China reported a 0.05 percent jump in its foreign direct investment in May. The meager growth reversed the downward trend, but it cannot change the fact that foreign investment in the world's second-largest economy is sluggish.

In fact, from November to April, FDI, an important indicator of investor confidence in China, has registered negative growth for six consecutive months.

Commenting on the dark FDI picture, Shen Danyang, spokesman for the Ministry of Commerce, advanced several reasons, including the European debt crisis, China's rising costs of labor, production and raw materials, and Western countries' initiatives to lure their companies back home.

They were fair explanations. But at least one other thing is dampening the enthusiasm of foreign businesses, especially European ones, for putting their money into China: the yuan's appreciation against the euro.

In recent days, 1 euro could be exchanged for about 7.9 yuan, according to the central parity rate set by the People's Bank of China, the central bank. On Nov 1 it was 8.7683 yuan. This means that the yuan has appreciated against the euro by 10 percent in the past six months.

In addition, the Chinese currency guarantees a much more handsome interest rate than the euro. In fact the interest difference between the two is more than 3 percentage points on one-year deposit rates.

Capital usually flows from a weak currency to a strong one and from a low-interest unit to a high-interest one to seek exchange and interest gains. So on the face of it European investors should be keen to put their money into China.

However, the strength of the yuan is a double-edged sword.

On the one hand, its strength ensures good returns for investors. On the other hand, it increases initial investment costs. It is a matter of which factor outperforms the other.

As most foreign investors have to exchange their currencies for the yuan to invest in China, they inevitably incur exchange losses when the yuan keeps appreciating. In the case of the euro, exchange costs have risen 10 percent in a little more than six months.

In good times the exchange costs are no problem for cash-rich investors. But when the European economy goes from bad to worse, and when the worst may well be yet to come, the exchange costs deter investors from digging deep into their pockets.

Investing in China could potentially bring foreign investors a 30 percent annual return, as some research has shown. But the increasing initial-investment costs, a result of the rising yuan, are now a barrier to many foreign investors who need to tend their ailing business at home.

For example, Telefonica SA, Spain's biggest telecom company, recently sold a 4.56 percent stake in China Unicom (Hong Kong) Ltd to its parent firm for about $1.41 billion. The money is to repay part of its 57.1 billion euros ($72 billion) in debt.

The Spanish telecom giant has to do so even though its investment in China Unicom brings in a double-digit return every year.

That is a perfect example of how long-term profit loses out to the needs of short-term liquidity in the European debt crisis. In fact, most of the blame can be sheeted home to the sluggish global economy, which in turn is mostly caused by the debt crisis.

The current FDI drop echoes what happened two years ago. The last time China had a prolonged drop in FDI was during the 2008 financial crisis, when the United States, bogged in the banking meltdown, withdrew its capital from China. During the world's worst financial woe of the past 70 years, FDI into China fell nine months in a row from November 2008.

In that sense, the current FDI drop should not be seen as a sign of loss of attraction of the Chinese market.

However, that does not mean China can be complacent. Instead, the country should accelerate the pace of opening up its markets.

To be sure, the opening-up of the Chinese market is not as febrile as it was in the first three years after it joined the World Trade Organization in 2001. This is because the country was not obliged to open up further after it met most of its commitments to the world trade body.

Another reason is that the financial crisis interrupted the process of opening-up because the Chinese leadership was not convinced that its economy was strong enough to embrace foreign competition.

In addition, the fact that China has fallen victim to rising global protectionism dampens the country's initiatives in market opening.

Strategic and emerging industries essentially remain in the hands of Chinese companies, State-owned companies in particular. Regulatory constraints are open to abuse in many sectors, and one area where this happens is logistics.

With such limits, China's allure to foreign investors cannot be sustained even if the global economy improves. To attract high-quality foreign investments, opening the market is a must.

The author is a financial analyst based in Shanghai.

(China Daily 06/22/2012 page7)