China's great investment transition

After years of being a foreign investment recipient, China's outward investment is starting to gather steam. But how large and fast will Beijing allow it to grow and what will be its defining charateristics?

For years, China has been one of the world’s largest recipient countries of foreign direct investment. In 2010, however, its outward direct investment (ODI) reached an unprecedented US$68 billion and China became the world’s fifth-largest overseas investor. China’s cumulative ODI of US$310 billion is still relatively small compared with its cumulative FDI of US$1.5 trillion. But Chinese ODI will undoubtedly become more important in the near future, as the Ministry of Commerce expects annual outward investment to outpace FDI by 2015.

As a middle-income country, China holds an outsized net international investment position of US$1.7 trillion due to government intervention in the foreign exchange markets. About 83 per cent of its total assets of US$3.4 trillion are foreign exchange reserves, mostly invested in foreign sovereign bonds. But 87 per cent of its total liabilities are equities, and such a mismatch not only affects returns on China’s international investments, but also constrains the private sector’s ability to expand overseas.

This picture may change soon, as the Chinese authorities are now acting to internationalise the renminbi. Of course, whether or not the renminbi will become an international currency is scarcely a call for China to make on its own. But in order to internationalise the currency, the government plans to implement reforms in three key areas – the liberalisation of interest rates, exchange rate policy and the basic convertibility of the capital account – which should help the process along.

These reforms will likely have significant implications for the world, as well as for China. With greater flexibility of the exchange rate, the renminbi may show more two-way movement, although rapid appreciation would probably persist. The current account surplus, which already fell from 10.8 per cent in 2007 to 2.8 per cent in 2011, may continue to narrow. And as China’s accumulation of foreign exchange reserves slows and even becomes negative, an equally important shift could occur through increases in its international equity investment, including through ODI.

Chinese outward direct investment is a relatively new phenomenon. In 2002, the first year after China’s accession to the World Trade Organization, China’s total ODI was less than US$3 billion. By 2010, however, it had already increased to more than 20 times this amount. According to forecasts by economists at the Hong Kong Monetary Authority, if China does liberalise its capital account, Chinese ODI stock could rise from US$310 billion in 2010 to US$5.3 trillion by 2020. If this prediction turns out to be correct, then China may well become the world’s largest outward direct investor by this time. While the scenario is entirely possible, China will need to overcome several major obstacles if it is to develop successful ODI practices.

To start with, Chinese authorities will have to lower regulatory barriers. At the moment, a company wishing to invest directly overseas has to obtain approval from three different government departments: the National Development and Reform Commission, the Ministry of Commerce and the State Administration of Foreign Exchange. Administrative costs for this process remain high, especially for non-state companies, which could potentially deter private sector involvement – although policy makers often claim that these departments rarely stop any ODI project.

China can only become a dominant ODI investor globally if the private sector plays a more prominent role. China’s state-owned enterprises often face tougher challenges overseas because of their perceived linkages with the Chinese state. Regulators and competitors in host countries regularly accuse SOEs of using state-provided resources to achieve government objectives in their investment projects, even if these investments are purely commercially oriented. To be fair, this suspicion is not completely groundless, as SOEs often use their state linkages to disadvantage domestic competitors.

It is also true that Chinese ODI exhibits several unique characteristics which set it apart from more-familiar practices. Economists generally identify two different types of ODI: the American type, whose main purpose is to gain market entry; and the Japanese type, whose main purpose is to take advantage of low production costs. Despite these differences, the two styles do have one thing in common – both American and Japanese companies generally relocate their main production facilities to the host country once an investment is made. Chinese ODI, on the other hand, is quite different because a company’s main production facilities will usually stay in China.

Chinese companies also tend not to invest in areas where they already have a comparative advantage. Instead, they focus on three key areas of investment: first, companies operating in the same industry as the investor, but which have advanced technology, management or brand names; second, commodities which are used intensively in Chinese production; and third, service companies that could facilitate exports from China-based factories.

China’s unique approach to ODI is largely determined by its current stage of economic development and the level of its production costs. China still enjoys significant cost advantages – at least productivity-adjusted cost advantages – compared with many other developing countries. In general, relocating factories overseas can yield only limited financial gains, although this is gradually changing. This means that, for now, the purpose of Chinese-style ODI is to strengthen domestic production facilities – not to move these factories overseas.

But this can only be a transitory phenomenon. For instance, as production costs continue to rise rapidly, some Chinese companies producing garments, toys and footwear are already looking for new production bases in Southeast Asian countries and in inland Chinese provinces. So, the Chinese style of ODI may gradually evolve to more closely resemble the Japanese or even the American type of ODI. China has already been one of the world’s largest investors for the past decade and it may keep this position over the coming decade, but there must be change during this time. The People’s Bank of China will likely give way to the private sector as China’s dominant overseas investor, and the shift from sovereign bonds to direct equities as the main focus of this investment could prove to be an historical event for the world economy.

Declining Chinese demand for ‘safe assets’ (sovereign bonds) could point to relatively weaker support for the traditional reserve currencies such as the US dollar and the euro. And China itself may also become a supplier of safe assets as it opens up its capital account and develops its government bond market. Consequently, China’s yields should rise in general, adding further pressure to the fiscal sustainability challenge faced by many developed economies.

But this pressure may also provide an historical opportunity for the global economy to benefit from such large-scale change. Chinese ODI will likely contribute to the formation of new divisions of labour around the world, and this should produce direct benefits for countries with comparative advantages in labour-intensive industries. Even developed economies could benefit from Chinese capital and experiences in economic development. It all depends on which countries are willing to take advantage of this new opportunity.

Yiping Huang is professor of economics at Peking University and at the China Economy Program, the Australian National University. He is also chief economist for Asia at Barclay’s Bank, Hong Kong.

This article appeared in the most recent edition of the East Asia Forum Quarterly‘China’s Investment Abroad’.

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