China's 1H 2017 Economic Review, part 3: Overseas Investment

This is the third and final installment in my short series on China's first-half 2017 economic performance (part 1, part 2). This post looks at one of the most important trends for the Chinese economy in the past several years: Overseas direct investment. As we'll soon see, ODI has reached a turning point in 2017 but not the one you might expect given the cover image of this article.

Overseas Investment:

Just to be clear about the terms, we're talking about China's overseas direct investment (ODI) — i.e., Chinese companies, rather than individuals, outbound investments overseas — as opposed to inbound foreign direct investment (FDI) which got most of the attention until the late-2000s. Also, we're talking about investments for things like greenfield company setup, M&A, JVs, and other 'hard' investments, rather than investment in stocks and bonds (which is called portfolio investment, not direct investment).

While continued FDI is still important for China, ODI began to rise in the mid-2000s with deals like Lenovo's purchase of IBMs PC division, accelerated following the global financial crisis with big acquisitions such as Geely's purchase of the automotive division of Volvo, and finally decisively surpassed FDI in 2014:

What the chart above doesn't show is the precipitous drop of ODI in the first six months of 2017, off by 45.8 percent, to US$48.2 billion compared with the first six months of 2016. Of course 2016 was a huge year for ODI, China’s biggest year ever in fact, so a pullback was somewhat expected, but there were clearly other reasons behind the sudden fall. Let's look into them briefly.

Sinophobia

By late 2016 and early 2017, a large number of overseas deals were dogged by controversy in some way. Generally speaking, there was a growing fear of Chinese investment that started to echo the 1980s-era fears against Japan Inc. You may remember that back then it was the Japanese economy that was thought unstoppable. Japanese companies, buoyed by the bubble economy and a booming stock market, were often seen as extravagant and sometimes predatory in their acquisitions, which was expressed in movies like Gung Ho and Rising Sun when Japanophobia was at its zenith.

Today, it is China starting to play the role of acquirer of automotive companies and purveyor of mysterious financial and real estate deals. At first there was a sense of amazement and gratitude for China's rapid growth in ODI, which helped to inject new life into some of the struggling companies during the financial crisis.

The pace of investments accelerated further under Xi Jinping and Li Keqiang from 2013, and reached the peak in 2016, when Chinese companies collectively invested a record 1.1 trillion yuan (US$,166 billion), up 44.1 percent over 2015.

The nature of many of these new acquisitions was more tech-centric than in the past: One company, ChemChina, even spent US$43 billion on a single acquisition, for Swiss agro-chem giant Syngenta; a Chinese appliance company, Midea, bought the appliance division of GE, and later Kuka, a German industrial robotics manufacturer; HNA bought Ingram Micro, the biggest distributor of electronics, and many more deals.

The other big category of deals was more traditional, real estate: Property developer Wanda bought more movie theaters and land abroad; China’s insurers bought billions in hotels and other revenue-generating properties in major cities around the around with companies like Anbang fighting over the Starwood hotel group, and so on.

All told, it was the biggest year for Chinese ODI, which saw Chinese enterprises invest in 7,961 companies overseas in 164 countries.

These deals started to attract significant attention from both overseas regulators such as the Committee of Foreign Investment in the United States (CFIUS) which worried that Chinese companies were trying to acquire key military and electronics technologies on behalf of the government’s 13th Five-Year Plan and Made in China 2025 plan. It didn't help that China didn’t allow reciprocal investment access in many of its own market sectors. Finally, the funding for the acquisitions was often coming through government-owned banks or investment funds acting as proxies for state enterprises, which went against the non-government-owned market-oriented economics of the West. Thus began the wave of Sinophobia as deal after deal was examined by CFIUS and eventually abandoned when approval was not forthcoming. And of course Trump signaled through any number of his statements (though few actions) that he was not going to let China continue any one-sided deals.

Following the US's lead, other countries began to look more closely at Chinese deals, with Australia in particular rejecting a number of investments, cracking down on Chinese real estate investment, and getting embroiled in a scandal about Chinese political donations. The UK after Brexit was cautious about rejecting any deals but made it clear after Theresa May came to power that it was keeping an eye on Chinese investments by, for example, reviewing the Hinkley Point C nuclear power station project.

Meanwhile the EU was mostly powerless to block deals except on the strictest national security grounds. Germany, in particular, saw and exceptional number o deals. The first six months of 2016 alone saw more deals by volume than all previous deals combined, 37 of them in that period, as reported by EY.

At the Midea mega-acquisition of Kuka, Germany's Chancellor Angela Merkel could only throw her hands up saying, in effect, "Well, ,what can we do? EU regulations prohibit us from taking any action." She initially opted for diplomatic discussions with China's Prime Minister Li Keqiang for reciprocal investment access but later, by the end of the first-half 2017, she was open to the establishment of an EU veto on foreign investment, echoing more protectionist leaders such as France's Emmanuel Macron, and Germany itself started to put in places measures to block acquisitions of critical infrastructure with a very broad meaning including hardware and software.

Thus the tone of countries' governments towards Chinese investment has changed completely in 2017 compared with previous years.

Capital Controls

The second big reason for the dramatic slowdown in Chinese ODI was China’s own government bodies, including the People’s Bank of China and State Administration of Foreign Exchange, as well as the Ministry of Commerce among others starting to oppose these deals for a number of reasons.

First and foremost, the magnitude of the outflow of foreign currency was becoming alarming, especially in the second half of 2015 and early 2016 when outflows were making global headlines. So on the basis of foreign currency outflows alone PBOC and SAFE were generally opposed to these high levels of ODI. More broadly, in the context of President Xi's anti-corruption campaign, there was also a fear that such deals were merely being done to shift ill-gotten gains overseas or move assets abroad pending a possible collapse in China's economy.

Second, Chinese media started to question the need for some of the deals. MOFCOM itself even went so far as to start describing as "irrational" some of the deals, such as appliance company Suning buying a soccer club, or companies like Anbang apparently over-paying for assets like the Waldorf Astoria and other prestige investments, instead of acquisitions related to core businesses or practical technologies which the government wanted more of.

Conclusions:

There's not much else to say except that both factors -- foreign markets' fears of Chinese investment and Chinese capital controls against outflows -- have had a dramatic effect on Chinese ODI in the first half of 2017.

Foreign opposition through bodies such as CFIUS has stymied many of the in-progress deals that were problematic. In 2017 even a probable review by CFIUS is enough to scuttle deals from even happening.

Capital controls in China have resulted in even the biggest players such as Wanda being prevented from completing billion dollar acquisitions. It looks like all deals are going to be vetted on the Chinese side even more strictly against criteria such as matching national aims and not being overly exuberant in the purchase prices, otherwise they won't be approved for funding from state-controlled sources. This is a nice power for a government to have and it seems China is starting to use it.

With all this bad news, it is hard to find a positive to end with, but don't discount the effects of Made in China 2025 and the Belt and Road Initiative as driving forces for billions in new deals. Those deals that align with China's key interests with almost certainly get approved.

Final thoughts on the series:

Going back to the original theme of this series, China's overall performance in the first half of 2017, it is clear that none of the factors in part one, two or three is truly cause for alarm even though by most measures China’s economy is doing less well than it did before. Or the more skeptical might say, less worse.

For the rest of the year, I am betting on more of the same. There are some big challenges globally with the US-China relationship being a very big question mark at the moment, but I don’t see any of the China doomsday scenarios (e.g., property crash, debt crisis) happening this year. Especially with the 19th National Congress of the Communist Party of China coming up in the autumn, no chances will be taken.

Please let me know what you think in the comments!

If you liked this article and haven't read the previous ones, don't forget to check out the first two parts of the series:

Want to read more ideas and analysis of China’s economy? Check out my new book on the subject, called The Man, the Plan, the Dream, the first book in the China 4.0 series, available now on Kindle ebooks.