Collapsing foreign direct investment might not be all bad for China’s economy

Capital is leaving the country, but some net FDI outflows to other manufacturing destinations allow Chinese firms to avoid trade friction with the US.

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On the face of it, China is facing something of a crisis when it comes to the flow of foreign direct investment (FDI).

For more than a year, the net flow of FDI into China has been increasingly negative. Data released last month by the State Administration of Foreign Exchange indicate that during the year to September 2023, a net outflow of more than $140 billion of long-term investment left China, or just under 1 per cent of China’s GDP. A decade ago, by contrast, China was attracting net inflows of FDI to the tune of around 2 per cent of GDP.

In the three months to September, foreign firms withdrew $12 billion of capital from the country, the first time that’s happened in a generation.

Chinese firms are investing more abroad than foreign firms are investing in China, and foreign firms now seem unwilling to invest in China at all. In the three months to September, foreign firms withdrew $12 billion of capital from the country, the first time that’s happened in a generation.

What all this is saying is that long-term capital – precisely the kind of capital Beijing needs to boost the economy’s productive potential and shore up confidence among China’s gloomy corporates – seems to be voting with its feet.

And it’s not just FDI that seems to have had a change of heart about China. Since August this year, international investors have withdrawn some $25 billion from the market for China’s ‘A’ shares, namely those that are denominated in renminbi and listed in Shanghai or Shenzhen.

Foreigners have been selling their holdings of Chinese government bonds too. Back in late 2021, according to China’s official data, foreigners owned some $430 billion worth of Chinese central government bonds. By the middle of 2023 that had fallen to a level closer to $340 billion.

What’s particularly embarrassing about the outflow of FDI is that it has accelerated, despite notable effort during the past year to encourage more foreign companies to set up shop in China. After the Communist Party concluded its 20th quinquennial Congress in October last year, the government worked hard to welcome more inflows of FDI. That initiative seems to have yielded nothing.

The data are undeniably grim. But… there are two reasons for thinking that things might not be quite as bad as they look.

The data are undeniably grim. But in the spirit of trying to find a silver lining around all these clouds, there are two reasons for thinking that things might not be quite as bad as they look.

Geopolitical arbitrage

The first is that the some of the outflow of Chinese capital to other manufacturing destinations can be described as a kind of ‘geopolitical arbitrage’, allowing Chinese firms to side-step tariffs, and the risk of sanctions, by going abroad.

For example, over the past three years, nine Chinese car firms have set up shop in Mexico, with a local market share that is now close to 10 per cent. Their hope will be that local success will spread northwards, taking advantage of Mexico’s trade agreement with the US and Canada to sell cars to the US without attracting the 27.5 per cent tariff levied on cars shipped from China. This looks like a possible victory for ‘China, Inc’.

China’s FDI into Mexico builds on an earlier large flow of investment to Vietnam, where Chinese firms can save on the cost of labour, and de-risk exports.

China’s FDI into Mexico builds on an earlier large flow of investment to Vietnam, where Chinese firms can save on the cost of labour, and de-risk exports, particularly now that US–Vietnamese relations are bound by a Comprehensive Strategic Partnership signed in September.

In 2018, Vietnam’s imports from China were around a quarter of total imports. Now they are a third – a boost that seems linked to the fact that during the same period, Vietnam’s exports to the US have risen from below 20 per cent of total exports to just under 30 per cent. Again, a victory for China, Inc.

These trends help explain why Vietnam and Mexico have seen their exports to the US boom in recent years. The share of the US’s total imports from Vietnam has doubled in the past five years to reach 4 percent. And 2023, remember, was the year that Mexico replaced China as the US’ biggest trading partner. The role of Chinese firms in that transition is worth noting.

Japan’s experience

A second reason why China’s net outflow of FDI might not be catastrophic comes from Japan’s experience in the 1980s.

Japanese outward FDI increased rapidly in the early part of that decade partly, as with China today, to help Japan avoid trade friction with the US and Europe. Forty years ago, Japan’s net outflow of FDI was roughly equal to China’s today: around 1 per cent of GDP.

Net FDI outflows from Japan accelerated sharply in the latter half of the 1980s… which made it cheap for Japanese firms to acquire foreign assets.

Net FDI outflows from Japan accelerated sharply in the latter half of the 1980s, boosted particularly by an overvalued yen, which made it cheap for Japanese firms to acquire foreign assets.

All that ended in tears, of course, and FDI outflows fell sharply after the collapse of Japan’s bubble in 1989.

Yet Japan has enjoyed a long-term benefit from all its acquisition of investments abroad, namely that they generate a substantial flow of income for the Japanese economy. Last year, the income Japan received from its foreign direct investment approached 4 per cent of GDP. That income is a source of comfort to Japan’s ageing population and helps limits the risk of financial crisis for the economy.

It’s not at all obvious that Chinese firms would be as willing to repatriate income as their Japanese counterparts. It is much more likely that a large chunk of their foreign earnings will be kept offshore.

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The reason for that is simply that that Chinese capital controls have prevented Chinese firms and households from getting as much money out of the country as they’d like to.

That might change in the future, though, if Chinese officials make it more attractive to repatriate capital.

In the meantime, China’s outward FDI does seem to be buying a kind of geopolitical insurance policy for Chinese firms. Officials in Beijing might take some satisfaction from that, even at the expense of seeing capital leave the country.