By Andy Busch, Global Currency and Public Policy Strategist, BMO Capital Markets
With the growth and development of the Chinese economy, there has been a corresponding growth and interest for Chinese firms and investors to expand their operations and investments overseas. From 2002-2009, Chinese outbound direct investment has been growing at an average of 54% annually. In 2009, the country ranked first amongst developing nations in terms of direct investment and is likely at the top in 2011 as well. There are three main groups involved: the governmental level, the corporate level and the retail investor level. For this article, I will contain my comments to the enterprise level.
Global Currency and
Public Policy Strategist,
BMO Capital Mark
Enterprises or corporations have numerous reasons for desiring to invest overseas. First, these firms may want to gain access to outside markets to expand their sales reach globally. Second, they may want to gain access to technology, intellectual property and talent to expand their capabilities and knowledge. Third, they may want to gain access to stable supplies of commodities and energy that can’t be met domestically. Lastly, these firms may want access to foreign markets to diversify their products to enable a more stable stream of income sources. All are legitimate reasons for Chinese firms to increase their overseas investments.
There are many complicating factors facing Chinese firms who want to invest overseas. There is the domestic regulatory process, there is the foreign regulatory process, and there is the foreign exchange process. All three may slow the investment sequence down and put Chinese firms at a disadvantage over foreign firms competing in the same space.
For Chinese outbound investment, the domestic approval process for a domestic firm has several layers that need to be navigated. Outbound capital account transactions in China require government approval and are closely regulated. As well, these firms usually rely on domestic bank financing for their outbound investments and this is regulated as well. The time frame for securing these approvals has recently been streamlined, but can still be lengthy for specific financial transactions such as M&A and may put Chinese firms at a disadvantage when competing with firms that don’t have similar regulatory structures.
For example, a Chinese incorporated firm with domestic funding needs to receive approvals before an off-shore investment can be made. Generally, this starts with an approval by the National Development and Reform Commission for the overseas investment project,then it moves to the Ministry of Commerce for transaction documentation, and finally ends at the State Administration for Foreign Exchange for the currency. The process can take from two to three months.
Also, the foreign regulatory process can either lengthen the process or stop it altogether. As an example, Chinese firms are unable to borrow funds offshore and therefore need to borrow from domestic Chinese banks. If a Chinese firm borrows from a policy bank such as the China Development bank or the Export and Import Bank of China, foreign governments (and competitors) have sometimes viewed these as unfair subsidies. Also if the acquisition is deemed to be in a sensitive sector such as telecommunications or energy, the investment may draw the interest of politicians who want to protect these companies from being acquired.
There may also be the fear of losing their “national champions” to foreign companies.The attempt of China National Offshore Oil Corp’s failed bid to buy US Unocal is an example of what can happen when a large, high profile investment is attempted. Also, the recent European Commission review of the DSM and Sinochem joint venture is illustrative of foreign regulators closely examining proposed deals with Chinese State-Owned Enterprises (SOEs). All of these examples complicate and slow outbound investment for Chinese firms.
Lastly, the controls on the capital account and on foreign exchange present another area for Chinese firms to navigate. China’s stated goal is to move towards capital account convertibility of the RMB. Given the rapid flow of funds out of emerging markets during the 1997 Asian currency crisis, China is still concerned about the potential risks to the Chinese financial system and economy should cross border flows be completely free. However, China has recently embarked on a new plan to internationalize the use of the RMB for international trade and finance while it remains inconvertible for capital account transactions.
Internationalization of the RMB has numerous positive attributes for Chinese firms:
- Reducing foreign exchange risks for Chinese firms by pricing foreign trade in RMB; reducing fluctuation of capital by having a greater proportion of bank assets in RMB; reducing the availability risk or liquidity risk of foreign currency and permitting the use of RMB as a lending currency of last resort.
- Strengthening the competitiveness of Chinese financial institutions because of greater access to a large pool of RMB assets. Boosting cross-border transactions by using RMB to settle trade transactions.
- Permitting seigniorage (the difference between the face value of paper currency issued by the government and the cost of printing the money — the “profits” from printing money), although this is deemed a secondary benefit.
- Preserving the value of Chinese savings, by making it more likely that a greater portion of the national “balance sheet” will be held in RMB denominated assets rather than depreciating foreign currency denominated assets.
All are important positives, but all take time to develop. What’s truly unusual about the current program is that China is attempting to implement the RMB first as a unit of account, a medium of exchange and as a store of value prior to having the currency float freely. China hopes to achieve the goals of facilitating Chinese international trade, making Chinese financial institutions more competitive and more active in international markets, and permitting the Chinese government the same “exorbitant’ privilege that the United States had in the US Dollar being the international reserve currency: the US would not face a balance of payments crisis, because it purchased imports in its own currency.
When it comes to the currency, Chinese enterprises also face the risk of trade sanctions and protectionism over the perceived under valuation of the RMB.Foreign countries believe that China manages its currency to the benefit of its exporters and to the detriment of foreign competitors. Given the large Chinese trade surplus with the United States, this risk of trade protectionism has risen to an acute stage. On this subject, President Barack Obama said “China has been very aggressive in gaming the trading system to its advantage and to the disadvantage of other countries, particularly the United States.” At the APEC conference in November of 2011, President Obama stated that the United States is growing impatient over the issue of the currency.
On October 17th, the United States Senate passed legislation letting companies seek duties to compensate for a weak Chinese Yuan.The Senate bill mandates that the Treasury Department identify misaligned currencies, instead of deciding whether a currency was manipulated, as is now required. Governments that undervalue their currencies and don’t take corrective action would face penalties, including increased dumping duties, a ban on federal procurement in the U.S. and ineligibility to receive financing form the Overseas Private Investment Corporation.
Fortunately, the legislation still needs to be passed in the US House of Representatives where many are circumspect over the bills value. Speaker of the House John Boehner stated, “To force the Chinese to do what is arguably very difficult to do I think is wrong, it’s dangerous. Given the economic uncertainty around the world, it’s just very dangerous and we should not be engaged in this.”Should this bill be passed, it is unlikely to survive if it is brought before the WTO. However, the process could take up to 2 years before the law would be suspended and Chinese companies compensated.
Ironically on October 12th, President Obama just signed into law free trade agreements with South Korea, Colombia and Panama, authorizing the most significant expansion of trade relations in nearly two decades. The agreement with South Korea is designed to break down barriers between the United States and the world’s 15th-largest economy. At the APEC conference, President Obama said he was optimistic a trade pact called the Trans-Pacific Partnership (TPP) could draft a legal framework for a free trade bloc in the Asia-Pacific region. The Financial Times reports that the focus of the TPP is on non-tariff barrier issues, including government procurement, the conduct of state-owned companies, regulatory convergence and protection of intellectual property. The nine nations of US, Australia, New Zealand, Singapore, Malaysia, Vietnam, Brunei, Chile and Peru are included with Japan stating its interest to join the discussions. At the APEC conference in Hawaii, Chinese President Hu Jintao said that China supported the TPP and said, “China supports the goal of the regional integration of the Asia-Pacific economy, using the East Asian free trade zone, full economic partnerships in Asia and the Trans-Pacific Partnership as foundations.”Clearly, a free trade pact that includes China will be most likely beneficial for Chinese enterprises as it reduces the risk of trade wars and reduces barriers to their exports.
Overall, the challenges for overseas investments by Chinese enterprises remain high. From domestic regulation to foreign regulation to a closed capital account, all of these generate elongated time horizons for outbound Chinese investment. Also, the RMB currency program is seen as a potential catalyst for trade sanctions that further complicates the investment choices for Chinese firms. Clearly, any steps taken in the direction to reduce trade barriers and reduce friction between countries will enhance Chinese firms’ ability to invest overseas.
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