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China foreign investment pattern changes as challenges grow

Workers sew blue jeans in Yilin textile factory in Dongguan, Guangdong province, China.
Lucas Schifres | Getty News Images | Getty Images
Workers sew blue jeans in Yilin textile factory in Dongguan, Guangdong province, China.

China's foreign investment mix is changing, with portfolio investors buying more stocks but foreign direct investment falling to a two-year low on a slowing economy, rising business costs and anti-monopoly probes and crackdowns on foreign firms.

Foreign direct investment (FDI) in China fell in over the first seven months of 2014 compared with a year earlier, while the offshore funds flowing into mainland stocks hit the highest in more than two years last month.

A plateau in foreign investment could be a challenge for China, as it offers manufacturers an alternative source of capital to the banking system. Any shortfall is unlikely to be made up by portfolio flows, which favour more liquid stocks and are limited by quotas.

Read MoreWhy manufacturing PMI still matters for China

"Foreign capital coming here needs to get a lot more discriminatory," said Gary Reischel, founder of venture capital firm Qiming Venture Partners in Shanghai, referring to overall investment.

The stock market has risen for the past six weeks, its longest streak since March 2012, after being among the worst performers in the first half of the year.

Investors are drawn to Chinese shares by low valuations for large-cap shares after a four-year slump, a rallying yuan, and the prospect of a pilot project to allow foreigners to buy yuan-denominated stocks on mainland exchanges.

Read MoreChina's July economic data points to further softness

FDI falls

Non-financial foreign direct investment was $7.81 billion in July, the lowest in two years, and fell an annual 0.4 percent in the first seven months of the year.

Chinese regulators have warned against reading too much into a single monthly FDI figure, and many economists agree.

Still, in the context of July data that included softness in manufacturing, lending, housing prices and fixed-asset investment, the numbers have prompted some debate.

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The FDI slowdown was led by a sharp decline in investment from Japan, which plunged 45 percent in the first seven months of 2014; Europe, down 17.5 percent; and the United States, off 17.4 percent.

"There are other geographies in Asia that are definitely more attractive for manufacturing," said Matt Koon, consulting manager at Tractus Asia in Shanghai.

At the same time, there has been an increase in funds flowing into stocks via exchange-traded funds (ETF) in Hong Kong from foreign investors, who cannot yet invest directly in mainland equities.

ETFs under the Renminbi Qualified Foreign Institutional Investor (RQFII) scheme had net inflows of 8.2 billion yuan ($1.3 billion) last month, the highest since December 2012 and nearly doubling from June, according to Morningstar data.

Launched in 2011, RQFII enables institutions to use offshore yuan to invest in the mainland's securities markets.

The net inflow in July was the equivalent to 14.5 percent of assets under management. A year earlier, there were outflows equivalent to 9.9 percent of assets under management.

Read MoreWill this be a breakout year for Chinese stocks?

Hostile environment

FDI has risen each year since China joined the World Trade Organization in 2001, hitting a record $118 billion last year, with manufacturing a main destination.

But Beijing's plans to make the economy more reliant on domestic consumption could not only temper the inflows, but change the composition. Indeed, FDI in manufacturing fell in the first seven months of 2014 while it rose in services.

Many economists argue that China is losing attractiveness due to reasons such as persistently increasing costs for labor, relatively higher prices for energy and expensive industrial property.

Read MoreChina RMBS: safe play or financial Russian roulette?

Coincidentally or not, the slowdown in FDI this year follows a campaign pillorying foreign firms for crimes including bribery, discriminatory pricing, monopolistic behavior, and poor quality control - which has led to massive fines and detentions by police.

"The more aggressive stance of Chinese regulators is doubtless galling to foreign executives, but it is unlikely to eliminate their interest," Arthur Kroeber, economist at Dragonomics, wrote in a research note, adding some firms had made so much profit that they can "easily afford to pay the fine and go on its merry way minting money in the Middle Kingdom."

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