Inward investment flows to China have slowed sharply, even turned negative, in the context of geopolitical risk and a diminished growth outlook; while geopolitical risk is unlikely to diminish much, greater certainty around China’s economic outlook and a U.S. cyclical downturn should help support a rebound in investment flows next, though geopolitical risk sensitive FDI flows may benefit less from lower U.S. and European interest than other types of investment. Foreign portfolio investment and other investment inflows turned negative during the second half of 2022, while foreign direct investment have fallen sharply over the past year. FDI are typically characterized longer lead and lag due to greater need for planning and higher transaction costs and less liquidity compared to cross-border portfolio and loan flows. All types of investment flows have experienced a sharp decline over the past year and a half.
Foreign investment inflows turned negative in the third quarter of 2022 to the tune of $70 billion. On a four-quarter trailing basis, it turned negative for the first time in the fourth quarter of 2022, reaching a negative $30 billion. It has since reached a negative $70 billion at the end of the second quarter of this year. The last time China registered negative quarterly inflows was in 2015-16. By comparison, investment inflows reached $340 billion in 2021 and they averaged $200 billion annually in 2015-19. On a four-quarter trailing basis, portfolio investment other investment inflows have turned negative, while FDI inflows have averaged $150-180 billion since the first quarter of 2022.
The relative attractiveness of Chinese financial assets has declined due to both cyclical and structural factors. Cyclically, higher U.S. interest rates and relatively strong U.S. economic growth compared to weaker-than-expected Chinese growth have made U.S. financial assets more attractive. U.S. interest rates increased very significantly in the past 18 months, from virtually zero in early 2022 to 5.25-5.5% in 2023. Longer-term U.S. bond yields have also increased sharply, reaching two-decade highs. By comparison, Chinese interest rates have been largely steady. Structurally, investor perceptions of increased geopolitical risk, more uncertain and likely diminished economic growth prospects and a more uncertain domestic business environment have likely contributed to the decline investment inflows. Moreover, investors expect lower post-rebalancing economic growth, as Beijing will struggle to reinvent its economic growth strategy, not least due to intensifying government intervention. Geopolitically, the Ukraine war has provided foreign companies with increased incentives to diversify their supply chains. Finally, U.S. and China’s economic tit-for-tat economic conflict and the threat of increasing restrictions not just around trade but also investment have led many international and especially U.S. investors to take a more cautious attitude towards investing in China.
The risk of geopolitical conflict will continue to weigh on investment flows to China, but weakening U.S. economic conditions and lower U.S. interest rates, particularly if it coincides with a more steady and less uncertain Chinese growth outlook will help support a rebound in portfolio and other investment flows to China. Geopolitical risk and the concomitant risk to foreign investors in China is not going to go away. Similarly, Beijing’s national-security-related crackdown on foreign companies is unlikely to be reversed and will, if anything, intensify, leading to even greater uncertainty. However, U.S. interest rates have now peaked, paving the way for potentially significant monetary easing (later) in 2024 against the backdrop of a further softening of U.S. economic growth or even an outright recession. Whether or not China will have managed to reassure international investors about economic growth, Chinese assets, especially portfolio and other investment, will then look relatively more attractive than today. Non-FDI will rebound. To what extent non-FDI inflows rebounds will significantly depends on the size of the U.S./ world – Chinese growth and interest rate differentials. FDI investment will likely recover more slowly, as neither geopolitical risk will decline significantly. Nor will the Chinese authorities take a less interventionist approach to domestic and foreign business in light of U.S-Chinese economic tensions.
The slowdown in foreign direct investment inflows comes at a particularly precarious time for the Chinese economy, which is struggling to rebound from its post-COVID-19 shock. While this will make it moderately more difficult for China to maintain high levels of medium-term productivity growth, its impact on China’s balance-of-payments and international financial position will be very limited. Reduced FDI inflows, especially in technology-related sector, will weigh on productivity growth, but it will not matter in terms of the availability of financing, given China’s solid external financial position in terms of both solvency and liquidity. China (ex-Hong Kong) remains the world’s third-largest international creditor and China continues to register substantial trade and current account surpluses. Capital account restrictions sharply limit the risk of a capita account crisis.
All of this sharply limits the importance of lower capital inflows from a financial point of view. Combined with restrictions on current account convertibility, the risk of diminished foreign investment inflows will be more than manageable. The central bank sits on more than $3 trillion of foreign-exchange reserves and the authorities have the ability to slow resident financial outflows to ease the pressure on China’s balance of payments. China is the world’s second-largest international creditor after Japan and Germany and its net foreign creditor position is roughly comparable to Hong Kong. China’s net international investment position amounts to $ 2.6 trillion. The composition of foreign assets is strongly skewed in favor of liquid government-controlled assets, readily available for intervention. Moreover, around 50% of Chinese foreign liabilities consist of relatively illiquid foreign direct investment liabilities. However, diminished investment flows, especially FDI into advanced technology sector, will negatively impact medium-term economic and productivity growth, all other things equal. The extent to which this is due to geopolitical risk and other countries’ restrictions, there is little China can do about this.