The number of foreign-invested research and development centers in China has risen from about 700 in 2004 to more than 1,200 this year. This is a clear indicator that China is transforming from a low-cost manufacturer into a center of innovation, says emerging markets expert Irwin Greenstein. However, investors need to treat the country’s foreign direct investment numbers. Statistics for China do not meet international standards…

Foreign direct investment (FDI) is a barometer for economic activity. Even more for investors in emerging markets.

By watching the FDI, investors can gauge the interest of foreign money in a growing economy. FDI statistics can also reveal where the money is going. This can reveal overlooked investment opportunities.

One of the most accredited sources for FDI is the UN Conference on Trade and Development (UNCTAD). For years now, UNCTAD has been monitoring the inflow of foreign money into different countries and issues reports on the results of their findings.

UNCTAD’s most recent report on China, however, reminded me of a TV pharmaceutical commercial where the happy face is merely a façade for a whole lot of cautionary fine print.

The fine print in this case cautions investors about how China is inflating its FDI numbers.

Perhaps the biggest problem here is that if you were read articles about China’s latest FDI results, you’d be pretty darn impressed. But get your hands on the actual report, and your expectations are deflated.

Before we get into the disclaimer, let’s go over the FDI numbers UNCTAD released yesterday.

In 2007, China attracted FDI worth $83.5 billion, the highest among developing countries and sixth in the world. About half of last year’s capital inflow went into the service sector, compared with 28% in 2003.

The report noted that the number of foreign-invested research and development centers in China has risen from about 700 in 2004 to more than 1,200 this year.

Reading between the lines, China is now transforming from a low-cost manufacturer with a bad rap for pirating intellectual property into a center of innovation – following the pattern established by Japan’s move up the economic food chain.

You can also see this as FDI increases in China’s financial sector.

While non-financial FDI in China was $60 billion in 2005, financial services surged to $12 billion, driven by major investments in Chinese banks.

Even though China has gradually been liberalizing FDI into its banks, it is only in the past two years that foreign banks have rapidly entered the Chinese market by acquiring ownership stakes in Chinese banks. By the end of 2005, 18 foreign financial institutions had invested in 16 banks. The largest deals involved four of the five top Chinese banks, according to the report. (Of course we have to bear in mind this data pre-dates the current fiasco on Wall Street.)

Real estate was another hot spot for FDI. According to the Ministry of Commerce (MOFCOM), inflows to China in this industry surged to $5.4 billion in 2005. The State Administration of Foreign Exchange (SAFE) said that purchases of real estate by foreign institutions amounted to $3.4 billion in 2005. According to SAFE, FDI now accounts for 15% of China’s real estate market.

With these FDI numbers under our belt, UNCTAD then went on to chide China for a little maneuver called “round-tripping.” Once you understand round-tripping, you begin to see that these FDI numbers from China may be inflated by as much as 25%.

As UNCTAD explains it, round-tripping is driven by differences in the treatment of foreign and domestic investors, which may motivate investors to channel funds out of, and subsequently into, an economy in the form of FDI. Because the funds originate in the host economy itself, “round-tripping” inflates actual FDI inflows.

In China, a significant share of FDI inflows is round-tripped, mainly via Hong Kong (China). Official estimates of this type of FDI by the Chinese Government are not available, but others have suggested that such flows may account for up to 25% of the total inflows.

China’s FDI statistics deviate significantly from international standards. For example, the threshold level applied in the definition of FDI is 25%, rather than 10%, as recommended by the International Monetary Fund (IMF).

UNCTAD said that with regard to problems related to China’s FDI statistics, a more centralized statistical system that is consistent with international standards would help policymakers. Until then, comparisons of China’s FDI inflows with those of other recipients should be interpreted with care.