China Economic Update: September 2017

Tightening the purse strings – China’s foreign investment is slowing in a more closely regulated environment.

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Overview:

  • After years of encouraging its firms to ‘go out’ and invest abroad, China’s government has recently been tightening the regulation around foreign investment. This policy shift reflects competing pressures – with potential gains from building its stock of foreign assets and political capital via the Belt and Road Initiative weighed against risks to financial market liquidity and currency stability from uncontrolled capital outflows – but is a backwards step from a reform perspective.
  • From 2014 onwards, capital has generally flowed out of China. China’s outward foreign investment has grown, but tighter regulation around shadow banking and fears around the stability of the country’s economy have also contributed to capital flight. Subsequent tightening of capital controls has stemmed much of the tide – albeit relatively modest outflows have continued in the first half of this year.
  • Despite the sizeable net asset position, the income flows associated with China’s international investment position have generally been negative – meaning that foreign investors have earned a greater return on their investment in China than Chinese investors earned abroad. The returns on China’s direct and short term investments have generally underperformed – suggesting that some of this investment has been poorly directed.
  • Poor returns on foreign investment pose some risk for China’s financial sector. Chinese State Owned banks have been the main source of funding for highly leveraged State Owned Enterprises investing abroad – meaning that the failure of a foreign investment could increase domestic risks – a major concern given China’s already high debt levels.
  • Capital outflows have slowed considerably in recent quarters – from peaks in late 2015 – reducing some of the risks around China’s economy. The continued tightening in regulation around China’s foreign investment will reduce some risks in the country’s financial sector, but it represents something of a backwards step within the broad reform agenda to modernise and open up China’s economy.

For further details, please see the attached document: