Saturday, 17 October 2009

China's outward direct investment: a recovery may be in the offing

Global FDI collapsed in 2008 and is continuing to fall in 2009, according to a recent OECD report, which showed that world FDI inflows fell by 35% year-on-year and FDI outflows fell by 19% in 2008, with early data for 2009 suggesting that global FDI outflows could this year dip below USD1 trillion for the first time since 2005.

So you may not be surprised to learn that China's outward direct investment (ODI), which has grown at an accelerating pace in this decade, has also collapsed. A report on the Chinese language version of the Invest in China website of China's Ministry of Commerce (MOFCOM) states that non-financial ODI from China in the first half of 2009 was only USD12.4 billion, a plunge of 51.7%  year-on-year.

So has the Chinese government's "go global" policy failed? Not a bit of it. China's ODI is certainly experiencing a bumpy roller-coaster ride, but the long-term trend remains sharply upward.


China has no lack of investment funds. During the past three decades of economic reform the savings rate, far from falling, as in other transition economies, has held up well and even risen. As a result, the savings:investment ratio has been 100% or more during all that time -- an enviable situation compared to that of other developing Asian countries, such as Indonesia, that have suffered chronic shortages of investment funds. Unlike them, China never needed foreign investment to fill the gap. Opening up to foreign investment was intended instead to help accomplish other goals: technology transfer, industrial upgrading, state-owned enterprise (SOE) reform, job creation, and so on. With massive current-account surpluses and continuing inflows of capital, China has built up huge foreign-exchange reserves -- these reached a record USD2.3 trillion by end-September 2009.

When China's sovereign wealth fund, the China Investment Corporation (CIC) was established in September 2007, it acquired USD200 million of the country's foreign-exchange reserves to invest abroad. Only a fraction of this money has so far been used for foreign acquisitions, which have been controversial both inside and outside China (for totally different reasons, which will be explored in a later blog posting). The point to note here is that these funds are probably dwarfed by hundreds of millions of dollars worth of foreign currency holdings of provincial governments that are also seeking to invest abroad -- a point that seems to have been entirely ignored by the world's media, perhaps because these holdings have not been made public.

The emergence of CIC resulted from the embarrassingly large accumulation of reserves, largely invested in low-yield US Treasury bonds, and the Chinese government's realisation that this represented a large opportunity cost in terms of riskier alternative investments.

Of course, no country would use all its foreign-exchange reserves to invest abroad. A good chunk of China's reserves needs to be liquid enough to cover several months of import cover and cushion unforeseen external shocks. But it is not only the government that has money in the bank. China's large corporations, which ten years ago were so heavily in debt that their non-performing loans threatened the stability of the banking sector, have now become profitable and have accumulated piles of retained earnings looking for a profitable home, whether in China or abroad.

China therefore has a massive war chest with which to go on an international shopping spree. So why the fall in ODI this year? The answer is simple: money is not everything. Foreign acquisitions are not like ordering a book on Amazon or popping into Louis Vuitton in the Champs Elysées to purchase an overpriced handbag. There are obstacles both at home and abroad. Chinese investors still face a series of approval hurdles within China before they can invest outside the People's Republic, including Hong Kong (which is why I'm not using the term "overseas investment", as Hong Kong is part of China and is still the biggest recipient of FDI from China and also the biggest provider of FDI to China). And even when these internal approval hurdles are cleared, Chinese investors may face screening in host countries, usually to maintain competition or protect national security. This screening may not be too different from the approval process for FDI projects in China, but Chinese investors may still have been surprised initially to find that it also exists in other countries. As a result, some massive natural resource deals were blocked in the first half of 2009 that, had they gone through, would have meant a big leap in total ODI instead of the sharp fall that actually happened.

The prospects for China's ODI in the closing months of 2009 and in 2010 are highly optimistic. Partly as a result of a partial relaxation of the approval process, the number of ODI projects submitted for approval in the first half of 2009 actually rose by 43.5% year-on-year, and 13 of them exceeded USD100 million each. This is made clearer if you look at the monthly figures: approvals picked up sharply in May and June, when the number of new ODI enterprises approved by both MOFCOM and its provincial equivalents shot up by 173.5% year-on-year. Another factor suggesting robustness of China's ODI is that around one-third of it now comprises reinvested earnings, even in this difficult global economic climate.

Is this a good time for Chinese investors to snap up bargains? The Chinese yuan, officially pegged to a basket of currencies but in practice still loosely tied to the US dollar, has not been allowed to rise to rates that would bring about equilibrium in China's international payments. This means that acquisitions are still expensive in yuan terms, especially outside the dollar area. But the low exchange rate has been maintained to prevent an even greater collapse of exports, and is helping to keep reserves high.

So while the biggest shopping spree of all -- the one that will take place when the yuan rises -- is not yet on the cards, this is obviously a good time to look for bargains. Mindful of "peak oil" and the need to keep China's ravenous industrial growth fuelled, China will continue to seek deals that lock in prices of energy and raw materials, as it has been doing for several years. An increasing proportion of ODI will take the form of M&A deals to acquire top international brands and market share.

But obstacles remain, so the ride will continue to be bumpy. A major problem is that of perception in host countries. Partly as a hangover of the cold war, fears remain that China's large outward investors, which are still mostly SOEs or ex-SOEs, are the arm of a one-party Communist dictatorship, so might be used for political, i.e. diplomatic or military, purposes. Even if major deals like CNOOC-Unocal pass national security screening, they may thus be blocked by legislatures or by public opposition. From a competition point of view, there is a fear that Chinese enterprises, and not just SOEs, have "deep pockets", because the Chinese government will provide them with enough cash to beat rival bids. In developing countries, especially in Africa, Chinese ODI is welcomed because it usually comes with unconditional ODA, but it is also criticised for failing to produce spill-overs such as local job creation and domestic enterprise development, and even for undermining the continent's own infant industries.

While these perceptions are often exaggerated, there is no smoke without fire. China needs to do more than improve its PR. Chinese corporations need to improve their corporate governance in line with the country's own Code of Corporate Governance so that their structures and operations are transparent. Their managements should be accountable to shareholders, not Communist Party appointees. Their accounting practices should meet international standards, as required by China's own legislation, so that any state funding of acquisitions can be clearly seen. And Chinese corporates can do themselves a favour be declaring that they will abide by internationally-recognised standards of behaviour such as the OECD Guidelines for Multinational Enterprises (which they can read online in Chinese) and set up management structures to monitor and enforce their own practices in the many areas covered by the Guidelines, including compliance with local laws, paying taxes, environmental protection, maintaining core labour standards, upholding human rights (i.e. of workers, women, children, etc.), fighting discrimination, consumer safety (a big issue within China as well as for its export markets), combating bribery, promoting education, and so on. If they do all this, they may find that they are welcomed abroad, and not just for the odd injection of funds to rescue failing companies.

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