This is the third in a series of blogs regarding private foreign investment in Chinese companies. Efforts are underway in Beijing to stimulate the Chinese economy to return it to its former levels of growth. Ordinarily this would provide potentially outstanding opportunities for foreign investors, but there are a number of pitfalls remaining that should be considered before investing as subtle elements of risk can occur that distinguish Chinese investments from those made in other economies.
State Encroachment into Private Sector Domains: Since 2013 when the Chinese government launched its “mixed ownership reform” policy, there has been a clear trend towards moving the state’s interests in front of those of the private owners of Chinese listed companies. The effort was designed to “blend state and private interests” so that those national interests would be better served. The consequence of this program has been for state companies to take controlling interest away from the private investors of as many as fifty listed private companies per year from 2019-2021. Overall private market capitalization in China’s 100 largest public corporations declined in favor of state capitalization from about 55% in 2021 to 39% in 2023. The sum of investment by state owned firms into private firms since 2018 has added up to about $390 billion. In an increasing number of cases, government agencies have been acquiring “golden shares” of private companies that translate into larger voting blocks for the state when it comes to board of directors or stockholder matters. Although officially these golden shares are declared to be harmless, private investors are savvy enough to see that it just simply isn’t the case, and the markets reflect this sentiment when such golden share programs are announced. This trend shows clearly that China’s ruling party is moving business in a direction from state capitalism to a form of capitalism that is manipulated to benefit the interest of the ruling communist party.
The Corporate Social Credit System: Another way the state influences decision making in private businesses is through a corporate social credit system that sets ratings for companies based on a variety of factors centered around debt paying and legal compliance. The companies with the best scores usually have officers and/or directors who formerly were significant government or communist party officials helping provide legal (or political) compliance. These companies often receive favorable treatment or preferential access to loans. Those others who wind up on the “red-list” can have an extremely difficult time trying to obtain needed working capital to continue to grow.
Slow Growth Leads to Capital Outflows: For most of the last year China’s economy has struggled to rebound from the draconian lockdowns of the Covid era. The sluggish recovery is owed to the Chinese consumer’s reluctance to step out and spend, fearing more such repression if another major event occurs. Compounded by unpredictable autocratic leadership and uncertain bilateral trade relations with trading partners, this investing environment has been marked by major capital outflows. The most recent era of capital flight took place as a consequence of a currency devaluation in 2015, instigated by a stock market collapse. Since that time capital controls have tightened to restrain the flight of capital out of the country. Additionally, various state legislatures in the U.S. have enacted laws restricting foreign nationals from buying major amounts of U.S. real estate. In Canada, a popular destination for Chinese real estate investment, non-residents are blocked completely from buying real estate. Other European countries have also shown a disfavor towards the influx of Chinese capital that was once sought after. In Singapore, however, Chinese capital was received with open arms for many years—probably attracted by a large Chinese resident population, low tax rates, and its proximity to China. But along with the huge influx of Chinese cash came problems with the local housing market dominated by the Singapore government that seeks to preserve housing for the poor owing to the limited space involved. The prices of a relatively small number of available private units receiving inquiries by Chinese investors have risen from $296,000 to $728,000 since 2020. To remedy this, Singapore enacted a whopping 60% tax on real estate purchases made by non-residents.
Murky Economic Statistics Mask Outflow Trends: A country’s current-account surplus is determined by the net of trade inflows and outflows combined with incomes received from foreign assets. If the trade data and income from foreign assets is understated and no discernable change in overall cash occurs, this result could mask the flight of capital out of the economy. When the trade data from China and Singapore are compared, there are some gaps where one side reports certain figures and the other reports different numbers for the same thing. One analyst, Brad Setzer of the Council on Foreign Exchange, calculates that China’s trade surplus could be as much as $200 billion more than what was reported. If true, where would the additional dollars be located that China has earned in trade surpluses? There is no evidence of it turning up in banks or financial institutions making it even more likely to be offset by capital outflows. Although accounting twists involving free trade zones could be part of the reason, it still should point to some type of cash flows back to either China’s financial institutions or to the population in the form of remittances from family members working overseas.
Conclusions: China’s economy is still struggling in spite of a government-initiated stimulus. The best interests of foreign shareholders are not achieved unless they coincide with those of the ruling communist party. Transparent reporting of financial and economic data is a requirement for a growing economy that needs foreign capital, but may not exist in China today. This all adds up to an unfriendly environment for investors to invest in.
Sources: The Economist, Xi Jinping’s Blurred Vision, December 2, 2023.
The Economist, Incoming Flight, December 16, 2023.