China’s economic clout is increasing. In 2016, China became a net exporter of foreign direct investment (FDI) for the first time. The Chinese renminbi (RMB) became the fifth currency to join the Special Drawing Rights (SDR) basket of the International Monetary Fund last year. Such feats bring tangible benefits. Outward FDI markets can provide avenues to invest at a time when excess capacity has been increasing in the Chinese economy. Growing international acceptability for its currency would help China in mitigating foreign currency risks. But they also bring risks. Reckless foreign investments can create bad assets. Radical reforms in currency markets and capital movements can make the Chinese economy more vulnerable to global volatilities. It seems that China’s policy approach is more concerned about the latter possibility.
China’s share in total outward global FDI was less than 2% in 2005. This increased to 14.7% in 2016. China is the second-largest FDI exporter in the world now. China’s growth story had been one of FDI-driven rapid expansion of manufacturing. However, the share of direct capital inflows in Chinese GDP has been coming down in this decade. In 2016, it became negative for the first time, implying that more FDI went out of China than what came in.
The Chinese government has adopted a cautious approach towards this development. China’s State Council (or the Cabinet) in August issued guidelines on overseas investments.
It warned Chinese companies against making risky investments in “real estate, hotels, entertainment, sport clubs, outdated industries." Instead, the government wants Chinese overseas investments to be aligned with the ‘Belt and Road Initiative’, which aims to link China to rest of the world through a network of roads, railways and ports.
It seems China is keen to avoid the mistakes Japanese companies made in the 1990s when they bought over-valued assets abroad, faced with low demand and excess capacity back home. Thus, Chinese mergers and acquisitions (M&A) abroad are being increasingly subject to regulatory and political scrutiny, according to a report by JP Morgan.
The recent stance of Chinese authorities is in contrast to its ‘Go Abroad’ policy, or zou chuqu, adopted in the early 2000s wherein China had loosened approval requirements for international deals and eased capital controls.
The Chinese government has also been exercising caution on movement of capital through other routes. It has tightened restrictions on residents’ ability to repatriate money abroad since 2015, when outflow concerns worsened. This comes at a time when portfolio channel outflows have depleted China’s foreign exchange reserves by $1 trillion since 2014.
At the same time China is luring international investors into its bond market through the “bond connect" arrangement between the Hong Kong and mainland Chinese markets
This highlights China’s dilemma: on the one hand it wants to promote greater use of RMB in international transactions and wants foreigners to invest in RMB-denominated assets. But on the other hand it is not ready to allow free capital mobility.
China’s move towards a market-based exchange rate for its currency has been very gradual after it abandoned the dollar-yuan peg in 2005. Yuan is a unit of the RMB. It took another 10 years for China to allow market forces to determine where the dollar-yuan pair opens every day. Even now, it is not exactly a market-determined exchange rate; yuan is allowed to fluctuate only +/-2% around the daily fixing, although the daily fixing has become more market-determined.
Continued restrictions have evidently hurt China’s stated goal of RMB internationalization. The RMB’s recorded global usage has dropped “with less than 1.7% of all international payments worldwide now settled in renminbi, down from nearly 3% in mid-2015", said the Asian Development Bank in a report released last month.
This setback for RMB comes despite its inclusion in IMF’s SDR basket last year. An SDR is a hypothetical currency used by IMF to settle accounts. Inclusion in SDR should theoretically increase the incentive for other countries to hold the Chinese currency.
China’s policy challenge is to devise a framework which acknowledges the changed economic landscape. China is no longer the economy which receives FDI from abroad and exports cheap manufactured goods to the rest of the world. Instead it has matured into a big economy, ready to invest overseas. At their 19th party congress, leaders of China’s ruling Communist Party need to take care of multiple objectives, which might often be conflicting – promoting strategic investments abroad and popularizing the RMB globally while at the same time maintaining external account stability.
This is the second of a two-part data series on the economic challenges facing China ahead of the 19th party congress of the ruling Chinese Communist Party. The first part looked at fundamental imbalances in the Chinese economy.
This is the second of a two-part data series on the economic challenges facing China ahead of the 19th party congress of the ruling Chinese Communist Party.