Permission to Reproduce: A version of this post was published as “The Chinese prefer investing overseas; dummy companies may ease transfers and devalue renminbi” by YaleGlobal Online, September 10, 2015; it was the number-one story in a Google search for “China FDI” that day and is also available as a podcast.
The Sudden RMB Devaluation in August 2015
The global panic in financial markets in August 2015 was catalyzed by the relatively sudden devaluation of the Chinese yuan or renminbi (from 6.2 to 6.4 RMB/$). The Chinese government may have had several reasons for setting the daily reference rate for the RMB at a lower level, for example to signal greater market flexibility or to support its exporters. However, the fact is that enormous amounts of liquid money held by Chinese individuals and companies has—for many years—been anxiously trying to leave China (i.e., leave the RMB as an asset) and park itself in non-Chinese assets such as a Manhattan or Sydney condominium, US stocks, a Singapore bank account, or simply luxury goods. That has created the devaluationary pressure in the exchange markets.
Figure 1: RMB to Dollar Exchange Rate Changes – Summer 2015
The reasons are clear. China is getting richer, and by some accounts (using the World Bank’s implicit estimate for the purchasing power parity [PPP] theoretical exchange rate for the RMB) it may already be coequal with the US as the world’s largest economy. In short, trillions of RMB in liquid assets are trapped inside China. Why trapped? Because the current rules do not allow the Chinese to convert RMB into other currencies without a commercial justification.
A company or individual cannot just go to a bank in China with RMB and ask that they be converted into, say, US dollars. The request would be refused unless the form you fill out shows documentary proof that you are a sanctioned importer, or your child’s tuition in an American university needs to be paid, or that the Chinese firm has a foreign subsidiary that needs funds. In short: you need a provable justification.
Foreign Direct Investment (FDI) Outflows from China and the Difficult-to-Believe Statistics
One stratagem likely used by Chinese companies for getting permission to move funds out of China is to create dummy companies in Hong Kong and the Caribbean. As far back as 2011, the OECD (Organization of Economic Cooperation and Development) reported that as much as 57.4 percent of all outbound FDI capital went to Hong Kong affiliates or subsidiaries, and another 12.7 percent to Caribbean entities. (See Figure 1.) By contrast, Chinese companies’ outflow of FDI capital used to invest in European or US affiliates totaled a mere 8.2 percent.
Figure 2: Hidden Patterns in Chinese Companies’ Outward FDI
That means that as much as 70.1 percent of Chinese outbound FDI capital flows (exceeding $100 billion per year since 2011) has gone to two tiny economies, the Caribbean and Hong Kong. Moreover, data gleaned from UNCTAD (United Nations Conference on Trade and Development) shows a suspiciously large number of Chinese FDI-affiliated companies outside China. (See Figure 2.) For the world as a whole, the number of multinational companies (headquartered mainly in North America, Europe, and Japan) totaled 103,786. Of these, the UN data show 12,000—or 11.6 percent of all multinational firms in the world—as being headquartered in China. This appears plausible, as Chinese companies are indeed increasing their global reach. But then, in Figure 2, look at the number of foreign affiliates or subsidiaries of Chinese companies, said to total a remarkable 434,248 in number—or 48.7 percent of the world total.
If this is to be believed, Chinese multinational parent companies each had as many as 36 foreign subsidiaries or affiliates, as against the rest of the world whose multinational parent firms averaged only 5 foreign subsidiaries. Are the Chinese Ministry of Commerce numbers to be believed? Yes. With a 2,000-year-old bureaucracy, the Chinese usually do keep meticulous data. The numbers appear to be authentic, but they reveal a hidden story—that a significant fraction of the Chinese company subsidiaries in the Caribbean and Hong Kong are mere shell companies. Many of these dummy firms are likely created for a principal reason: to create a justification for the conversion of RMB into foreign currencies. In other words, the fake companies facilitate a hidden capital outflow that is not really intended for business purposes, but to get money out of China on behalf of the owners.
It is true that a fraction of the mainland China FDI outflow that goes to Hong Kong affiliates comes back to the mainland for investment purposes in a “round trip” (since a Hong Kong company can pose as a “foreign” investor and enjoy benefits such as cheap land that a purely domestic investor may not get). Other Hong Kong affiliates may be intended to mitigate the perceptual drawback of an investor originating from mainland China. But a significant (unknown) fraction of the outward FDI emanating from China and going to Hong Kong—plus most all of the outflows going to Caribbean havens—is intended for owners to get money out of China for tax benefits or to invest in a Singapore bank account, US equities, Australian property, or a Manhattan luxury apartment.
A World Awash in Cash and Liquidity (It’s Not Just the Chinese)
In 2015, Chinese purchasers topped the list of foreign buyers of Australian and US real estate. In the 12 months up to March 2015, the Financial Times reported that Chinese buyers spent $28.6 billion to buy US property and that Chinese are the top buyers of housing in New York, Vancouver, London, Sydney, and Auckland. Hundreds of multimillion-dollar Manhattan apartments lie empty, functioning merely as an investment for wealthy foreign buyers that rarely visit.
But it is not just the Chinese who have become richer and seek to diversify their asset holdings out of China. The world as a whole is awash in liquidity (i.e., cash and quickly sellable assets), conservatively estimated upwards of $75 trillion and likely exceeding $100 trillion. Worldwide, mutual fund assets alone exceed $30 trillion, with probably double that amount in bank or bank-like deposits.
In an important respect, this is a thrilling story. Probably a billion-and-a-half or two billion people around the world have become affluent enough to have investable savings. But then this worldwide flood of money is seeking places and financial instruments to invest in. And in a global arena, this creates the need to convert from one currency to another. When there is a sudden, collective rush to sell billions of one currency (and buy another), its value can go down sharply, despite government counter-purchases—as seen in the August 2015 devaluation of the RMB.
Global Panics, Manias, and Exchange Rate Crises: A Thundering Herd of 500 Million Savers
Worldwide, a billion-and-a-half to two billion middle-class to affluent individuals—or, say, 500 million heads of households who actually manage the family’s savings—are aware of investment options and seek a place to park their savings. Likely, almost all of them have an Internet connection that amplifies news reports, fears, phobias, and panics. When all is said and done, in August 2015 no deep, fundamental economic reasons existed for the simultaneous swoon of stock markets around the world. The Chinese economy is slowing down, from the heady days of over 10 percent annual growth rate to a mere 6 or 7 percent. But so absurd is the news hype and consequent global angst, amplified by the Internet and media, that a 6 or 7 percent growth rate—which ordinarily would be the envy of most nations—instead gets protrayed as a reason to sell assets. Similarly absurd is the portrayal of a mere 3 percent devaluation of the RMB (from 6.2 to 6.4 per dollar) as cause for panic, selloffs, and crashes.
A global civilization that is intimately interconnected and awash in liquidity is also one that is prone to collective global psychology, manias, and herd instinct. Be prepared for more thundering hooves and market gyrations in the future.
For the past 30 years, India has been governed by a series of raucous coalition governments. At least some of the caution, vacillation, and even backtracking on investment and taxation policies that have dismayed foreign companies contemplating foreign direct investment (FDI) in India can be attributed to this. At the federal level (as well as in many states), coalition viewpoints had to be accommodated, often leading to legislative paralysis and lack of policy clarity.
In my April 12, 2014 post What the Indian Election Means for Foreign Direct Investment (FDI) in India, I described how India is a multicultural and multireligious pastiche, with more than 22 official languages (some say more than 780). Every religion on earth has adherents in India, although India’s 2011 census shows six major religions dominating. Even within Hinduism, which includes 81 percent of the population, the worldview varies depending on which of the 3,000 subcastes a person belongs to.
Democracy in India functions as a noisy forum for a thousand interests and viewpoints. Coalitions have been the political norm. Given India’s diversity, one party gaining a majority has been an unlikely event. However, in the 2014 election, the BJP (Bharatiya Janata Party) has been handed a rare opportunity—an outright majority, having captured 52 percent of the 543 lower house seats. With its coalition partners, Narendra Modi’s government will enjoy a comfortable 62 percent.
Under the previous Congress Party government, opening the gates to FDI and dismantling bureaucratic obstacles progressed well until 2008. The Indian economy grew at previously unprecedented rates of 7 or 8 percent annually. But after 2009, all reform came to a halt because of infighting among the ruling coalition, as well as the global slowdown. Each budget year saw backtracking and zig-zagging on taxation, industrial policy, and FDI policies, as well as hundreds of corruption cases. The slowing of economic growth to below 5 percent sealed the image of the Congress government as paralyzed, incompetent, and unable to meet the job aspirations of millions of new voters since 2009. Although India’s population growth has slowed, nevertheless as many as 150 million crossed the threshold from adolescence to adulthood in the last five years, during which time job creation has been inadequate.
The last five years also saw a number of well-publicized FDI disasters. Posco Steel of Korea would have made the largest investment in India to date, $12 billion, and Vedanta Resources based in London proposed FDI in the aluminum sector worth more than $8 billion. But both were torpedoed by regulatory and land acquisition snarls at the state level, with the federal government too weak to intervene. Tata Motors, part of the multinational Tata Group, had to withdraw from a partially initiated project to build Nano cars in West Bengal.
To the rescue came a decisive Gujarat State Chief Minister, Narendra Modi, who induced the Tata Group CEO, Ratan Tata, to switch his investment to Gujarat. Regulatory clearances and land were obtained in less than one month’s time. This is only the latest illustration of investment flocking to Gujarat State because of a dynamic leader who cuts through bureaucracy and is widely regarded as a decisive, straight-arrow, no-nonsense, pro-business leader. While over the past five years the rest of India grew only modestly at 5 percent per year (still a growth rate that would be the envy of most other nations in today’s economy), Gujarat State grew at more than 10 percent annually—a remarkable achievement.
Narendra Modi (center) with the CEOs of India’s two largest business conglomerates (Mukesh Ambani of the Reliance Group is at the extreme left and Ratan Tata from the Tata Group is second from the right) with other foreign executives.
With a comfortable outright majority in Parliament, Narendra Modi has been handed a historic opportunity in Indian politics. His singleness of vision, unsullied resumé (except for serious allegations of an anti-Muslim animus), insistence on quick action, and ability to cut through bureaucratic red tape all bode well for investment in India.
When a company goes abroad, it faces the extra hurdle of unfamiliarity with the local market, its culture, its regulations, and its institutions. Sometimes, the national origin of the firm is looked down on. An example is the skepticism and mild hostility toward Chinese products in some nations.
Becoming “multinational” is difficult enough for US and European firms. What explains the success of companies based in emerging nations that face a greater hurdle in doing business in advanced markets? If you bought a Jaguar, you purchased from an Indian-owned auto company. An American who boards a “regional jet” (under 120 seats) is most likely in an aircraft made by Embraer of Brazil. If you watch a movie in an AMC theater, it is owned by the Wanda Group in Dalian, China. Small refrigerators are produced by Haier of China in their US plant. Volvo and Lenovo, familiar brand names, are Chinese-owned.
So what are the competitive advantages of emerging market multinationals that enable them to overcome not only the ordinary hurdles of global business, but, in addition, the drawbacks of an emerging-nation home base?
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