Beware the Pitfalls

By+Mei+Xinyu

The phrase “negative list” has been one on everyones lips since the Chinese Government approved the establishment of the China （Shanghai） Pilot Free Trade Zone（FTZ） last August.

Under the negative-list approach， foreign investment into the sectors excluded by the list only needs to register with the relevant authorities. Among all the pilot programs in the Shanghai FTZ， the negative-list approach has been the focus of public attention.

Various local governments， especially those applying for the establishment of FTZs， have proposed utilizing the negative-list approach， and almost all their proposals have been shorter than the one put forward for the Shanghai FTZ.

However， there is some cause for concern regarding this system. At the end of March， the Indonesian Government announced its decision to terminate all of its 67 bilateral investment treaties， shocking the international investment market and urging people to review the potential risks of the negative-list approach.

A positive move

In China， the negative-list approach is connected with the reform of an investment administration system that is transforming from an approval-based to a registrationbased one. At present， the establishment of foreign-invested enterprises must be subject to the approvals of development and reform commissions and commerce authorities at both national and local levels.

The Chinese Government relaxed the approval-based system in 2004， but the application procedure was not simplified and applicants still have to submit the same documentation. After the negative-list approach is adopted， establishment of foreign-invested enterprises need only be subject to registration， and investors will spend less time being embroiled in the application process.

The negative-list approach is nothing new in the countrys administration of foreign investment or foreign trade. In the Catalogue for the Guidance of Foreign Investment Industries， a document oft-revised by the Chinese Government， foreign investment industries are divided into three categories： encouraged， restricted and prohibited. The administration of foreign investment in China adopts a mixed approach， which mainly relies on the lists of restricted and prohibited industries and is supplemented by a positive list of encouraged industries.

According to the Protocol on the Accession of the Peoples Republic of China to the WTO， China made a commitment to not collecting export tariffs on products excepting the 84 varieties of products listed in Annex 6. This effectively constitutes a negative-list approach. But it wasnt until July 2013 that the country expanded the negative-list approach to cover international commitments when it agreed to adopt the approach in China-U.S. bilateral investment treaty negotiations. Later on， it initiated a pilot program in the Shanghai FTZ.endprint

The negative side

By adopting a negative-list approach rather than a positive-list approach， a host country undoubtedly runs greater risks.

Under the positive-list approach， if the host country can maintain its economic and social development， the number of industries that can withstand international competition will increase， and industries previously unsuitable for foreign investment can be gradually opened up. Therefore increasing the number of items on the positive list conforms to the interests of foreign investors and their parent countries and will not engender any problems.

As for emerging industries and technologies， if the host country finds they are not appropriate for opening up to foreign investment， under the positive-list approach， it can decide at its leisure if and when to open these industries. Under the negative-list approach， however， if the emerging industries and technologies are not incorporated into the negativelist， by the time the host country finds they are not appropriate， it will be too late. Attempts to incorporate them into the negative-list will be met with opposition from foreign investors and their parent countries， leading to potential disputes. Even if the host country wins in such disputes， it will have to spend time and effort and lose maneuverability in decisionmaking. Additionally， if the host country is sued through the International Center for Settlement of Investment Disputes （ICSID） and loses the lawsuit， it will be required to pay economic compensation.

Such risks are evident from Chinas defeat in the WTO raw material dispute， even though China is not liable to pay compensation in the case of losing a lawsuit in the WTO. However， the liability for paying compensation does exist in some cases， and the stakes are so high that even the United States， which has advocated a negative-list approach for more than 30 years， would not be able to afford the fallout. Under the North America Free Trade Agreement， by the end of 2009， Canadian investors had launched at least 15 international litigations against the U.S. Government， demanding compensation from the U.S. Government reasoning that its behavior had pulled down the value of their investment in the United States.

Because the negative-list approach is more favorable to international investors and their parent countries， the United States， the largest parent country of overseas investment since World War I， used to actively advocate the approach. It published a model bilateral investment treaty with this approach as early as 1982 and revised it in 1994， 2004 and 2012， respectively. However， as U.S investment overseas declines， the United States has found itself in the curious position of being put at grave risk by the very approach it has popularized.endprint

The most pressing reason for Indonesia to terminate all its 67 bilateral investment treaties was that it was sued by foreign investors through the ICSID and was the loser in the ensuing litigation. In February， Indonesia also lost a dispute with Churchill Mining Plc. concerning coal mine assets， and may have to pay compensation of up to $1.05 billion. Indonesia is also facing dozens of litigations of a similar nature through the ICSID.

Moreover， since the current model of negative-list was formulated by the United States， the highly liberalized financial service industry has greatly increased the difficulty developing host countries have experienced in managing financial risks. In a climate of subprime mortgage and sovereign debt crises in Western countries as well as turmoil in emerging markets， the threats inherent in such an approach grow ever larger.

No haste

In the face of a management approach that carries both benefits and risks， there are various reasons for China to be decisive in commencing its experiment. First and foremost， Chinas comprehensive national strength has significantly improved. As the worlds only country with all of its industries listed in the International Standard Industrial Classification， the country with the worlds largest foreign exchange reserve， the worlds No.1 manufacturer and exporter， and the worlds second largest economy， China is far better able to tolerate risks than most other developing countries.

Based on its confidence in its management ability China has thus decided to proceed with the negative-list approach， so as to improve the efficiency of its governments public services， to attract more international investment， especially in technological and capital-intensive areas， to improve the treatment of Chinese investors in other countries and ultimately improve Chinas position in the international economy.

However， this does not mean Chinas local governments should be encouraged to get involved in a race to shorten their negative lists. It would be irresponsible to hide long-term risks just for the sake of the political achievements of a few government officials and the profits of a handful of speculators.

Taking heed of the lessons learned by various countries that have been involved in international investment litigations， therefore， should China first carry out experiments and then extend the negative-list approach in an orderly way， or should it expand the approach to the whole country hastily and then stop it when crises inevitably arise in the future？ The former is surely the wiser one to take.endprint