Capital Outflows from China and the Hidden Story in China’s FDI Statistics

© 2015 Prof. Farok J. Contractor, Rutgers University

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.

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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

Source: Yahoo Finance

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[1]) 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.

Capital Controls

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.[2] 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,[3] 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.[4]

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.

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[1] The World Bank’s PPP exchange rate for the RMB is below 4.0 per US dollar, which, together with the 1.3 billion population, makes China’s economy large. See for example my January 2, 2015 post, Is China set to become the world’s largest economy in 2015?

[2] Anderlini, J., Chinese take lead among foreign buyers of US homes, June 18, 2015.

[3] 2014 Investment Company Fact Book, A Review of Trends and Activities in the U.S. Investment Company Industry (54th edition).

[4] Bloomberg News, China Sells U.S. Treasuries to Support Yuan, August 27, 2015,

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