Beijing acts to plug leaky capital controls

Posted on November 29, 2016

The role of foreign direct investment in emerging economies should go roughly as follows. In the early stages of development, countries import FDI and the technical and management expertise that goes with it. As they become richer, they develop domestic companies that invest abroad themselves.

China, having followed the first part for some decades, appears to be balking at the second. Beijing is planning tough restrictions on outbound FDI via a clampdown on the foreign exchange purchases necessary to execute deals.

This makes some short-term sense as a solution to two of China’s problems. One is the risk of destabilisation arising from rapid capital outflows. The second is the growing threat that overseas acquisitions by Chinese companies will be blocked by foreign governments, inflaming tension with its trading partners. That the administration of Xi Jinping, the Chinese president, has to resort to tactics like this underlines the contradictions and inefficiencies of its approach to economic policy.

The net capital outflows from China and associated weakness in the renminbi this year have gained less international attention than in 2015, when a jolt downwards in the currency shook financial markets. Since then the People’s Bank of China has improved communications about the foreign exchange regime, diminishing uncertainty. But still, the currency has fallen 5.8 per cent in 2016, putting it on course to be the worst year on record.

Capital is leaving China through both hot money and FDI flows: on net, the latter have turned negative for the first time. And the recent strength of the dollar has added to the risks of a fall in the exchange rate that could turn into a rout. Some use of capital controls at present in China is inevitable. The alternative of allowing the currency to plunge, would be destabilising given the loss of competitiveness that this would create among China’s trading partners. Yet controls do have a way of springing leaks, such as false invoicing for imports to take money out under the guise of trade, meaning that the authorities need to keep plugging pesky holes.

The second problem the restrictions are intended to address is that China faces suspicion of its companies making acquisitions overseas. Even traditionally welcoming countries such as Germany are considering blocking Chinese purchases of domestic assets. The reasons given are generally issues of national security, but the wariness of Chinese business practices and state involvement in investment decisions goes much deeper. Beijing appears to have decided to pre-empt blocks on its overseas investment by imposing restrictions itself. Rolling with an incoming punch is a familiar Chinese tactic in trade relations.

Far better, though, would be to encourage a two-way flow by making the environment for inbound FDI more, rather than less, welcoming. But that does not square with the general approach of Mr Xi’s administration, which is to extend official control rather than to liberalise. Beijing’s current attitude seems to be to regard international trade and investment as a zero-sum game.

Controlling foreign exchange purchases to stop outbound FDI is a symptom rather than a cause of China’s underlying problems, and is certainly not a cure. A debt-ridden, unstable economy and a philosophy leaning towards economic nationalism have put the country in a bind. Soothing short-term tension by restricting investment flows out of the country may bring some immediate relief but it leaves the deeper malaise untreated.

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