Chinese market still attractive for foreign investment
Direct investment inflow into China has dropped sharply, from $75 billion per quarter in 2020-21 to only $10 billion in the past four quarters and is even turning negative in the most recent quarter, according to China's official Balance of Payment Statistics. But a smaller drop was seen in the FDI survey by the Chinese Ministry of Commerce, as well as direct investment to China reported by other countries.
By our analysis, this discrepancy has largely resulted from the fact that direct investment in BOP statistics has broader coverage than traditionally-defined FDI flows. In particular, its recent drop may be mainly owing to flows related to offshore listings by Chinese companies, reinvested earnings by foreign-owned companies in China, and intercompany debt flows. These three factors combined could explain about two-thirds of the drop in direct investment inflows.
Our analysis suggests foreign companies have not stopped investing in China, of which the Ministry of Commerce's FDI utilization survey may be a more accurate measure. Nevertheless, the reduced inflows from aforementioned channels may have added depreciation pressure on the renminbi in the near term. Whether such inflows will rebound in the coming quarters will be important for the renminbi's medium-term outlook.
China's official BOP statistics reported a sharp drop in direct investment inflows since mid-2022. China's BOP statistics is published quarterly by the State Administration of Foreign Exchange. The "Direct Investment: Liabilities" item in the BOP statistics, which is often cited by media and investors as FDI inflows into China, showed a sharp drop since mid-2022. Flows under this item averaged only $15 billion in the past one and a half years, compared to a $60 billion average in the 2010s. Its most recent reading even turned negative, at $11 billion in Q3 2023.
What's puzzling, however, is that this sharp drop in direct investment inflows seems to be at odds with some other available measures of FDI.
Most notably, the foreign investment survey by China's Ministry of Commerce showed only a modest fall of FDI utilization in 2023. According to its survey, FDI utilization remained high in the first three quarters of 2023 at 920 billion yuan ($128.59 billion), which is only 8 percent lower than the number for the same period in 2022, and is higher than in any of the preceding years.
Similarly, outbound direct investment to China reported by China's major trading partners showed a mixed picture. Although the Republic of Korea, Japan and Germany's direct investment in China have all declined since 2022, they have not deviated too much from historical average levels. Interestingly, the US' direct investment into China has increased in 2023.
Thus, to explain this sharp drop in "FDI" and its difference with other measures, we need to better understand the statistical concept of Direct Investment Liabilities. In fact, the direct investment in BOP statistics has broader coverage than traditionally-defined FDI flows. In particular, we've identified three main factors that have contributed to its recent decline.
The impact of offshore IPOs
Direct investment liabilities indeed include investment flows that are commonly understood as FDI. That means, when a foreign company sets up or increases equity investment in a Chinese company where it has 10 percent or more control of its share, such capital flows will be categorized as DI liabilities.
One issue here, however, is the definition of "foreign company". BOP statistics capture all cross-border trade and financial flows. By its nature, any company outside China's borders should be labeled as a foreign company, regardless of who actually owns or controls that offshore company.
Offshore listings by Chinese companies may have a huge impact on direct investment reported in the BOP. Many Chinese companies have set up offshore entities to tap into offshore financial markets. These offshore entities, often set up in the Hong Kong Special Administrative Region or the Cayman Islands, obtain financing through IPOs or other means and then invest back in the Chinese mainland's onshore entities. We think such financing may have been categorized as direct investment liabilities under the BOP statistics (but not under FDI utilization by the Ministry of Commence). Evidently, we see a strong correlation between the flows of DI liabilities and IPO/refinancing activities of Chinese companies abroad. When Chinese companies were active in offshore markets in 2020-21, DI inflows were also large. IPOs have reduced significantly since early 2022; after that, DI inflows have also dropped.
Another important component of direct investment liabilities is reinvested earnings. Companies normally do not distribute all of their profits to shareholders but retain part of those profits. If a foreign-owned company decides to retain part of its earnings, the share of retained earnings that belongs to its foreign shareholders is considered as "reinvested" by the foreign investor. The amount of reinvested earnings is then recorded as an inflow under direct investment liabilities.
China reported the reinvested earnings component of direct investment up to 2013. The total investment income that belongs to foreign direct investors is still being reported, and peaked in 2021 at $432 billion before dropping to $368 billion in 2022, and will likely drop to $330 billion in 2023. Historically, about half of investment income has been reinvested each year. This means annual reinvested earnings might have reduced by $50 billion from its 2021 peak; and potentially higher if foreign companies also decided to repatriate a higher share of their profits.
Direct investment liabilities also include flows under debt instruments: that is, the intercompany lending/borrowing flows between a Chinese company and its foreign direct investor. In the past decade, Chinese companies borrowed from their foreign investors $10 billion per quarter on average, understandably because dollar or euro interest rates have stayed lower than renminbi interest rates. Owing to a sharp rise in dollar interest rates compared to domestic interest rates, a reversal has been observed since 2022. The negative flows in recent quarters suggest Chinese companies have paid back their external borrowing from foreign companies.
In conclusion, the two key takeaways from our analysis are as follows. First, foreign companies have not stopped investing in China. The Ministry of Commerce's FDI utilization survey may be a more accurate measure of traditionally-defined FDI flows, which showed only a modest decline this year.
Second, the reduced inflows under the broader definition of direct investment, such as offshore IPOs and intercompany borrowing, have nevertheless added to the depreciation pressure on the renminbi in the near term. Whether such inflows will rebound will be important for the renminbi's medium-term outlook.
The author is chief China economist at Deutsche Bank.
The views don't necessarily represent those of China Daily.
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