CHINA S COMPENSATION TRADE: A NEW SOURCE OF FOREIGN INVESTMENT

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP84S00554R000200040001-2
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 13
• Document Creation Date: December 20, 2016
• Sequence Number: 1
• Content Type: REPORT

Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Directorate of
Intelligence
China's Compensation Trade:
A New Source
of Foreign Investment
Secret
Secret
EA 82-10134
December 1982
Copy 289
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Directorate of
Intelligence
China's Compensation Trade:
A New Source
of Foreign Investment
China Division, OEA,
Office of East Asian Analysis. Comments and queries
are welcome and may be directed to the Chief,
This assessment was prepared by
Intelligence Council.
Secret
EA 82-10134
December 1982
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Secret
China's Compensation Trade:
A New Source
of Foreign Investment
Key Judgments Since 1978, China has acquired approximately $380 million in foreign
Information available investment through compensation trade, a term used to cover a variety of
as of 1 December 1982 nonequity investment vehicles available to foreigners. Compensation trade
was used in this report.
attracts capital to China by allowing foreigners to exercise considerable
control over their projects without the long-term commitments, legal
uncertainties, and other problems associated with equity investment in
China. Last year's compensation trade exports were valued at $1.2
billion-approximately 5 percent of China's total exports-and netted
Beijing over $200 million in foreign exchange.
For the Chinese, compensation trade offers an opportunity to develop its
light industrial exports without expending substantial foreign exchange. To
date, China has signed nearly 20,000 compensation trade contracts,
involving some 8,000 factories. Most are small-scale processing or assem-
bly operations for light industrial goods and almost exclusively involve
overseas Chinese businessmen. The typical deal entails foreign supply of
raw materials, equipment, and technology in return for Chinese provision
of land and labor. Notwithstanding its successes, Beijing must show
additional administrative flexibility, develop more sophisticated managers,
and demonstrate that compensation trade can produce greater profits
before investors other than overseas Chinese will be willing to use the
mechanism to any great extent. The long-term potential for expanded
compensation trade is also constrained by internal Chinese political factors.
Chinese proponents of compensation trade must be sensitive to domestic
political criticism stemming from a stricter attitude toward foreign influ-
ences in China. In addition, the lack of Chinese control over these projects
makes them particularly vulnerable to bouts of xenophobia.
Secret
EA 82-10134
December 1982
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Secret
China's Compensation Trade:
A New Source
of Foreign Investment
The Setting
Since 1978, compensation trade has quietly but
steadily become an important conduit for foreign
investment in China. China's experiment with com-
pensation trade in that year was one of the first signs
that Beijing was making a major change in its foreign
economic policy. Prior to 1978, foreign investment in
China had been a forbidden topic because of Beijing's
adherence to the principle of self-reliance. In July
1978, the State Council published a series of experi-
mental rules that opened the door to this type of
investment. These rules were never strictly enforced.
In July 1979 they were superseded by Beijing's
decision to approve the establishment of special eco-
nomic zones (SEZs) and to encourage the promotion
of compensation trade and equity joint ventures.
Guangdong Province was given the lead in this effort
and was authorized to sponsor any compensation
trade deal involving only locally produced materials.
Although Beijing considers compensation trade to be
an integral part of its foreign investment program,
these credits cannot be treated as actual foreign
investments by Western standards because no foreign
claims on real assets located in China exist. Beijing
defines foreign investment rather loosely and
claims-partially in an effort to overcome Western
reluctance to invest in China-to have received a total
of $1.8 billion in direct foreign investment. Less than
25 percent of this total, however, constitutes paid-in
foreign capital for actual "equity" and "contractual"
joint ventures. Beijing also includes loans to Chinese
enterprises and the over $300 million spent by West-
ern oil companies in service contracts for geophysical
surveys under the offshore oil program as part of
foreign investment. Most of the oil ventures eventual-
ly will be taxed under the Foreign Enterprise Income
Tax Law rather than under the Joint Venture Tax
Defining Compensation Trade
Compensation trade can be divided into three catego-
ries-processing and assembly deals, direct compen-
sation trade, and cooperative production. In the first
two categories, the foreign firms supply the raw
materials, semifinished goods or components, and
frequently the production machinery. The Chinese
provide the land and labor inputs. In processing and
assembly deals, the Chinese are paid a fee for
producing the final product, which is then returned to
the investor. Direct compensation trade deals usually
involve larger investments by foreign firms which the
Chinese either compensate directly with the goods
produced by the project or indirectly with alternative
goods agreed upon by both sides. In both cases, the
Chinese side retains any machinery and equipment
provided by the investor. Cooperative production
involves the transfer of technology with the foreign
firm assisting a Chinese enterprise under license. The
Chinese side usually imports most of the necessary
components during the project's initial years, repay-
ing the foreign investor either totally or partially in
finished products.
Current Status
According to Chinese press reports, all but about
1,000 of the almost 20,000 compensation trade con-
tracts signed have been for processing raw materials
or assembling components. This figure may be some-
what inflated by Chinese double-counting renewals of
previously unpublicized contracts. The Chinese press
Law.
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
also reports that these processing and assembly deals
have involved total imports of $156 million worth of
equipment and have earned $352 million in foreign
exchange. Most of the remainder of the projects are
the over 500 direct compensation trade deals which
involve some $120 million worth of equipment
Beijing began its experiment with compensation trade
largely because it offered a chance to use China's
most abundant resource-labor-to earn foreign ex-
change for the modernization program. We believe
the break with the principle of self-reliance and the
image of foreign exploitation associated with compen-
sation trade troubled some hardline elements in the
Ministry of Foreign Trade. But their view was not
shared by local factory managers, who saw an oppor-
tunity to retain and employ a share of the foreign
exchange earned by their enterprises. Moreover, Beij-
ing for the first time allowed local officials to deal
directly with foreign businessmen, exposing these
officials to international business practices. These
relationships furthered Beijing's policy of decentraliz-
ing bureaucratic controls and offered a potential for
expanding China's overall access to foreign technol-
ogy and equipment.
Advantages of Compensation Trade
For the investor, the central attraction of compensa-
tion trade has been the availability of low-cost labor
and land. Almost all compensation trade deals have
integrated foreign-supplied equipment and technology
into existing factories in need of renovation. This has
reduced the cost and startup times and has avoided
the considerable bureaucratic hassles involved in set-
ting up a new factory in China. In addition, existing
factories can readily supply a pool of semiskilled
labor. Foreign contributions of machinery, equipment,
and raw materials have almost always been at unso-
phisticated levels-primarily for producing textiles
and other light industrial goods. The Chinese never-
theless have acquired a few high-technology imports
or production processes through compensation trade.
For example, under a cooperative production agree-
ment with McDonnell-Douglas, China makes landing
gear doors for the DC-9 aircraft.
For the Chinese, the principle of mutual benefit is the
keystone of compensation trade. The arrangements
provide them access to production technology and
equipment that generate products to earn foreign
exchange, create employment, and establish foreign
links that can help transfer marketing and managerial
skills and, eventually, may pave the way for equity
joint ventures. We believe Chinese managers have
been particularly attracted to this "over the shoulder"
learning experience because it has enabled them to
acquire some knowledge of marketing a product while
leaving the responsibility for that function in the more
experienced hands of the foreign investo
For the foreign investor, the primary benefits of low
production costs-cheap land and labor-are comple-
mented by other intangible advantages. Most impor-
tant, perhaps, compensation trade allows investors to
establish solid business ties with their Chinese coun-
terparts without a substantial financial commitment.
In any event, both the Chinese and the investors
appear to believe that successful compensation trade
deals will create a favorable investment climate for
further foreign participation in modernization.
About two-thirds of the compensation trade deals
have been signed with organizations located in
Guangdong Province. Guangdong's geographic prox-
imity to Hong Kong, the close ties between its
residents and the overseas Chinese in the colony and
in Macao, and its control over three of China's four
special economic zones, all have contributed to the -
proliferation of deals in the province. Beijing acknowl-
edged the unique nature of these economic ties in
South China by giving both Guangdong and Fujian a
special autonomous status to conduct their own for-
eign trade. Essentially the two provinces are allowed
to sign almost any deal without prior approval from
Beijing. By contrast,, official guidance to other prov-
inces requires officials there to have the central
government's approval for deals-depending on the
locale-involving from $1 million to $5 million.
Compensation trade has been a major source of
foreign exchange for China's special economic zones.
Eighty-four percent of the foreign exchange earned
since 1979 in Shenzhen-the most successful zone by
far-has been generated from activities associated
with compensation trade including processing fees,
wages, and land leases. Here, too, the vast majority of
25X1
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Secret
compensation trade deals are consummated with over-
seas Chinese who are inclined to seek out their
mainland relatives as business partners.
Adapting to New Environs: The Learning Curve
Beijing has altered its original terms for investment in
compensation trade deals as Chinese experience in
dealing with foreign businessmen has produced a
"learning curve" that has underwritten the program's
success. Nonetheless, in the view of foreign investors
many problems remain, and China will need to be-
come more bureaucratically flexible before business-
men, other than overseas Chinese, are willing to make
substantial commitments to China through compensa-
tion trade
Labor Force Concessions
Labor force deficiencies-particularly the caliber and
selection of local Chinese workers-have been one of
the most serious problems for the compensation trade
program. Beijing initially stipulated that local labor
bureaus would provide the labor force for these
projects and that they would do so without involving
the enterprise management in the process. Improper
selection procedures quickly led to poorly qualified
work forces, low productivity, and substandard out-
put. Despite investor complaints, however, Beijing
only made concessions on the labor issue when exas-
perated foreign investors shut down one of China's
best known projects (see box).
As a result of the episode, Beijing gave local factory
managers authority to promote, transfer, punish, and
fine workers and allowed the factories to recruit and
select their own workers. Workers who failed to meet
standards after being trained could be dismissed if
management chose. Compensation trade factories
could also use a bonus system to spur production. The
Chinese did not formally adopt these concessions until
December 1981, when Guangdong Province included
them in its regulations for the special economic zone.
These concessions have alleviated some investor frus-
trations, although China's labor productivity remains
low by world standards.
Cracking the Domestic Market
Although some foreign investors believed that they
could use compensation trade to break into China's
domestic market, especially in consumer goods,
The Unraveling of China's First Direct
Compensation Trade Deal
The Xiangzhou Wool Spinning Mill was constructed
in 1978 opposite Macao in Guangdong's Zhuhai
municipality. It was China'sfirst direct compensation
trade project. Overseas Chinese investors financed the
importation of the equipment under an agreement
that called for the production of finished yarn from
the raw wool provided by Hong Kong and Macao
firms. After months of low and inferior production,
the investors reluctantly cut off the material supply
in September 1980 and detailed their concerns in a 25X1
letter to several senior Chinese officials. Beijing's
embarrassment over the plant's closure produced a
mea culpa in two People's Daily articles, in which the
government took full responsibility for the shutdown
and stressed that China intended to learn from the
cutoff. The mill resumed production a few months
later following a number of concessions designed to
improve the quality of labor force used in compensa-
tion trade.
Beijing until recently has essentially maintained that
compensation trade products are only for the export 25X1
market. At the UN-sponsored Investment Conference
in Guangzhou last June, Wei Yuming, the Vice
Minister of the Ministry of Foreign Economic Rela-
tions and Trade, announced that foreign investors
could sell up to 80 percent of their products in China.
However, the Vice Minister stipulated that the for-
eign firms must generate sufficient foreign exchange
from its exports to be able to earn its own profits, pay
its foreign employees, and buy any imported material
needed for its operations because Chinese yuan are
not convertible.
Despite this attempt to offer opportunities in China
for foreign investors, there are countercurrents that 25X1
may curtail efforts to further liberalize the format for
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
design is more typical. Here, the Chinese have desig-
nated 80 percent of the production for export to repay
the Japanese investment, with the remainder available
for either the domestic market or additional exports.
High-level concern about corruption in China has
been reflected in an apprehension over the disruptive
effects that foreign goods can have in the domestic
market. We believe that Beijing will keep its approval
for domestic sales limited and that in the longer run,
these arrangements may not endure; at a minimum,
the recent warnings from Gu Mu will not encourage
foreign investors who hope that compensation trade
will provide them an entree into the domestic market.
Compensation With Alternative Goods
Beijing's unwillingness to offer alternative goods to
foreign investors in cases where the investors do not
want to accept the output of a compensation trade
project has been a major stumblingblock to growth of
this investment vehicle.
potential foreign investors have been reluctant to
provide equipment and technology for Chinese fac-
tories whose exports have a potential for competing
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
compensation trade. Recently, for example, the Chi-
nese have discovered that some processing deals have
been illegally manipulated to circumvent trade regu-
lations-a discovery that has already led to closer
surveillance of the domestic market to spot the prod-
ucts of compensation trade deals.
In late June, State Councilor Gu Mu. stated in a
speech, subsequently published in the Chinese press,
that some Chinese were colluding with foreign busi-
nessmen to smuggle goods by falsely reporting the
quantity of raw materials imports and exaggerating
the quantity of finished export products in their
processing deals. Gu said that other Chinese enter-
prises were also selling their imported raw materials
for processed products on the domestic market, result-
ing in the disruption of the local marketplace. He
later told a national conference on smuggling that the
rules on the use of imported raw materials would be
tightened and specified that finished products would
require import permits as well as payment of duties
and taxes if they were sold domestically.
While Gu's comments were targeted primarily at
abuses of processing and assembly deals, his guidance
indicates a basic Chinese reluctance to follow a
generally more liberal policy on domestic sales of
compensation trade products. A recent article about
the special economic zones in the Guangdong press
also reflected that attitude in calling for strict control
of domestic sales of goods produced in the special
economic zones, although the author did suggest that
certain needed items of technology, especially those in
short supply at home or only available as imports,
should be excepted from these strictures.
In fact, there are at present only a few successful
compensation trade deals that involve large-scale do-
mestic sales. Two of the most well known are with US
firms-Coca-Cola's soft drink bottling plant and R. J.
Reynolds's Camel cigarettes project-that sell their
finished products exclusively on the domestic market.
They are in a class by themselves, however, because
the bulk of their products are sold to foreign visitors,
who use foreign exchange coupons to pay for them.
The Beijing Camera Company's agreement with
Canon to produce 35-millimeter cameras of Japanese
25X1
25X1
25X1
25X1
25X1
25X1
25X1
 Approved For Release 2007/08/07: CIA-RDP84S00554R000200040001-2
Secret
Curtailing the Use of Compensation
Trade for Plant Modernization
Perhaps the most significant adjustment Beijing has
made in its compensation trade program was the
decision early this year no longer to pursue compensa-
tion trade as a major source of direct foreign invest-
ment in plant modernization. Because of the need to
conserve foreign exchange, the Chinese initially
viewed compensation trade as an inexpensive way to
acquire foreign equipment and technology. The effort,
however, was hampered from the start by the concern
of foreign investors that the programs would create
new competition. Moreover, many foreign investors,
supply and marketing functions so that China could
gain a better understanding of international economic
activities.
are reluctant to assist the
payoff is to be in Chinese goods.
Beijing appears to have concluded that it can more
efficiently acquire desired foreign and technology
equipment by direct purchases. Direct purchase, in
any event, eliminates the need to depend on compen-
sation trade for help in the plant modernization effort
and places the primary focus of the compensation
trade program on developing deals where the foreign
investor actually wants the project's output.
Other Problems
China has attempted to blame foreign investors for a
variety of other difficulties with compensation trade.
Processing and assembly agreements have come under
particular criticism because in these deals the foreign
investor, who provides the raw inputs, has most of the
control over the project. A recent article in Hong
Kong's Ming Pao referred to these deals as putting
Chinese enterprises into a "passive position." More-
over, an article in June in Guangzhou's Nanfang
Ribao criticized investors for providing rudimentary
and obsolete equipment and for falling behind in
payment of workers' wages.
In August, People's Daily published a signed article
that leveled more serious criticisms against the com-
pensation trade program, claiming that the lack of
marketing and management experience available in
some deals makes them failures and worth avoiding.
The author encouraged greater Chinese control of the
Other Chinese officials have complained that the
prices investors charge for equipping and managing
these projects are too high.
25X1
25X1
Beijing is also concerned about the effects of shady 25X1
business practices, including the use of bribes, on its
program. While this form of corruption has been only
one of several illicit activities under scrutiny, the
government's desire to maintain an "open door" for
foreign investors has limited its willingness to expose
such cases. Moreover, most foreign investors involved
25X1
25X1
trade deals, such as television sets, can easily be 25X1
disguised as gifts 0
in compensation trade are ethnic Chinese who often
deal with relatives, making "corruption" more diffi-
cult to spot. For example, "incentives" that facilitate
In general, the Chinese have tried to handle investor
problems by issuing laws or regulations that often
raise as many questions as they answer. Beijing is now
preparing to issue regulations covering compensation
trade deals that will define and describe the execution
of contracts, as well as lay out procedures to settle
disputes. While the new regulations are likely to
present problems in themselves, several American
lawyers are working with Chinese legal experts on
them, indicating a Chinese willingness to consult with
foreign experts in order to reach compromises that
can help satisfy the needs of investors.
Approved For Release 2007/08/07: CIA-RDP84S00554R000200040001-2
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
A critical problem not yet addressed by the Chinese is
the lack of coordination between local Chinese enter-
prises and higher authorities-a failing that has de-
railed or slowed several important compensation trade
deals with US firms. For example, a $2.5 million deal
signed in 1980 between the Singer Sewing Machine
Company and a Shanghai firm was canceled several
months later by Shanghai's municipal government,
which based its belated decision on its own estimate of
negative effects of the deal on the domestic market.
More recently, the R. J. Reynolds Company's two-
year-old compensation trade deal to produce Camel
cigarettes in Xiamen, Fujian Province, ran into trou-
ble after Beijing doubled its tariff on imported tobac-
co to protect the domestic industry. As a result, the
Camel factory has temporarily stopped production. In
both cases local officials who set up the projects
expressed their irritation with actions of the higher
authorities. In the Camel deal, they are appealing to
Beijing for reconsideration
reputation as a reliable investment site.
Prospects
China needs to demonstrate additional flexibility in
its compensation trade policy and greater manage-
ment skills before Beijing develops a reputation that
can attract substantial investment from non-Chinese
sources. Given the large number of compensation
trade projects already under way, as well as the over
40 equity joint ventures in China, potential foreign
investors already have an assortment of investment
options to evaluate in making new investment deci-
sions. Nonetheless, the obvious contradiction between
Vice Minister Wei's statement at the UN-sponsored
Investment Conference and Gu Mu's concern over the
infiltration of unwanted goods in the domestic market
must be corrected if China hopes to develop its
compensation trade program. Beijing is anxious to
attract foreign investment and can hardly afford to
limit the effort to such key provinces as Guangdong
and Fujian. In addition, the small scale of most
compensation trade deals currently excludes them
from central review, a policy that Beijing probably
realizes facilitates their consummation.
In political terms, compensation trade will remain
vulnerable to domestic criticism because Chinese
partners generally lack control over the venture and
because the investment has similarities to the pre-
1949 economic exploitation in China. Moreover, the
level of control that foreign investors have over com-
pensation trade deals, even to the point of being able
to shut them down, almost certainly disturbs some
segments of the Chinese leadership. While the current
climate for foreign investment in China is good, a
return to greater economic self-reliance or a broad
revival of antiforeign campaigns could precipitate
attacks on compensation trade. However, the small,
short-term nature of most compensation trade deals
almost automatically protects foreign investors from
substantial losses even if the political climate or
leadership changes.
We expect that recent moves to recentralize control
over economic policymaking highlighted at China's
12th Party Congress will not have much effect on the
 Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Secret
Appendix
Two Examples of Compensation Trade
These examples of compensation trade are typical of
arrangements negotiated in the past few years.
Shantou Watch Parts Factory
This factory originally produced clockwork springs
and watch parts, but, under a processing and assem-
bly-type deal signed with a Hong Kong partner in
1978, it began assembly of electronic watches and
transistor components. The partner, who provided
$16,000 in secondhand equipment, pays a processing
"fee" ranging from 40 cents to $1.20 for each item
produced-a fee some 30 percent under the factory's
original price because of the agreement to compensate
the investor for the equipment. With 250 workers,
the factory assembled 78,000 watches and earned
$91,000 in fees in its first 18 months of operation, F
AMF-Shanghai Number Three
Rubber Products Factory
Under a 1979 direct compensation trade agreement,
AMF provided the Shanghai factory with $1 million
worth of equipment to produce sports balls. The
factory, which received the machinery in mid-1981,
can use the equipment free of any payment to AMF
for 10 years; after that period, it can purchase the
equipment at a negotiated price. AMF is supplying
some raw materials to make basketballs and soccer
balls in return for an annual output from the factory
of at least 340,000 balls per year. The project deliv-
ered 50,000 balls to AMF during its first quarter of
operation in 1981. AMF expects it to generate ap-
proximately $10 million in export products over its
10-year term.
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
 Secret
Secret
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2
Approved For Release 2007/08/07: CIA-RDP84SO0554R000200040001-2