China Investments Raise Economic Risks

An analysis by Michael Lelyveld
2016-10-03
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A Chinese clerk counts U.S. dollar banknotes next to yuan renminbi bills at a bank in Nantong city, eastern China's Jiangsu province, July 28, 2016.
A Chinese clerk counts U.S. dollar banknotes next to yuan renminbi bills at a bank in Nantong city, eastern China's Jiangsu province, July 28, 2016.
ImagineChina

As economic growth weakens, more investment is flowing out of China than is flowing in, raising questions about the country's prospects and the government's goals.

In the first eight months of the year, China's non-financial outbound direct investment (ODI) jumped 53.3 percent from a year earlier to over 775 billion yuan (U.S. $116 billion), the Ministry of Commerce (MOC) reported.

Over the same period, foreign direct investment (FDI) in China rose by a much milder 4.5 percent to 548.8 billion yuan (U.S. $82.2 billion), making the country a net capital exporter this year.

While China portrays its soaring overseas investment as a sign of influence and strength, the outflow has raised concerns about declining opportunities for capital in the country, which has been a magnet for FDI over the past 30 years.

According to a report by the New York-based Rhodium Group, China had previously run FDI surpluses since record keeping started in 1982, with average inflows of U.S. $200 billion (1.3 trillion yuan) a year between 2010 and 2014.

Accounts differ on when the balance shifted in China.

According to earlier MOC reports, China's outbound investment exceeded FDI for the first time in 2014, based on preliminary figures published in January 2015.

The Rhodium Group said China suffered its first quarterly FDI deficit in the third quarter of 2015 before recovering slightly and then falling into deficit again in this year's first quarter.

Last month, the MOC said China became a net capital exporter for the first time last year.

While details of timing and totals may vary, there is broad agreement on the causes of the shift.

"The main underlying thing going on here is that the Chinese economy is weakening," said Derek Scissors, resident scholar at the American Enterprise Institute in Washington, which compiles the China Global Investment Tracker with the Heritage Foundation.

"There are fewer opportunities in China for private capital, for state capital and for foreign capital, and therefore capital is going to leave China and look for opportunities elsewhere," Scissors said.

No longer the star attraction

With the arrival of "new normal" economic growth rates and higher costs for labor and land, China is no longer seen as the world's star attraction for FDI.

Based on MOC reports, FDI has grown by modest single digits in each of the past three years, while China's ODI has climbed at strong double-digit rates.

Several forces are behind the widening gap.

"Anemic FDI growth is partially a reflection of slowing Chinese growth and structural changes such as higher costs for labor and other factor inputs," the Rhodium Group said in its June report. "It is also a result of China's slow progress with reforming its FDI policies."

China still bars or limits foreign investment in many sectors of its economy, although it has gradually whittled down the numbers on its "negative list."

At the same time, China has encouraged its companies to invest overseas and acquire new technologies to compete, easing restrictions on outbound capital for approved deals.

The government's "One Belt, One Road" initiative to create new infrastructure and trade routes through Asia to Europe and Africa has added to ODI outflows.

Last year, China's investment in Belt and Road Initiative countries rose more than 38 percent to nearly U.S. $19 billion (126 billion yuan), accounting for 13 percent of ODI, the MOC said.

In the first eight months of this year, Chinese companies have signed some 4,000 engineering contracts valued at nearly U.S. $70 billion (467 billion yuan) for belt and road projects in 61 countries, Xinhua reported.

china-haier-appliances-shanghai-expo-novt27-2015-400.jpg
Chinese visitors look at electric home appliances manufactured by Haier Group at an expo in Shanghai, Nov. 27, 2015. Credit: ImagineChina
'Hot money' inflows

But some forces behind the investment outflow are not necessarily driven by government plans.

While China's previous economic boom brought it under pressure to strengthen its currency for much of the past decade, the more recent weakening has reversed sentiment after a pair of surprise devaluations in August 2015 and January of this year.

The problem of "hot money" inflows in expectation of a rising yuan soon gave way to fears of capital flight and domestic bets on further depreciation.

So, on top of the government's outbound initiatives, Chinese investors have been motivated to invest in safe havens abroad and dollar-denominated deals.

"The big jump in Chinese investment this year is private Chinese firms investing in the United States," Scissors said,

Without investment in the U.S. market, China's ODI at midyear would have grown by only about 18 percent, he estimates.

The China Global Investment Tracker has recorded U.S. $134.3 billion (896 billion yuan) of Chinese investments and contracts in the United States since 2005, including about U.S. $35 billion (233 billion yuan) so far this year.

The Rhodium Group, which publishes its China Investment Monitor, listed U.S. $18.4 billion (122.7 billion yuan) of Chinese ODI in the United States in the first half with 55 completed merger and acquisition (M&A) deals.

Major transactions this year include Haier Group's U.S. $5.6-billion (37.3-billion yuan) purchase of the General Electric Corp. appliance business and Dalian Wanda Group's deal to buy Legendary Entertainment for U.S. $3.5 billion (23.3 billion yuan).

The surge of M&A deals comes in addition to a wave of property investment, largely in the United States.

In the first half, Chinese investors spent U.S. $16.1 billion (107.4 billion yuan) on overseas properties, with the United States accounting for 52 percent of Asia's total, according to a study by California-based CBRE Group cited by the official English-language China Daily.

Many of the M&A deals may be seen as "strategic" investments, but how much they are driven by economic and currency concerns is hard to say.

Scissors said the currency consideration accounts for the surge and speed of the recent deals.

"I think there's a rationale behind all of them, but they are made in a hurry, they are overpriced, and there isn't necessarily due diligence being done to a full extent," he said.

In a competitive situation, the currency concern is likely to make Chinese bidders the most motivated buyers.

Controversy and consequences

China's ODI boom is not without controversy or consequences.

In the property sector, China Daily noted that Chinese investment has driven up housing prices in some cities like Canada's Vancouver, leading to new tax measures to cool the market down.

Reports have also raised suspicions about some of the tactics that China has used in pursuing its strategic acquisitions.

Last month, The New York Times raised questions about a Chinese plan to buy German semiconductor maker Aixtron SE for some U.S. $750 million (5 billion yuan).

The deal with the Fujian Grand Chip Investment Fund was announced in May, five months after Aixtron's main Chinese customer—Xiamen-based San'an Optoelectronics Co.—abruptly cancelled its orders, causing Aixtron's shares to tumble by 43 percent.

"Ultimately, both San'an, the customer and Fujian Grand Chip, the buyer, are recipients of government funds earmarked to help China build out its semiconductor capabilities," said The Times.

"While it's not clear whether the two coordinated in any way, they are a product of a new approach Beijing has taken to develop its semiconductor industry," it said.

Far larger sums in Europe are at stake with the pending U.S. $43-billion (287-billion yuan) takeover of the Swiss agriculture technology business Syngenta AG by China National Chemical Corp. (ChemChina).

The record-high price for a Chinese acquisition appears to reflect the mix of currency motivations and strategic goals.

"There is nobody who would pay more for Syngenta than the Chinese would," Scissors said.

How long will it last?

From an economic standpoint, there are questions about how long China's investment deficit can go on before it becomes a problem.

On the surface, a country that holds U.S. $3.185 trillion in central bank foreign exchange reserves should have little to worry about. But in August, reserves fell to their lowest level since 2011 after reaching a high of U.S. $3.99 trillion in June 2014.

Estimates of the minimum of forex that China needs to maintain stability and confidence in its currency, the economy and credit have ranged from U.S. $2.6 trillion to U.S. $2.8 trillion.

The current pace of ODI and net capital outflow suggests that China may face the consequences in two or three years.

Arguably, China's foreign acquisition and "belt and road" strategies were conceived when reserves were rising and the economy was growing faster, so that they are now out of proportion with what it can afford.

Scissors believes that if outflows continue, China will be forced to make a choice between its investment initiatives.

"You can have all this investment in rich economies ... or you can have One Belt, One Road but you can't have both. You don't have the reserves anymore," he said.

"China is not a rich country," Scissors said. “Money should not be leaving China on a net basis.”

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