.3 1
Adding to these problems was the high price tag locally produced vehicles had to
carry before they reached the customer. All automobile joint ventures in China were
required to contribute to a fund for raising capital for localization costs. Besides, the
vehicles they produced were subject to localization taxes the Chinese government
imposed and used to subsidize local parts suppliers. Localization taxes varied across
regions. In Shanghai, they were as high as 50 percent of the sale price.3 2 Although
these taxes, somewhat like sales taxes, were not imposed at the manufacturers’ cost,
they nevertheless artificially inflated the prices of domestically produced vehicles.
As a result, automobile joint ventures found themselves in an unfavorable position if
they were to compete with the Japanese. The higher the level of localization, the
more they were dependent on protection. In fact, the demand for protection by
automobile ventures not only sustained the tariff rate established in 1985 but also
propelled it to a new high.
The high tariff rate was under fire in the early 1990s when China stepped up its
preparation for entry into the GATT.3 3 Participation in the GATT would require a
more open market for imported goods. Given the choice between the joint venture
3 1 Mann, Beijing Jeep, p. 231.
3 2 Todd Thurwachter, “Development o f the Chinese Auto Industry: Foreign Participation and
Opportunities,” report prepared for U.S. and Foreign Commercial Service, 1989, p. 16.
China was a founding member o f the GATT, but withdrew in 1949 after the communist party came
to power. In 1986 the Chinese government first applied for admission (or readmission) to GATT
membership, and subsequently the Working Party on China’s Status as a Contracting Party was
established in March 1987. China also participated in the Uruguay Round o f multilateral trade
negotiations. Although the negotiation procedure was suspended for about three years after the
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97
products, now loaded with inferior local parts and carrying a price tag bloated with
various taxes, and the less expensive imports from Japan, many Chinese customers
would naturally opt for Toyotas, Hondas, and Nissans. Anticipating the influx of
Japanese car imports if trade liberalization actually occurred, the managing director
of Shanghai VW, the country’s largest passenger car manufacturer, expressed his
concern, “At the moment, we are not competitive. If they [the government] were to
open the market, we could not compete.”3 4 FAW VW, the country’s No.l joint
venture, was more tactical. It declared its willingness to compete head-on with
Japanese auto producers, but urged the government to give the venture more time
- i f f
before it was ready. Both VW and Chrysler complained about the high localization
"3 ft
taxes and surcharges levied on vehicle buyers. They argued that the pricing scheme
would demolish any possibility of competing with imported automobiles in the
T 7
domestic market. Elsewhere in the automotive industry, there was a sense of
urgency as GATT negotiations came near.
The subsequent developments, however, dispelled the fear of foreign investors,
as the Chinese automobile market remained highly protected. Now the question is
whether the government did all these on its own or in response to foreign complaints.
There are reasons to believe foreign complaints had an effect. By signing joint
crackdown in Tiananmen Square, the negotiations were resumed in 1992 and became very intense in
the course o f 1993-94, since China wanted to become a founding member o f the WTO.
3 4 Financial World, December 8, 1992, p. 50.
3 5 South China M orning P ost (Hong Kong), April 1, 1992, p. 3.
3 6 Levying o f surcharges on vehicle buyers started in 1985, in line with a decision o f the State
Council. The income was used in various road construction projects, including high-grade highways,
large bridges, stations, and other facilities for road transport.
3 7 China D aily (Beijing), June 20, 1992, p. 2.
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98
venture agreements with foreign investors and engaging them in import substitution
or export promotion, the government became contractually tied up to foreign
interests and was obliged to respond to foreign demands. Moreover, the government
knew the ventures were suffering from parts localization, for which it was
responsible. If the government ever wanted to push ahead with localization, it had to
make sure that the interests of the ventures were taken care of. From the many
statements made by top Chinese officials (see quotes below) at the time, it is quite
clear that the intended audience were foreign investors. Anyway, the Chinese
government did not want to see the incidences leading to the 1986 Beijing Jeep crisis
happen again.
In early 1993, the State Council instructed provincial governments to get
approval from the central government before importing cars and light trucks. That
meant all import licenses issued by provincial governments had to be cancelled
in
unless they were endorsed by the central government. While the instructions were
issued in the aftermath of an upsurge in car smuggling by provincial officials, they
served the interests of the ventures, which had experienced sluggish domestic sales
due to the flood of smuggled cars. In December 1993, Lu Yansun, a Vice Minister of
Machine-Building Industry, disclosed in Hong Kong the government plan to cut
tariffs on imported passenger cars and jeeps, but he was quick to point out that
3 8 Yonhap News Agency (Seoul), April 27, 1993.
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99
“China would consider how to protect the young industries such as the car-making
industry.”3 9
Although the government deliberately leaked the news beforehand, the 1994
tariff cut still surprised many China observers. On the surface, the tariff cut was a
step toward opening the domestic market in the context of GATT negotiations. But
in fact, the decision was largely prompted by increasing activities of car smuggling
along the southeast coast. In 1993, cars smuggled into China reached 100,000,
compared to 90,000 in 1992. That was about the output of Santana at Shanghai VW
in 1993 and 7.7 percent of the industry’s total output of 1.3 million vehicles the same
year. As a result of the inflow of smuggled cars, sales of domestically produced
vehicles declined and some factories had to reduce production in face of rising
stockpiles.4 0 By revoking import licenses and lowering tariffs, the government hoped
to reduce the incentive to smuggle cars into China and keep things under control.
Moreover, the yuan devaluation over the years increased the prices of imports on
the domestic market, making the tariff cut a less painful choice. As Figure 15
indicates, yuan was effectively devalued by almost 25 percent between the first
quarter of 1987 and the first quarter of 1993. Taking into account the effect of the
exchange rate, a tariff rate of 150 percent in 1994 was slightly lower than a rate of
220 percent in 1987, but still higher than the initial rate of 150 percent in 1985.
Obviously, the tariff cut was not as deep as it seemed to be. That is why the
government was pretty confident that the tariff cut would not affect total (legal and
39 Ta Kung Pao (Hong Kong), December 15, 1993, p. 5.
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100
illegal) imports to a great extent. One government official even predicted, “Fewer
foreign-built cars and vans will enter China’s mainland this year [1994] than in
1993.”4 1
Figure 15
China’s Real Effective Exchange Rates, 1987-93
(1980=10)
5.5
4.5
2.5
& & & & N # ' # ^ f & & N # > ° ' ^ o f ' ^
Source: World Bank, China: Foreign Trade Reform (Washington, DC: World Bank, 1994), p. 299.
In August 1994, the government announced a new policy for the automotive
industry, which set the goal of producing 90 percent of China’s total vehicle output
by 2000. Two major points contained in the new policy were the development of
China’s automotive industry into a pillar industry of the national economy by 2010,
and the restriction of imports and encouragement of exports until domestic products
40 China D aily Business Weekly (Beijing), January 2-8, 1994, p. 1.
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101
were internationally competitive.4 2 To avoid the confusion surrounding the 1994
tariff cut, Chinese Vice Premier Li Lanqing later reiterated the government’s long
standing position that opening the Chinese market for automotive imports was
“unacceptable.”4 3
In 1996, when tariff rates in some other manufacturing sectors were drifting
lower amid GATT/WTO talks, the government quietly adjusted the automobile tariff
rate a little higher. While this decision disappointed many WTO members,4 4 it was
cheered by domestic automobile manufacturers. Don St. Pierre, former president of
Beijing Jeep who made his name for his outspokenness, even came out to defend the
move. “Every country in the world has been allowed to protect its developing
industry and China should be no exception,” he said. “I hope [people] will
understand this and go along with this, but sometimes some blockheads don’t think
straight.”4 5
By the late 1990s, China’s average tariff rate for passenger cars and jeeps was
still among the highest in the world. When contemplating China’s proposed entry
into the GATT, a Chinese author argued, “To what extent a country should reduce its
tariffs is necessarily correlated to its ability to export its products.”4 6 While this view
may not sound liberal, he was telling the truth of what would happen in China.
4 1 China D aily Business Weekly (Beijing), January 2-8, 1994, p. 1.
42 Graeme Maxton, The Automotive Sector o f the Pacific Rim and China (London: Economist
Intelligence Unit, 1994), pp. 17-18.
4 3 Ta Kung Pao (Hong Kong), October 11, 1994, p. 2.
4 4 One analyst at a Western embassy in Beijing commented, “I think many members o f the WTO will
not look kindly on this at all.” See South China M orning P ost (Hong Kong), February 7, 1996, p. 3.
45 South China M orning Post (Hong Kong), February 7, 1996, p. 3.
46 Guoji Shangbao (International Business News, Beijing), March 27, 1993, p. 3.
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102
Unless the country is able to reach a high level of efficiency in car manufacturing
and to equip domestically produced vehicles with parts of world standards necessary
for export capability, the tariff rate will remain high for some time.
3. The Outward Orientation of FDI and Trade Policy Opening in the
Consumer Electronics Industry
In contrast to the sustained high tariff rate of the automotive industry, the average
tariff rate for consumer electronics was declining over the years. One variable that
stands out to account for the variation is the outward orientation of foreign investors
in the consumer electronics industry.4 7 As exporters, consumer electronics foreign
investors wanted to see their imported inputs liberalized and domestic tariff barriers
lowered if they ever became a source of foreign retaliation. That occurred in the first
half of the 1990s, when the heated issue of whether the United States should extend
the most favored nation (MFN) status to China tipped the balance of power in favor
of foreign investors.
Of the foreign investors undertaking export production in China, Hong Kong—
the world’s leading exporters of telephone sets, tape recorders, radios, calculators,
electronic watches, and electronic game—excels in producing fashionable consumer
electronics characterized by rapid changes in design. The electronics industry in
Hong Kong is the second largest manufacturing industry after garments. Since Hong
Kong’s garments exports were restricted by quota after the Lancashire Pact of 1958,
47 Other reasons for the consumer electronics opening were the bilateral trade deficit with the United
States and the campaign to joint the GATT/WTO. But an interest-driven argument can account for
their importance by highlighting the forces that directly brought about the change.
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pundits predicted that electronics would surpass garments to become No. 1 industry
in Hong Kong. That, however, did not happen because Hong Kong’s electronics
industry started moving northward to China in the early 1980s. Most of Hong
Kong’s investment in China involved export-processing activities that relied on out
sourcing of raw materials and components. The goods processed were then exported
to Hong Kong for re-export to third countries. In 1995, Hong Kong’s re-exports of
goods made in China under export-processing contracts were estimated at nearly
$63.7 billion, which was more than twice as much as the value of Hong Kong’s
48
domestic exports. Due to geographical proximity and kinship ties, Guangdong
received more than 80 percent of Hong Kong’s investment in China from 1979 to
1995.4 9
A majority of Taiwanese originated from Fujian. That is why Taiwan accounted
for the bulk of foreign investment in that province. Nevertheless, the prime
destination of Taiwanese investment in China was still Guangdong. While Hong
Kong has established a strong position in fashionable consumer electronics, Taiwan
is best known for its PC-related industries. Its products range from electronic
components and parts (logic ICs, memory ICs, chip sets, smaller liquid crystal
displays [LCDs], cathode ray tubes [CRTs], and motherboards) to PC peripherals
(keyboards, monitors, image scanners, PC mice, and power supply units). With the
increase of Taiwanese investment in China, there emerged a division of labor across
48 Yun-wing Sung, “Hong Kong and the Economic Integration o f the China Circle,” in Naughton, ed.,
The China Circle, p. 42.
49 Yun-wing Sung, “Hong Kong and the Economic Integration o f the China Circle,” p. 47.
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the Taiwan Strait. Taiwan retained the high value-added IC chips, but relocated the
production of labor-intensive, low-end PC-related items to China. Like their Hong
Kong counterparts, Taiwanese businesses were based on export processing,
involving imports of raw materials and components, and their processing or
assembly into exportables. Because of Taiwan’s ban on direct trade with the
mainland, Hong Kong served as an entrepot for China’s imports from Taiwan.
Almost all major Taiwanese PC makers—Acer, First International Computer, Copam
Electronics, and Mitac International—participated in the offshore production in
China, starting from the most labor-intensive keyboards and PC mice to switch
power supply units, and then to motherboards and monitors.
A look at the changing composition of the U.S. trade deficit with China, Hong
Kong, and Taiwan confirms the relocation of export production to the mainland. The
United States began to run a large trade deficit with all three economies in 1987, but
at that time the deficit was predominantly with Taiwan. After 1987, the total U.S.
deficit with the region continued to grow. More striking than the growth in the
overall deficit was the change in its distribution. As the U.S. deficit with Taiwan was
narrowing down, China overtook Taiwan to become responsible for most of the U.S.
deficit with the region throughout the 1990s. In a dramatic turnaround from the 1987
situation, the United States even ran a modest surplus with Hong Kong since 1994.
Although China was blamed for the U.S. deficit, Chinese exports into the United
States during this period came exactly from the outward-oriented foreign investors
who operated from Taiwan and Hong Kong before the 1990s.
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105
Take Guangdong to illustrate the outward orientation of foreign investors in
consumer electronics. The province received more foreign investment in electronics
than anywhere else in China. Of the four earliest SEZs—Shenzhen, Shantou, Zhuhai,
and Xiamen, the first three were located in Guangdong. As early as the mid-1980s,
the electronics industry became Shenzhen SEZ’s largest industry and constituted
48.7 percent of the total industrial output.5 0 Between 1985 and 1991, FDI stock in
Guangdong increased 254 percent, whereas exports generated by FDI soared 2,310
percent.5 1
On a national basis, this export propensity was also phenomenal. Tables 8 and 9
list electronics exports of foreign-invested enterprises (FIE) as a percent of total
output, sales, and sectoral exports. Unfortunately, no data are available for years
prior to 1993, though a trend of increasing exports over the years is perceivable.
Moreover, the data are for all electronics exports and do not permit a breakdown by
the sub-sectors of consumer electronics, industrial electronics, and components. But
judging by U.S. import statistics, Chinese electronics exports consisted
overwhelmingly of consumer electronics plus in recent years significant quantities of
PC peripherals and subassemblies. As of 1993, the share of FIE exports in output
and sales were already over 40 percent, and rose to over 50 percent in 1996 (see
Table 8). At the same time, FIE exports as a percent of total sectoral exports
increased from over 50 percent in 1993 to more than 70 percent in 1996 (see Table
5 0 Lai Si Tsui-Auch, “Industrial Restructuring and Regional Division o f Labor: A Study o f the
Electronics Industry o f Hong Kong and Shenzhen Economic Zone” (Ph.D. diss., Michigan State
University, 1995), p. 112.
5 1 Guangdong Tongji Nianjian (Guangdong Statistical Yearbook), Guangdong, 1992, p. 355.
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106
9). Unlike the case with the automotive industry, FDI in the consumer electronics
industry was indisputably outward-oriented.
Table 8
China’s Electronics FIE Exports as a Percent of Total Output and Sales, 1993-
96
(1990 constant price, except 1995 figures that are calculated using current
price; millions of yuan)
Item Exports Output Sales % o f
output
% o f
sales
1993
Equity joint ventures 3,715 16,935 16,731 21.94% 22.20%
Cooperative joint ventures* 147 354 335 41.69% 43.98%
Foreign-owned enterprises 29 29 29 99.76% 100%
Overseas Chinese equity 2,637 11,590 11,276 22.75% 23.39%
Overseas Chinese cooperative 34 150 134 22.65% 25.25%
Overseas Chinese foreign-owned 599 1,297 1,205 46.19% 49.71%
TOTAL 7,161 30,354 29.710 42.50% 44.09%
1994
Equity joint ventures 7,280 28,125 26,767 25.88% 27.20%
Cooperative joint ventures 179 501 454 35.69% 39.37%
Foreign-owned enterprises 119 165 159 72.25% 74.60%
Overseas Chinese equity 4,549 13,827 13,856 32.90% 32.83%
Overseas Chinese cooperative 59 459 427 12.82% 13.79%
Overseas Chinese foreign-owned 2,470 2,711 2,595 91.12% 95.18%
TOTAL 14,656 45,787 44,258 45.11% 47.16%
1995
Equity joint ventures n.a. 38,300 33,509
Cooperative joint ventures n.a. 264 249
Foreign-owned enterprises n.a. 8,925 8,026
Overseas Chinese equity n.a. 30,118 28,742
Overseas Chinese cooperative n.a. 945 918
Overseas Chinese foreign-owned n.a. 4,702 3,920
TOTAL 83,255 75,364
1996
Equity joint ventures 19,477 48,207 45,969 40.40% 42.37%
Cooperative joint ventures 146 322 313 45.33% 46.67%
5 2 Barry Naughton, “The Emergence o f the China Circle,” in Naughton, ed., The China Circle, p. 25.
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107
Foreign-owned enterprises 10,218 22,748 22,482 44.92% 45 45%
Overseas Chinese equity 11,889 32,538 31,658 36.54% 37 55%
Overseas Chinese cooperative 611 986 988 61.95% 61 80%
Overseas Chinese foreign-owned 4,459 5,039 4,841 88.48% 92 10%
TOT$L
46,799 109,840 106,250 52.94% 54 33%
* Cooperative joint ventures sometimes are also referred to as contractual joint ventures. They differ
from equity joint ventures in that no company or other legal entity separate and distinct from the
contracting parties is established. In the absence o f a separate corporate body, each party is
responsible for making its own contributions to the venture, paying its own taxes on profits distributed
to it and bearing its own liability for risks and losses. While differing from equity joint ventures,
cooperative joint ventures have been established for many o f the same purposes, including the
construction and management o f hotels, the exploration o f offshore oil, and the production o f
manufactured goods. As o f November 1985, more than 3,000 cooperative joint ventures had been
approved by the Chinese government with a total pledged investment o f over $5.5 billion. See
Michael Moser, ed., Foreign Trade, Investment, and the Law in the P eo p le’ s Republic o f China
(Oxford: Oxford University Press, 1987), pp. 95-100.
n.a. = Not available.
Source: Zhongguo D ianzi Gongye Nianjian (China Electronics Industry Yearbook), Beijing, 1994, p.
11-10; 1995, p. 18; 1996, p. 14; 1997, pp. 12-13.
Table 9
China’s Electronics FIE Exports as a Percent of Total Sectoral Exports, 1993-96
(Millions of U.S. dollars)
Item 1993 1994 1995 1996
Equity joint ventures 2,248 3,474 4,877 7,088
Cooperative joint ventures 605 1,040 1,255 1,404
Wholly foreign-owned enterprises 1,464 2,576 4,359 6,899
Total FIE exports 4,317 7,090 10,491 15,391
State-owned and other enterprises 3,758 5,272 5,861 5,814
Total sectoral exports 8,075 12,362 16,352 21,205
% of FIE exports in sectoral total 53.46% 57.35% 64.16% 72.58%
Source: Zhongguo D ianzi Gongye Nianjian (China Electronics Industry Yearbook), Beijing, 1994, p.
VI-2; 1996, p. 235; 1997, p. 234.
Because of the nature of export processing, electronics FIEs preferred trade
liberalization of imported inputs. Since they were oriented toward international
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108
markets, they also did not need any domestic protection for their processed products.
To the contrary, they would rather have the electronics tariffs lowered in exchange
for greater access to foreign markets.
Although the raw materials and components imported by export-processing FIEs
might be exempted from import duties, the procedure of applying for the tariff
benefits was very complicated and time-consuming. Once an export-processing
contract was signed by a FIE, the applicant should file appropriate documents with
the local office of the China Customs within five days and fill out a schedule of the
goods to be imported and the finished products to be exported. The Chinese Customs
would then issue a registration booklet reflecting that information. This registration
booklet, together with the normal customs declaration forms and other
documentation, such as invoices or bills of landing, would be used as the basis for
clearing the items without duties on imports. After full performance of the contract,
the booklet should be turned in for cancellation. All finished products, plus left-over
raw materials and components, should in principle be exported. If any portion of the
finished products made for exports was for any reason sold on the domestic market,
it would be subject retrospectively to import duties on the raw materials and
components originally exempted.5 3 Removal of the tariffs on imported inputs would
obviously eliminate those bureaucratic and procedural headaches as well as
uncertainties involved in further policy change. Moreover, as the U.S. trade deficit
with China grew larger, electronics FIEs that relied on the U.S. market got
5j Moser, ed., Foreign Trade, Investment, and the Law in the P eo p le’ s Republic o f China, pp. 28-29.
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109
increasingly nervous about any possible U.S. trade sanction. Their fear became
reality in the early 1990s when the United States threatened to revoke China’s MFN
status.
After having been suspended in 1951, MFN status was restored to China in 1980
on condition that the country be in compliance with the Jackson-Vanik freedom-of-
emigration amendment, and must be renewed annually. The MFN renewal went
smoothly until the crackdown in Tiananmen Square on June 4, 1989. After the
crackdown, President Bush quickly imposed a number of economic sanctions against
China, including restrictions on arms and munitions sales, military exchanges,
transfer of dual-use technologies, and U.S. government financing for projects in
China. Nevertheless, the President decided to continue China’s MFN status. Each
year from 1990 through 1992, therefore, Congress vented its frustration at Beijing by
voting to disapprove the President’s renewal of China’s MFN status, forcing
President Bush in turn to veto the resolution of disapproval. During the 1992
presidential campaign, then Governor Bill Clinton lambasted President Bush for
“coddling tyrants” and vowed to force the “butchers of Beijing” to improve their
observance of human rights by attaching human rights conditions to the MFN
renewal. With Clinton as the President, China’s fear of losing the MFN status
increased.
The crackdown in Tiananmen Square triggered the MFN debate. But the
dramatic increase in U.S. trade deficit with China since the 1990s complicated the
issue. As a matter of fact, many advocates of denying MFN status to China based
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their opposition on China’s violation of human rights, large and growing U.S. trade
deficit with China, and China’s uncooperative attitude in weapons and nuclear
nonproliferation.5 4 Obviously, in order for China to have its MFN status renewed, it
had to do something more than the improvement of its human rights conditions.
With the MFN status, China could access the U.S. market at tariff rates that
averaged 6 percent. The termination of MFN treatment would raise the rate to 44
percent level, resulting in substantial increases in the cost of imports from China.5 5
On the Chinese side, those who would suffer most were foreign investors from Hong
Kong, Taiwan, and elsewhere who set up export-processing operations on the
mainland. In the early 1990s, about 70 percent of China’s exports to the United
States were re-exported through Hong Kong.5 6 If China’s MFN status were revoked,
the volume of re-exports would fall 33 to 46 percent, amounting to a $2.4 to $3.4
billion profit loss. Consequently, Hong Kong’s GDP growth rate, which stayed at
about 5 percent at the time, would drop by 2.2 percentage points to 3 percent. A
withdrawal of China’s MFN status would also have adverse effects on Taiwan,
because re-export trade between the two sides of the Taiwan Strait had increased
tremendously since the late 1980s and most of the goods re-exported were destined
for the United States.5 7
54 Vladimir Pregelj, “Most-Favored-Nation Status o f the People’s Republic o f China,” CRS
(Congressional Research Service) Issue Brief for Congress, updated version o f April 13, 2000,
Internet search result: http://www.cnie.org/nle/inter-12.html.
5 5 The Washington Post, May 20, 1997.
56 Pregelj, “Most-F avored-N ation Status o f the People’s Republic o f China.”
5 7 China N ews Agency (Hong Kong), May 12, 1994.
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Ill
Caught in the middle of a dispute between China and the United States, Hong
Kong and Taiwanese investors favored a solution that would satisfy the United
States. If political issues were beyond their comprehension, how about trade
concessions? After all, trade liberalization would not hurt them at all. But instead of
making outright complaints about the situation, their special relationships with the
Chinese government required them to take a middle road. Here is what they did:
lobbying for the MFN renewal in the United States and bringing U.S. pressure back
onto the Chinese government. Their goal was to prevent the dispute from developing
into a full-scale trade war even if that meant China would have to bring down its
tariff barriers.
Since Hong Kong had a big stake in the MFN status, its lobbying for the MFN
renewal was most intense and well organized. Even before President Clinton
assumed the office, Hong Kong businesses began to urge top Hong Kong officials to
lobby the new Clinton administration and the members of Congress. The lobbying
activity kicked off in February 1993 when the members of Congress returned to the
Capitol Hill. Referring to a $2.27 billion U.S. trade deficit with China for September
1992, Peter Lo, Minister of Hong Kong Economic and Trade Affairs, admitted that
there was no time to lose. To provide financial support for the lobbying efforts, the
Hong Kong government spent about $10 million every year after 1993.5 8
Meanwhile, the Hong Kong Business and Professional Federation regularly sent
its delegations to Beijing to meet top Chinese leaders, including Zhu Rongji, then
5 8 The Standard (Hong Kong), December 5, 1992, p. 17.
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112
Vice Premier of the State Council, Qian Qichen, Minister of Foreign Affairs, and
Wang Zhaoguo, Minister of the United Front.5 9 By briefing them on the MFN
situation, Ftong Kong investors hoped to build up pressure on the Chinese
government.
Obviously, Beijing was taking note of what Hong Kong had been doing, and
knew exactly what this was intended for. In mid-1993, the paramount leader Deng
Xiaoping instructed to use trade to solve the MFN issue. Deng was not the first
person who came up with this idea. It was Vice Premier Li Lanqing who proposed to
“handle the trade issue through the means of trade,” which impressed Deng.6 0 In the
eyes of the Chinese government, U.S. purpose to attach conditions to the extension
of China’s MFN status was to reduce its trade deficit. If China took action to place
more orders for U.S. products through its purchasing groups and remove obstacles to
market access, the U.S. President would have better reasons to back down on the
MFN issue.
When making this trade-for-trade decision to deal with the MFN issue, the
government apparently had in mind the interests of Hong Kong investors. A selective
and voluntary tariff reduction would not only appease Hong Kong investors but also
keep the export drive alive. Anyway, the government had to share the concern of
Hong Kong investors, with whom it had signed joint venture agreements. Moreover,
because of numerous duty exemptions allowed for export production, tariffs in
certain sectors, especially the light industries, already lost their appeal as a source of
5 9 Ta Kung Pao (Hong Kong), April 8, 1994, p. 2.
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113
revenue. It would not hurt to make tariff cuts there to ensure continuing access to the
U.S. market. Also, this was a time when China was negotiating with Britain over the
future of Hong Kong. The government would do whatever it could to win over
people in Hong Kong, not to mention Hong Kong investors.
In a meeting with the prominent members of Hong Kong’s industrial and
commercial circles, Wu Yi, Minister of Foreign Trade and Economic Cooperation
(formerly MOFERT) confirmed that China’s trade-for-trade decision was made in
response to the concern of Hong Kong investors. After expressing her appreciation
for Hong Kong’s efforts to lobby for China’s MFN status, Wu reiterated the Chinese
government’s position that MFN was “purely a trade issue.” “If confrontation were
to emerge between China and the United States,” she acknowledged, “the losses the
territory [Hong Kong] would suffer would be even greater” than China. She
promised that China would do everything within the realm of trade to find a solution
to the MFN dispute.6 1
In a move largely to satisfy Hong Kong investors, the Chinese government
gradually cut tariffs in sectors where it considered China had a competitive edge and
where tariffs were no longer a source of revenue. Thus, the low-tech, labor-intensive
consumer electronics industry was among the first to see its tariffs lowered. Between
1987 and 1996, trade-weighted average tariff rates for electronics and
telecommunication products fell from 51.9 percent to 21.8 percent. Although the
60 Xinhua N ew s Agency (Beijing), May 8, 1993.
6 1 Ta K ungP ao (Hong Kong), April 8, 1994, p. 2.
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114
1996 rate remained high by international standards, it was one of the lowest within
China’s manufacturing sectors at the time.
Due to Hong Kong’s special relationship with China, Hong Kong investors were
not as vocal as other foreign investors would be to press for an open trade policy
when U.S. trade sanctions loomed ahead. But Hong Kong’s role as a mediator
between Beijing and Washington helped it get the message across and build up
pressure on the Chinese government. The mounting pressure notwithstanding, the
fact that outward-oriented FIEs were a major source of China’s export earnings itself
meant that the government could hardly afford to take their preferences lightly.
To better understand the divergence in sector-specific trade policy change in the
Chinese automotive and consumer electronics industries, firm entry negotiations are
a place to begin with. These negotiations not only defined the inward or outward
orientation of foreign investors, but also exposed the Chinese government to foreign
pressure by inviting foreign investors to participation in production for domestic
sales or exports.
While the inward or outward orientation of foreign investors originated from
government policies, this orientation could reinforce itself over time. In the
automotive industry, the low quality and high costs of domestically produced
vehicles due to parts localization only increased the demand of inward-oriented
foreign auto producers for protection, which explained why automobile tariffs were
higher in 1996 than in 1985.
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In the consumer electronics industry, as outward-oriented foreign investors
exported more, they became increasingly uneasy about China’s high tariff barriers,
which they believed could be a source of foreign retaliation. Since they relied mainly
on imported inputs for export production, they would lose nothing in the event of
import liberalization. Their pressure for a more open trade policy gained momentum
in the early 1990s when the dispute over China’s MFN status posed a serious threat
to their exports into the United States, forcing the Chinese government to cut
consumer electronics tariffs further in the ensuing years.
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Chapter Four
Conclusions: Limitations and Applicability of the Hypotheses
In the above analysis, I have proposed two hypotheses for understanding the
relationships between foreign capital inflows and trade policy change. I started with
the aggregate of foreign capital inflows at the macro level. Specifically, I looked at
the ratio of FDI stock to debt with commercial banks and tried to find out whether a
change in its value leads to trade policy change in one direction or the other. I
expected a higher FDI/debt ratio to facilitate trade policy opening, and a lower
FDI/debt ratio to contribute to trade policy closure. All this is done by way of the
exchange rate. Here is how I reasoned: Foreign investment involves foreign
exchange risk. When FDI dominates foreign capital inflows, it is the foreign investor
who is exposed to foreign exchange risk. This gives the host government more
incentive to devalue its currency when it faces BOP problems. A real devaluation, as
it makes imports more expensive and helps alleviate the pressure on the current
account, is conducive to tariff reduction. But if the risk of devaluation falls upon the
host government itself, as is the case with countries where external debt is a primary
source of foreign capital inflows, the incentive turns into disincentive. Since
devaluation now directly increases the value of a debt denominated in hard currency,
commercial policy or a tariff hike is more likely used for external adjustment.
At the micro level, I looked at the inward or outward orientation of MNCs. Here,
I expected the inward orientation of MNCs to increase the demand for protection and
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117
hence shift trade policy toward closure, and the outward orientation of MNCs to
have the opposite effect.
Overall, the four episodes provide support for these hypotheses. In Brazil,
massive external borrowing in the late 1960s dramatically changed the composition
of foreign capital inflows. With the external debt growing rapidly against FDI, the
government became increasingly reluctant to use foreign exchange policy as an
external adjustment tool. Instead, it resorted to higher tariffs to stem imports. In
contrast to the previous episode, trade policy opening in the 1990s was correlated
with a higher FDI/debt ratio due to debt rescheduling and reduction as well as the
success in real exchange rate devaluation.
Also in Brazil, foreign auto producers moved their production facilities to Brazil
in the late 1950s and the 1960s initially to penetrate the domestic market. Not
surprisingly, they favored higher tariffs that would prevent competition from abroad
and protect their sunk investment. Their demand for protection eventually shifted
sector-specific trade policy toward closure in the late 1960s. The change in trade
policy toward opening in the 1990s came after foreign auto producers became more
and more oriented toward international markets for both sales and sourcing of parts
and components.
In China, the variation in the trade policy orientation of MNCs reflected a
growing government policy tendency to selectively promote exports within the
general framework of import substitution. While inward-oriented foreign auto
producers helped sustain the industry’s restrictive import regime, outward-oriented
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118
consumer electronics investors were a driving force behind a change toward a more
open sector-specific trade policy—an outcome not anticipated by the government
when it first introduced foreign investment to the country to increase export
capabilities.
When comparing the Chinese episodes, I deliberately held constant the macro
level variable to focus only on the trade policy orientation of MNCs. The expected
variation in the outcome without the inclusion of the macro-level variable may
suggest that the micro-level variable is at the core of these two hypotheses. While the
macro-level variable may work independently anyway despite the micro-level
conditions, its effects on trade policy have to filter through the micro-level variable.
In other words, the trade policy orientation of firms defines the magnitude of foreign
exchange effects. In Brazil, massive external borrowing and a real appreciation of
the exchange rate in the late 1960s led to an increase in tariffs across industries. But
higher tariffs were concentrated in industries where the demand of inward-oriented
firms for protection was strongest (see Chapter 2 and Table 5 above).
By proposing these two hypotheses, this study contributes to the existing
literature in two important aspects. First, current studies of the capital account tend to
focus only on external debt and its impact on trade policy. They do not distinguish
between external debt and FDI. Building upon the existing literature, this study
focuses on the aggregate of external debt and FDI, and how a change in the level of
external debt relative to FDI or vice versa affects trade policy. Second, instead of
concentrating on the effects of government policy on FDI flows, this study goes the
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119
other way around. It seeks to explain how a changing orientation of foreign investors
shifts trade policy in one direction or the other.
Nevertheless, there are certain limitations of these hypotheses.
First, foreign capital inflows have to reach a significant level for these
hypotheses to work effectively. Specifically, external debt must be large and FDI
predominant over local capital.
The emphasis on the level of external debt is because a rapid increase of foreign
indebtedness relative to FDI is usually followed by exchange rate rigidity or
overvaluation, which in turn tends to shift trade policy toward closure. If external
debt is negligible or not large enough, such effects simply do not exist. On the other
hand, foreign domination of a particular sector gives foreign investors more
influence on sector-specific trade policy.
In addition to the Brazilian episodes presented above, the effects of external debt
on foreign exchange and trade policy can also be found in other Southern Cone
countries at the time. Take Chile as an example. With the opening of the capital
account since the late 1970s, Chile’s total outstanding external debt almost tripled
between 1978 and 1982. The pace of debt accumulation far exceeded that of FDI. As
a result, the country saw a real appreciation of the peso by 35 percent from 1979 to
1982, which effectively put a stop to trade liberalization beginning in 1974.1 But in
countries with little external debt, the exchange rate movements are more likely
1 Sebastian Edwards and Alejandra Cox Edwards, Monetarism and Liberalization: The Chilean
Experiment (Cambridge, Mass.: Ballinger Publishing Company, 1987), pp. 70 & 75.
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determined by overall development strategies or BOP considerations rather than the
capital account situation.
Foreign domination of a particular sector ensures foreign influence. Foreign
ownership is a most common measurement of foreign domination. Foreign
domination of the Brazilian automotive industry was an extreme example, allowing
foreign auto producers to exert influence on the Brazilian government. Besides, the
implementation of ISI in the Philippines was also accompanied by large infusion of
U.S. private investment in consumer goods industries to reap monopoly profits in the
Philippine domestic market.2 But in the East Asian industrializing economies, except
for Singapore, local firms were largely responsible for export expansion, putting
together the package of local and foreign skills themselves.3 Therefore, the argument
about foreign influence does not apply to these economies to account for the
transition from ISI to export production.
Sometimes, FDI may not be overwhelming in total sectoral capital formation.
But its role in foreign technology transfer, managerial training, and export market
access allows MNCs to have a disproportionately large influence on sector-specific
trade policy, as is the case with the Chinese consumer electronics industry in the
1990s.
Second, foreign influence builds only on an existing government policy and
comes after foreign investors have established their local presence. Therefore, it is
2 Sylvia Maxfield and James Holt, “Protectionism and the Internationalization o f Capital: U.S.
Sponsorship o f Import Substitution Industrialization in the Philippines, Turkey and Argentina,”
International Studies Quarterly 34, 1990, pp. 62-68.
3 UNCTAD Division on Transnational Corporation and Investment, Transnational Corporations and
World Developm ent (London: International Thomson Business Press, 1996), pp. 58-60.
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important to distinguish between a trade policy change that is foreign interest-driven
and one that is a mere response to an established government policy.
Generally, whether FDI is export promoting or import substituting depends
largely on government policy. Just as tariff barriers motivate import-substituting
FDI, export subsidies facilitate export-promoting FDI. But the developments later on
are beyond the control of the government. It is in this latter stage that the causation
runs from the orientation of foreign investors to trade policy rather than the reverse.
There are three situations in which the orientation of foreign investors can make
a difference. (1) The inward orientation of foreign investors reinforces itself due to
the deepening of import substitution. As a result, foreign demand for increased
protection sustains a restrictive import regime or pushes tariffs to a higher level, as is
the case with the Chinese automotive industry in the 1990s. (2) The outward-oriented
foreign investors can no longer live with a restrictive import regime. They fear that
protection against imports could lead to foreign retaliation, which will hurt their
exports. So they stand up for a more open trade policy, as is the case with the
Chinese consumer electronics industry in the 1990s. (3) A shift in the orientation of
foreign investors itself changes their trade policy preferences. Foreign investors exert
pressure on the government, forcing it to change trade policy in the same direction,
as is the case with the Brazilian episodes. In the last situation, foreign investors rise
to challenge the very policy that leads them into the country in the first place. In each
situation, the orientation of foreign investors explains trade policy change.
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Third, the pressure o f foreign investors occurs only when the existing policy
hurts.
Foreign investors may choose to live with the existing trade policy no matter
what it is. Their pressure on the government mounts when the existing policy hurts.
This actually is the case with all the episodes examined. Catalysts for mounting
pressure from foreign investors include a departure from the previous sector-specific
trade policy they prefer, a change in the orientation of foreign investors, or some
external factors such as potential foreign retaliation resulting from international trade
disputes.
Fourth, when pressure is exerted, chances o f success increase if foreign investors
are able to form inter-industry coalitions with other investor groups or obtain
support from the government o f their home country.
In Brazil, the call for a more open trade policy by foreign auto producers in the
1980s was part of a broader campaign jointly launched by microelectronics and
pharmaceutical MNCs to pressure the Brazilian government to open the domestic
market. The Reagan administration was directly involved in the disputes, which
culminated with U.S. threats to impose trade sanctions against Brazil. Faced with
mounting pressure from all comers, the Brazilian government finally backed off.
Starting from 1990, it announced a number of import liberalization plans. In the
Philippines, the collaboration of U.S. private investors, policy organizations
representing U.S. firms and the key executive agencies drafting policy (such as the
National Foreign Trade Council), as well as the State Department ensured that the
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country followed an ISI development strategy in the immediate postwar years.4 By
establishing inter-industry coalitions and obtaining support from their home country
government, foreign investors are able to increase the intensity of their pressure.
This tactics, however, could be both a blessing and a curse. On the one hand,
foreign investors seem to have more cards at their disposal. On the other hand, the
effectiveness of their pressure is constrained by state-to-state relations. If for some
strategic reasons the home country government choose not to side with MNCs, the
influence of foreign investors will be greatly discounted.
Beyond these limitations, these two hypotheses should offer a new line of
thinking about trade policy change. Below are some implications of this study.
First, future analysis of trade policy change may need to take into account the
trade policy preferences of foreign interests. This is largely a reaction to a changing
reality. By the mid-1990s, at least 37,000 MNCs operated more than 200,000 foreign
affiliates in virtually all countries around the world.5 At the same time, MNCs
accounted for between 25 and 30 percent of the world’s GNP.6 As the international
capital movement penetrates national boundaries, the interests of different origins are
intertwined. Even if foreign interests alone cannot explain sector-specific trade
policy due to small size, their presence would change the configuration of domestic
interests for or against a particular trade policy.
4 Maxfield and Holt, “Protectionism and the Internationalization o f Capital,” pp. 62-68.
5 UNCTAD, World Investment Report 1994: Transnational Corporations, Employment and the
Workplace (Geneva: UNCTAD), 1994.
6 John Dunning, “Re-evaluation the Benefits o f Foreign Direct Investment,” Transnational
Corporations 3, no. 1 (1994), pp. 23-51.
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Second, external debt relative to FDI may be a better measure of the effects of
foreign capital inflows on trade policy change than external debt alone. At least, this
measure takes into account the aggregate of foreign capital inflows, thus giving a
bigger picture of what the actual capital account situation looks like. In some
countries such as Brail in the 1990s, external debt may still be large in absolute
terms, but as it becomes smaller relative to FDI as a result of debt rescheduling and
debt reduction, it still gives the debtor country an incentive to liberalize its import
regime. After all, if the opening of the capital account attracts more foreign capital
inflows in the form of FDI rather than external debt, it should be considered positive
in the long run.
Third, considering the costs and benefits of FDI versus external debt, FDI should
be preferred over external debt in LDC economic development. Here, external debt
refers to debt with commercial banks rather than long-term investment financing by
multilateral lending institutions such as the World Bank. From a macroeconomic
point of view, if a country has accumulated a large amount of external debt, debt
rescheduling and reduction should facilitate trade liberalization. To attract more
foreign investment, it is the recipient country’s responsibility to improve the
investment environment, which includes improved infrastructure, better logistic
support, and streamlined approval procedures.
Recent developments in the international capital movement have already
attracted increasing interest in the role of foreign capital inflows in trade policy
change.
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For example, many would agree that the 1997 Southeast Asian currency crisis
originated in the strengthening of the dollar that carried the Southeast Asian
currencies (which were pegged to the dollar at the time) along with it and the rigidity
of the Southeast Asian exchange rates as a result of external borrowing. Beginning in
1995, Southeast Asian countries such as Thailand, Malaysia, Singapore, Indonesia,
and Philippines switched from labor-intensive manufacturing activities to more
capital-intensive industries as they moved up along the technological learning curve.
Consequently, they became increasingly reliant on short-term debt to finance huge
imports of capital equipment and other items for government projects. In 1995-97,
Japanese banks alone had lent roughly $150 billion to Southeast Asian countries,
whereas Japanese foreign investment in the region was only $5.8 billion.7 The rapid
increase in the short-term debt reduced the incentive to devalue the currencies
periodically, contributing to the overvaluation of the exchange rates that eventually
led to the currency crisis. Had the currency crisis delayed or not occurred, the
overvalued exchange rates would have forced these countries to raise tariff rates to
avoid external imbalance.
As to the activities of MNCs, in May 1997 IBM demanded that Hungary sign
two WTO agreements on general purchases and information technology, because
Hungary’s failure to do so had hindered IBM’s exports from that country to the
United States. It is unclear whether the United States threatened to retaliate if
Hungary did not comply. But obviously, what IBM was doing was to pressure the
1 Business Week, July 28, 1997, pp. 66-70.
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Hungarian government to follow a more open trade policy. By the time of the
incident, IBM had invested $100 million in Hungary and had created over 3,500 jobs
directly or through IBM projects.8
In sum, foreign capital inflows are reshaping the way trade policy in LDCs is
formulated. With the globalization of the world economy and the acceleration of the
international capital movement, the role of foreign capital in the formulation of LDC
trade policy will only become larger rather than smaller.
8 Reuters (Budapest), May 27, 1997.
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Creator Xu, Feng (author)

Core Title Foreign capital inflows and trade policy change: The automotive and consumer electronics industries in Brazil and China

School Graduate School

Degree Doctor of Philosophy

Degree Program International Relations

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, Commerce-Business,OAI-PMH Harvest,political science, international law and relations

Language English

Contributor Digitized by ProQuest (provenance)

Advisor Lowenthal, Abraham F. (committee chair), Odell, John S. (committee chair), [illegible] (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-120492

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