In the winter of 2009, the developed economies gazed into a financial abyss. The collapse of American subprime mortgage markets in 2008 provoked the worst US recession since the Great Depression, and dragged most of its trade partners down with it. Growth reversed, unemployment rates leapt and stock markets plunged.
For China, the crisis presented an historic opportunity. Fu Ziying, vice minister of the Ministry of Commerce (MofCom) at the time, pointed out that the West was holding the biggest bankruptcy sale in history: “Well-known [Western] enterprises and research organizations have fallen into difficult positions. These firms possess well-known brands, formidable international sales networks, and relatively strong research capabilities. If our firms can successfully acquire them, we can use these resources to greatly enhance Chinese firms’ international competitiveness.”
But while Chinese state-owned enterprises (SOEs) did snap up bargains in raw materials and energy resources, there was no mass rush to buy well-known brands, sales networks or research capabilities. Chinese overseas direct investment (ODI) did spike in 2008, hitting US$70 billlion. But US$46 billion of that was produced by two deals. In 2009, Chinese outbound direct investment declined 42%.
“In retrospect it was a missed opportunity,” said Yao Shujie, professor of economics and head of the School of Contemporary Chinese Studies at the University of Nottingham. “China had tons of money, especially huge foreign exchange reserves, but none of the investment opportunity actually took place during the bottom … and now the market is pretty high.”
Today, the media is once again forecasting a new great leap forward in overseas investment. The Asia Society
published a report in May predicting that Chinese outward direct investment will reach US$2 trillion by 2020. Some Chinese officials now claim that outbound direct flows will exceed inbound flows within three years.
But the optimism begs the question: If Chinese companies didn’t buy low before, why would they buy high now?
Fear factor
“Going global” has been an explicit policy goal since President Jiang Zemin inserted the phrase into the text of the 10th Five-Year Plan. But China has always been relatively tight-fisted when it comes to overseas M&A. In 2010, the nation spent 5% of its GDP on overseas acquisitions, compared to a developing economy average of 16% and a global average of 33%. The world’s second-largest economy accounts for only 1.2% of global foreign direct investment stocks.
The scale of the lost opportunity is tragic. During the crisis, Chinese capital could have saved hundreds of thousands of jobs overseas that were destroyed for want of cash alone; by doing so, it could have ameliorated much of the political damage that its pro-export currency policy has done to its trade relations.
Instead, Beijing made the uninspired decision to avoid the global downturn by plowing yet more cash into infrastructure investment. While the US$586 billion stimulus package kept GDP growth chugging along – how could it not? – it was also overdone. It exacerbated inflation by increasing demand for raw materials, encouraged speculation in real estate, exacerbated manufacturing overcapacity and put local governments in (at least) US$1.65 trillion in debt.
Worse, in some sectors Beijing’s spending package actually strengthened the position of foreign competitors against Chinese brands. According to the United Nations Council on Trade and Investment, foreign firms invested US$95 billion in China in 2009, nearly twice as much as Chinese firms invested overseas (US$48 billion) during the same period. Many were attracted by strong Chinese demand derived from policy stimulus. Ford, for example, massively ramped up China production capacity to meet subsidized demand for passenger cars, which helped drive its revenues to new heights.
In contrast, consider mainland car maker Geely. Geely spent US$1.5 billion taking Volvo off of Ford’s hands in what turned out to be the most significant acquisition of a foreign brand by a Chinese company during the financial crisis. But it’s unlikely to help Geely compete with Ford. Technology transfers and operational synergies between Geely and Volvo appear minimal. When China Economic Review asked Michael Ning, vice president for public affairs at Volvo China, what advantages the Volvo acquisition would give Geely in going overseas, he spoke bluntly: “None whatsoever.”
20/20 hindsight
It’s easy to criticize Chinese managers for not buying at the bottom, now that it’s clear where the bottom was. Fear of the unknown held many investors back, and not just in China.
Nor should caution be confused with cowardice. Most Chinese companies were short on managers with operational experience in foreign countries. “[The Chinese] were thinking, ‘Even if we scoop them up at a good price, how do we manage them?’” said David Iwinski, managing director at investment consultancy Jinfu Consulting.
But this obstacle was not insurmoutable. Thanks again to the crisis, experienced foreign management could have been hired at a deep discount.
No, the reason that most Chinese firms stayed home is because Beijing grounded them. Any overseas acquisition requires approval from an intimidating gauntlet of bureaucracies (including the State-owned Asset Supervision and Administration Commission, MofCom, the National Reform and Development Commission, and the State Administration of Foreign Exchange) that are highly risk-averse. Shortly after Fu of MofCom encouraged Chinese companies to start investing abroad, other voices in the government, including Vice Premier Wang Qishan, began publicly pouring ice water on the idea. In a sarcastic tongue-lashing published in state media, Wang accused Chinese firms planning overseas investments of hubris. “Do you have a handle on your own management capabilities? … If you don’t know yourself and your opponent, then this kind of confidence scares me.”
Even in cases where the state backs a deal, the narcoleptic pace of Chinese regulatory approval can still jam the gears, especially when the ministries involved disagree about a given deal.
Given that the process can take six months in some cases, sellers end up accepting an alternative offer before the Chinese bid is approved. But when it comes to distressed asset deals, the patient can die on the operating table. Ghislain de Mareuil, partner at Shanghaivest and advisor at Allbright Law, pointed to the currently stalled acquisition of Swedish automotive brand Saab by a Chinese consortium as an example. “The transaction started a couple of months ago, but the deal has not closed yet because it is going through the regulatory process,” de Mareuil said. “And right now Saab is dying. They stopped paying their employees in early July because they did not receive cash from their Chinese
investor.”
The state also controls the banking system. SOEs have little problem here, but privately-owned Chinese companies find it near impossible to get bank financing for overseas acquisitions.
For managers of state-owned firms, this system reinforces their inclination to play it safe. Far easier to feed at the subsidized government trough, borrow from government banks, and deposit monopoly rents. Why risk an overseas dalliance?
In addition, unlike at multinationals, the private ambitions of Chinese managers at SOEs are often poorly served by a stint abroad. “If you look at the large SOEs, they have a very tough time finding the right managers to manage overseas acquisitions because they don’t have the career structure in place for the guy who does it,” said Malcolm Riddell, CEO of Riddell Tseng, a US-based boutique investment bank specializing in facilitating Chinese ODI. “The guy who comes over here is taking himse
lf out of the promotion path.”
Some argue that China doesn’t actually need to change its current investment model. After all, the country has a massive internal market, just like the US. And given Chinese companies’ lack of experience overseas, direct investment in foreign markets risks throwing money away. “M&A is only a mode, a tool, a means – not an end,” said Ge Dingkun, a business professor at the China Europe International Business School (CEIBS) in Shanghai. He argued that M&A should be conducted for one reason: profit for the individual firm. A frequently cited McKinsey study showed that only one-third of M&A deals globally actually create value. So why not stick with minority stakes, stocks, bonds and sovereign debt?
“I don’t think China has to go out in a major way,” agreed Riddell. “It could continue to develop its own consumer economy and internal brands and internal champions, which the government seems to be doing by favoring SOEs over privately-held companies. The government seems to be structuring the economy in the way that suits it.”
But this tendency to feather the nests of state monopolies may be counterproductive. Private companies, Yao points out, create some 85% of the jobs in China, most of them in the informal sector. Even the larger private companies have trouble competing for human capital with SOEs that offer salaries that are, on average, 1.8 times higher than private-sector equivalents. As more SOEs focus on expanding domestic monopolies through price wars and regulation, they tend to destroy margins at the private companies that employ most Chinese citizens. “If state-owned national champions fail to go out and compete with the Western giants, they have to further crowd out the private sector at home, leaving informal workers stuck in low-income jobs. This is not a very bright future for our country,” said Yao.
Still, predictions that Chinese ODI is set to climb do have some basis in reality.
On the bureaucratic front, while the approval process is still slow, at least one stage – the application to SAFE for access to the foreign exchange necessary to conduct transactions – is being removed. Ben Chan, senior vice president for business planning and strategy at HSBC Hong Kong, said that a pilot project is underway that allows Chinese firms to acquire overseas firms directly using renminbi, under the supervision of the central bank and MofCom.
For Chinese firms, he said, using renminbi eliminates currency risk. For foreign firms, it means getting their hands on one of the world’s most sought-after currencies.
Open door
Another frequently cited reason for Chinese companies staying home, namely foreign resentment, appears to be on the wane. Guillaume Rougier-Brierre, partner at French law firm Gide Loyrette Nouel, has been busy facilitating deals between Chinese buyers and European sellers, including a successful bid by China’s COFCO to acquire a vineyard in Bordeaux in February.
Given the strong connection wine has with French identity, the deal did inspire a few menacing headlines (“China invades Bordeaux!”), but the government and the vineyard did not seem to feel threatened. After all, a Chinese owner can help open the Chinese domestic market.
“In such transactions, there is always a pro-Chinese environment,” Rougier-Brierre said.
Dennis Unkovic, partner at law firm Meyer, Unkovic & Scott and author of a guidebook for foreign investors in the US, said that he is surprised at the relatively low level of resistance – at least at the firm level – to Chinese investment in the US these days. Compared to widespread resistance to Japanese investment in the 1980s, he said, the US is actually far less paranoid this time around.
“I had thought personally that there would be more anti-Chinese sentiment here, but there’s been very little of that, which is surprising to me. The companies with trade secrets are extremely careful, but none of them are refusing to talk to the Chinese.”
And despite a few high-profile cases, US security is not being invoked on a regular basis to block deals, he said.
On the Chinese side, companies are moving away from investing abroad for solely domestic purposes. TCL, Lenovo, Huawei and Haier are already famous for using M&A to acquire foreign customers. The Chinese e-commerce sector is also looking outward, most notably
Alibaba.com, which acquired two US firms last year.
Rougier-Brierre of Gide Loyrette Nouel is currently acting as Crédit Agricole Corporate & Investment Bank’s representative to sell a 20% stake in the company’s brokerage business to China’s CITIC Securities. He says the deal is all about foreign markets.
“It’s true that the majority [of Chinese ODI] has been to serve domestic purposes. But the CITIC acquisition is clearly not a China-focused transaction. CITIC is already the leader in China. They want to become visible in the brokerage industry outside of China.”
Finally, Chinese companies are increasingly willing to rely on foreign talent to handle overseas subsidiaries, which can compensate for their lack of experience.
Trevor McCormick, CEO of executive search firm Foster Partners, said that Chinese firms are increasingly willing to hire foreigners: Where his firm once made 95% of its revenues from head-hunting for multinationals in China, today 70% comes from finding foreign executives to run Chinese subsidiaries in Western markets, a near complete reversal.
Pay, previously a sticking point for Chinese firms hiring foreign executives, is also less of an issue. “There are huge packages around now,” McCormick said.
Slow burn
Therefore Chinese direct investment overseas is likely to increase. But it is unlikely to explode. “I wish there would be more outbound investment – I earn my living out of it,” said de Mareuil of Shanghaivest. “[But] while I think there will be an acceleration, there will not be a jump.”
The China Council for Promotion of International Trade (CCPIT), a government organization, has surveyed Chinese companies regarding their outbound direct investment activities and intentions since 2006. Results from the 2010 survey reveal little sign of any sea change in the offing. Around 30% of respondent firms plan to maintain their current investment level where it is, and 43% plan to abstain entirely from investing overseas. Of those that plan to invest abroad, most plan to invest less than US$5 million.
The targets haven’t changed much either: According to Thomson Reuters, three-quarters of the value of outbound investment deals to date in 2011 involves raw materials (US$6.3 billion) and energy (US$5.3 billion).
There is one sign that Chinese companies are at least increasingly cognizant of the need to find foreign customers: Nearly one-third of the CCPIT survey respondents said they wanted to go outwards to escape increasingly saturated local markets. “You don’t have to convince the Chinese that this is an opportunity anymore,” said Unkovic of Meyer, Unkovic & Scott.
Of course, being aware of a trap is not the same as being able to escape from it. China’s private firms know well that they cannot compete with SOEs at home, but what can they do about it? Until Bejing truly releases its regulatory grip on outbound investment – and by extension its grip on the domestic economy – Chinese ODI will remain cramped by the politics of fear.
There is no way to produce a global competitor without competing globally. China’s hesitation will be its competitors’ gain.