Increasingly, China's external financial strength, in the form of its cache of foreign currency reserves, is belied by continuing domestic corporate weakness. When addressing the question of whether China is going to become the next big global investor, it is important to differentiate between the state-owned sector and Chinese corporates that view international acquisitions as a vital, but basic developmental step. Most Chinese corporations are going "outside" after years of domestic bloodletting, and they are limping, rather than charging, to get there.
Non-financial Chinese outward direct investment (ODI) totaled US$2.68 billion during the first quarter of 2006, a year-on-year increase of 280% and a continuance of the growth which saw Chinese ODI reach US$6.9 billion in 2005. The Ministry of Commerce (MOFCOM) expects total ODI to increase by US$60 billion during the Eleventh Five-Year Plan period (2006-2010). About half of all Chinese ODI goes on supplies of energy and raw materials.
Diplomatically significant, the necessity driving this activity needs little elaboration. Just as important for China's long-term economic development are the structural factors driving corporate ODI outside of China's resource acquisition strategy.
Accent on Asia
In geographic terms, at the end of 2004, the last year for which MOFCOM has made disaggregated figures available, 75% of China's cumulative ODI was channeled to Asia (mostly Hong Kong), 18% to Latin and South America, 2% apiece to the EU, Africa and the US and 1% to all others.
It is important to draw distinctions between what is real investment that meets the general definitions of FDI – an equity investment with substantial operational involvement in a going concern – and the flow of funds that is simply part of elaborate efforts by Chinese entrepreneurs to turn domestic funds into FDI.
It is estimated that 25-40% of Chinese ODI may simply be undertaking the first leg of a round-trip journey in order to arbitrage the institutional preferences afforded to foreign firms. At the end of 2004, 84% of all Chinese cumulative ODI flows went to Hong Kong and the sunny tax havens of the Cayman and Virgin Islands, all of which happen to be major FDI investors into China. While multinational corporations (MNCs) have been known to register special purpose companies in tax friendly jurisdictions for further investment in third countries – and it would be very difficult to show FDI as the mirror image of ODI – the correlation is nonetheless unmistakable The consequences of China's corporate underdevelopment is not lost on Beijing, which is increasingly frustrated at domestic firms' lack of competitiveness. In reality, China's ballooning trade surplus is mostly due to exports by MNCs – domestic companies have largely failed to take a big share of the value added in goods being produced in and exported from China.
Their first priority for corporate China is to assist them in technology acquisition and bolster R&D capabilities. In this light, the acquisitions of factories from MG Rover and ThyssenKrupp by Nanjing Automotive and Shagang respectively, only to send the factories back to China on container ships, are more understandable.
The persistent use of the same lexicon to describe corporate China as the private sectors in advanced economies is misleading. For decades Chinese companies across a wide range of sectors have been investing to out-produce their competition, sending industrial materials prices higher, and eroding any pricing power they might otherwise have won from efficiency enhancements. Many Chinese firms will go abroad simply to find some breathing room. Additionally, corporate China is far more dependent on retained earnings as a source of investment funds (around 75% during 2005) than is commonly acknowledged.
With share prices just starting to rebound, it appears that most international acquisitions will likely be made with bank credit. However, a quick look at how domestic credit has been distributed in the past shows a financial system that continues to favor politically connected firms. This is likely to be replicated as firms jockey for funds to invest abroad.
The motivations to encourage Chinese companies to "go outside" are far more basic than Western MBA jargon would imply, as it assumes a decision making process motivated by financial and strategy considerations that have been absent from domestic dealings. Additionally, the institutional dependencies that have helped to make most domestic companies what they are won't whither away any time soon.
Chinese companies may become active global investors, and this level will to some extent depend on how policy considerations are translated into quasi-fiscal resources in the form of concessionary bank loans from state-owned lenders. Research on M&A activity in economies far more advanced than China's has shown that most acquisitions fail to create shareholder value. With this in mind, the post-acquisition prospects for Chinese companies that heed the government's call to invest abroad would not seem to be so bright.
Overall, policy makers in Beijing may have far more in common with foreign investment bankers than they would otherwise acknowledge: they are playing a numbers game where a few big successes may make up for far more false starts, and in the process earn large bureaucratic bonuses for themselves.
William H. Hess is senior analyst and country manager for Global Insight, China Regional Service – economic forecasting, analysis and risk monitoring across China's 31 administrative regions
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