This paper argues that foreign investment is a second-best instrument that helps China to succeed in export-led growth by circumventing the many distortions that discriminate against domestic private enterprises. China's dependence on foreign investment for exports should decline as China builds up its market economy, but its generous preferences for foreign investors may unduly prolong its dependence. It is found that China's exports are increasingly dominated by the low value-added processing exports of foreign affiliates. In the case of Hong Kong investment in export processing on the Chinese mainland, the value-added in the Mainland is often less than that of re-exporting the output in Hong Kong. Since 2004, China has amended its treatment of foreign investments to attract higher-quality foreign investment and upgrade processing exports in order to transform itself from a world sweatshop to a global manufacturing center. The policies appear to have the intended effects.

This is a revised version of a paper prepared for the Asian Economic Panel Meeting in Keio University, Tokyo, 29–30 September 2006. The author thanks Fukunari Kimura and Wing Thye Woo for helpful comments, and Wing Tse for research assistance.

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