Reversion to the Mean: Why Chinese Investment in the US Did Not, In Fact, “Collapse”

The rapid decline of US-bound Chinese direct investment in 2017 has led many to conclude that the wave of Chinese money is subsiding. To be sure, the drop in Chinese direct investment from 2016 to 2017 was nothing short of dramatic, but that is because 2016 was, in fact, a significant aberration and an exceptional year, not because Chinese investments are now disappearing.

From my vantage point, 2017 simply marked a “reversion to the mean.” In other words, it is premature to declare the drying up of Chinese foreign direct investments (FDI) in the United States.

Figure 1. Chinese Direct Investments in the United States, 2009- 2017
Sources: MergerMarket, State Administration of Foreign Exchange, and author’s calculations.

As Figure 1 shows, the absolute value of Chinese FDI in 2017 returned to its mean of roughly $8 billion during the years prior to 2016. Since the 2008 financial crisis, Chinese investors have pumped a total of $122 billion into the US economy, half of which came from that single banner year of 2016. At more than $9 billion, Chinese FDI in 2017 was nonetheless still higher than in 2012.

What’s more, US-bound Chinese FDI as a proportion of China’s total global outbound investment also returned to its historical mean in 2017. From 2009 to 2015, for every $100 million of Chinese money invested abroad, on average $8.3 million (8.3%) found its way to the US market, according to the Ministry of Commerce (MOFCOM). In 2016, that proportion skyrocketed to nearly 29%, more than three times that of previous years.

So, it seems clear that rather than a “collapse” of Chinese FDI, 2017 was really a normalization after a highly abnormal year. What exactly happened in 2016, then, that prompted such an excess of Chinese outbound investment? And why has US-bound Chinese FDI contracted since then?

Some have pointed to Washington’s increasing wariness of Chinese investment activity in America as the principal reason for the post-2016 contraction—an attitude that has been further influenced by the abnormality of 2016. To put this a bit differently, heightened bilateral economic tensions resulted in part because of a political reaction to the staggering scale of Chinese investment in 2016, an election year in the United States.

But politics alone cannot satisfactorily explain how Chinese FDI contracted from $55 billion to $9 billion in a single year, since cross-border investments are complex, involve long-term planning, and proceed slowly. So rather than pinning the explanation on a deteriorating political climate in the United States for Chinese investors, my view is that the 2016 excess and subsequent reversion to the mean were driven primarily by what was happening inside China itself.

Specifically, there were several important catalysts: a pair of domestic policy changes, and the emergence of mega private investors that we at MacroPolo have dubbed the “Group of 4.”

In the immediate aftermath of the financial crisis, Chinese investors began waking up to the opportunity of cheap assets globally. Initially, they proceeded cautiously and gradually scoped investment opportunities overseas. But policies adopted by the central government in Beijing in 2014 and 2015 seem to have both laid the groundwork for—and precipitated—what took place in 2016.

One of those policies came from the National Development and Reform Commission (NDRC) in April 2014, when it announced what is commonly known as the No. 9 Order. This order stipulated that outbound investments under $1 billion in non-sensitive sectors no longer needed pre-approval from NDRC and that investments over $1 billion could expect NDRC to complete reviews within 20 days. It was part and parcel of the State Council’s obsession with cutting red tape for businesses. With this streamlining of the approval process, Chinese investors could move much faster in targeting overseas acquisitions.

Then came the infamous exchange rate regime reform on August 11, 2015, colloquially referred to as the “811 reform.” On that day, the People’s Bank of China devalued the Chinese currency by 2%, which roiled global markets. A combination of inadequate communication and poor economic indicators in China spooked markets into thinking that a competitive devaluation was about to take place. Chinese companies and investors, too, were expecting further depreciation and weak growth. Indeed, the Chinese yuan reached its weakest point at the end of 2016. The bungled handling of this exchange rate reform and its aftermath further accelerated the pace and magnitude of Chinese FDI, as my colleague Houze Song has argued.

Figure 2. Chinese FDI’s Target Industries in the US, 2016
Sources: MergerMarket and author’s calculations.

One class of predominantly private Chinese investors reacted swiftly and perhaps opportunistically to these policy changes. Not surprisingly, these Chinese companies were the ones that made splashes abroad for sealing outsized deals while grabbing headlines back home for being put into political purgatory.

To illustrate, more than 60% of US-bound Chinese FDI in 2016, or about $34 billion, can be traced to just four companies: HNA Group (3 deals), Anbang Insurance (1), Wanda Group (1), and Oceanwide Holdings (1). These six deals were concentrated in five sectors: leisure, real estate, media, business, and financial services (see Figure 2). In fact, 2016 saw 8 out of the 10 biggest Chinese investment deals since 2008.

And here is the key point: Excluding these eight deals from a total of 80 would make 2016 less of an aberration and instead a fairly normal year for Chinese FDI (see Figure 3). (Another mega deal in 2016 was Apex Technology’s acquisition of Lexmark International for $3.4 billion, seven times Apex’s total assets, though Apex sold one of the two business units for $1.4 billion after just a year.)

Figure 3. 2016 Chinese FDI in the US without Mega Deals
Sources: MergerMarket and author’s calculations.

Even within the context of policy changes in preceding years, this does not fully explain why this small set of Chinese investors moved so aggressively to deploy capital in the United States in 2016. But perhaps no one can explain their rationale better than the mega dealmakers themselves. In November 2015, just three months after the exchange rate reform, Wanda Group’s founder Wang Jianlin blurted out in an interview in Boston, “The direct outcome of overseas investments is asset reallocation. There is no right or wrong; there is only legal or illegal when it comes to asset reallocation or investing abroad. It is our hard-earned money and we will invest it wherever we please.”

Wang’s answer provides a window into the wider pessimism that gripped China’s business community at the time. Faced with a depreciating currency and a slowing economy, investors looked for safe havens to park their assets. This isn’t a surprise, as wealthy elites have done this over and over again in emerging markets, including Mexico in the 1980s, Argentina in the early 2000s, and even Europe in the 2010s. Wang’s point about the legality of asset reallocation was that whether labeled pejoratively as “capital flight” or not, he and others like him had the right to move their assets wherever they choose.

It is, in fact, difficult to distinguish between “capital flight” and normal capital outflows as volume increases, since illegal outflows by definition try to hide their true intentions. But it was already apparent in 2015, for the first time in two decades, that there was more Chinese outbound direct investment than inbound investment into China, according to the State Administration of Foreign Exchange (SAFE). The net capital outflows caused China’s foreign exchange reserves to take a dip, falling to $3 trillion from nearly $4 trillion in 2013 (see Figure 4).

Figure 4. Indicator of Capital Flight
Source: SAFE.

Other indicators also show evidence of capital flight. First, the errors and omissions on China’s balance of payments records rose to 5.5% of total trade in 2016 from roughly zero in 2008. This means an increasing amount of capital outflows cannot be properly accounted for, implying more illegitimate outflows were taking place. Second, in both 2015 and 2016, the discrepancy between outbound investment-related capital outflows recorded on China’s balance of payments and those recorded by MOFCOM was about $20 billion, indicating that for the first time since 2008, the actual amount of capital outflows as recorded by SAFE’s Balance of Payment were likely higher than the amount claimed by Chinese investors. A total of $40 billion left the country through unrecorded channels, further indicating capital flight (see Figure 5).

Figure 5. Discrepancy in Chinese Outbound Investment (in million USD)
*Based on MOFCOM estimate of Chinese outbound investment in 2017.
Source: SAFE, MOFCOM, and author’s calculations.

Such volatility suggests that beyond the mega dealmakers, many Chinese investors were also of the mind that they needed to “reallocate assets.” This investor psychology merely served to reinforce the volatility, and the Chinese government became gravely concerned.

What Beijing did next is now well known: it imposed stringent capital controls and made examples out of the Group of 4 to send a political message. By the end of 2016, the Group of 4 investors were singled out and had their finances closely scrutinized. And the sectors in which these investors conducted deals, such as real estate and entertainment, were now off limits. These virtual “oligarchs,” from the Chinese Communist Party’s (CCP) view, were setting the tone by voting with their assets and undermining confidence in the Chinese economy. Of course, the CCP would not tolerate oligarchs running wild and so China’s politicians pushed back vigorously. The tenor quickly changed as these dealmakers were strong-armed into submission.

With the Group of 4 cowed, these dealmakers started to sell their newly acquired assets. By the end of 2017, Chinese FDI in the United States had returned to its historical mean. That doesn’t mean Chinese FDI evaporated in 2017—rather, several factors converged to make 2016 an extreme outlier year that isn’t likely to be replicated again.