For the first time since records began, China has suffered an outflow of foreign direct investment (FDI), raising market concerns about the prospects for the world’s second-largest economy and causing some observers to argue this is a sign that foreign firms have chosen to de-risk or ‘friend-shore’ their businesses.
The drop in FDI in the third quarter of 2023 (see Exhibit 1) has also been seen as indicating investors are pulling their money from China in the wake of Russia invading Ukraine and rising tensions around Taiwan.
The billion-dollar question is whether this is the start of foreign investors exiting China or a short-term phenomenon that will reverse as the dynamics change.
The difference between China’s balance of payments (BoP) data (reported by the State Administration of Foreign Exchange — SAFE) and utilised FDI data (reported by the Ministry of Commerce) gives us a clue as to whether foreign firms really are deserting China.
The BoP data includes foreign firms’ undistributed and unremitted profits, while the utilised FDI data does not. Hence, the value of the former is usually larger than that of the latter.
This gap has been narrowing since 2016 (see Exhibit 2) as foreign firms have repatriated profits rather than reinvesting their earnings or withdrawing investment from China. The exception to this pattern was 2021 when the pandemic stopped international capital flows (including multinational corporations’ profit repatriation), boosting the data gap.
There seems to be no disinvestment then from China before 2022, when both the BoP and utilised FDI data fell sharply. This decline could indicate foreign investors are leaving China. The utilised FDI data for 2023 were not available at the time of writing.
Outflows, permanent or temporary?
Nevertheless, two factors indicate that the recent drop in FDI inflows to China could be temporary.
Firstly, there is now less of an incentive for direct investment in China. The excess return on FDI – the rate of return on FDI minus the risk-free rate – has fallen significantly since the US Federal Reserve’s sharp policy tightening raised the risk-free rate to an average 5.25% in the first three quarters of 2023 from just over 2.0% in 2022 and 0% in 2021. This increase has reduced businesses’ risk appetite and their motivation to invest abroad.
Arguably, such risk aversion has led to FDI outflows not only from China but more widely. Europe has also suffered (see Exhibit 3). Given, however, the view that the US rate-raising cycle has peaked, and interest rates will eventually drop, the incentive for FDI should increase again and investment could flow back to China.
Secondly, negative sentiment over China’s disappointing post-Covid economic recovery and geopolitical tensions with the US have hurt FDI flows. This, too, may be changing.
China’s economy appears to have reached a ‘pain point’ (see “Beijing mulls aggressive easing as ‘pain point’ hits”, by Chi Lo, 15 November 2023). The current problems are expected to prompt Beijing to ease policy more aggressively to stabilise the property market and reverse the declining growth momentum.
There is evidence that such a policy shift is already happening. Sustaining such measures should give China’s economy and asset markets a chance to rebound in 2024, help turn around the negative sentiment and reverse the FDI outflow.
There are signs that Sino-US relations are stabilising: the two countries have increased their dialogue since May. The Xi-Biden meeting at the APEC summit in November provided a further indication of this.
More stable relations should go a long way to reducing the risk premium on cross-border investment, allowing companies to focus on the economic fundamentals.
FDI and China’s growth
Concerns that FDI outflows will hurt China’s economic growth should not be exaggerated. China does not depend on foreign investment to finance its development: FDI accounts for only about 3% of total investment.
Rather, FDI is important because it is a channel through which know-how, in the form of international best practice, is transferred to Chinese firms.
Furthermore, FDI brings international market discipline, which should enhance the competitiveness of domestic enterprises and improve governance.
New sources of foreign direct investment
While the US’s strategic foreign policy is reducing US investment in China, especially in sectors that the US deems strategic to its national interest, the Middle East (especially Gulf Cooperation Council (GCC) countries) is ready to step up its investment in China amid improving diplomatic and economic relations.
The six GCC nations – Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman – have sovereign wealth funds with assets totalling an estimated USD 4 trillion. Less than 2% of this is invested in Asia, including China. However, this situation is expected to change.
One estimate forecasts that GCC investment could grow to USD 10 trillion by the end of this decade, with USD 1-2 trillion allocated to China by 2030.
Some FDI could flow to China by stealth when players circumvent US government restrictions on directly investing in China, repackaging their investments in financial hubs such as the UAE and sending the money on to China (and Asia).
GCC countries and China do appear to be doing more business. In March 2023, Saudi Arabia announced its state-owned oil and gas company Aramco would build oil refineries with China for RMB 83.7 billion. It would also join the China-led regional security and trade club, the Shanghai Cooperation Organisation, in a sign of Saudi Arabia’s improving diplomatic relationship with China. These moves should help advance their talks on trading oil in renminbi.
In May 2023, the UAE signed three agreements with Chinese nuclear energy organisations, giving China an entry into the GCC region. In the third quarter of 2023 alone, Saudi Arabia, the UAE and Qatar signed investment and partnership agreements with China worth at least USD 5 billion, covering energy, research & development, industrial/green projects, and finance.
The list of joint events and agreements will likely grow as Sino-Middle East cooperation deepens.
Too early to be negative
While the latest FDI data will give China critics the firepower to argue for a decline of China, we believe they are missing this development of new sources. FDI is flowing from the Middle East (and other countries, especially in Asia), replacing the flow of FDI from the US into China.
When the dynamics change – a falling risk-free rate, improving prospects for China’s economy, and stabilising Sino-US relations – we believe it is realistic to expect that FDI flows to China will resume.