August Insight - China’s Investment-The Era of politics is shifting to the era of portfolio return

Since the first round of experiments in outbound investment by Chinese companies in the eighties the breadth of China’s outbound capital flows have advanced to the point where its financial institutions and corporate entities appear to be on the cusp of a major player in international capital markets.

Despite the  need to place funds outside of China as part of systemic monetary and foreign exchange policies that have fostered China’s accumulation of well documented foreign exchange reserves there are a number of reasons on the horizon that China’s industrial capacity may not be able to invest as much as currently predicted. Yes, Forex reserves have been recently estimated to be approximately US$ 3.5 Trillion.  This is primarily invested primarily in historically low yield Eurobonds and American government debt.

Clausewitz wrote: War is not merely an act of policy but a true political instrument, a continuation of political intercourse carried on with other means.  When CNOOC first bid for Unocal it failed in part because investments by Chinese state owned enterprises were perceived in the west as political instruments and not commercially motivated. There was a concern in many G-8 capitals that China was using its investment funds as a new form of war. Eight years later CNOOC successful secured approvals from Industry Canada and “CFIUS” or the Committee on Foreign Investment in the United States.  

Acceptance of Chinese capital now is due to the recognition of most of the mature economies post-2008 of the importance of funding the capital deficit that exists in in many G-20 economies, an increasing understanding that commercial targets increasingly govern State owned enterprises and better public and government engagement work is being under taken director or through advisers by investors from China.

The recent approval by CFIUS of the acquisition of Smithfield Foods by China’s Shuanghui International suggests that the era of politics is over. This has created a new era where China’s investments   can potentially be treated as a form of peace by other means. A critical part of this shift in mindset happening will be China’s opening its own capital markets, resource sector and consumer sector to international investment.

The end of this era of investment politics also means that state policies in China that prompted major Chinese corporations to invest abroad will be replaced by a set of policies framed around the simple but powerful market practice that the deployment of capital should follow the best rate of return inside or outside of China.

This creates new challenges for Chinese companies that plan to invest for commercial reasons. The first is domestic. As interest rates start to rise for government debt then the State Administration of Foreign Exchange and the China Development Bank will increase the threshold that must be met to obtain support. There will also, be due to bank and local government debt, an increasing demand for China’s savings power to be dedicated to fill in the large holes in China’s domestic financial system. The third domestic challenge is the current focus on better governance within China will make state companies and state approval agencies risk adverse and potentially less likely to take the risks that investing outside of China imply.

These domestic factors pale in comparison to the embedded but dormant buying power of the free cash reserves currently held on the books of American, Canadian and European public companies. This cash, estimated to be between US$ 1.5 and 2 Trillion is not being invested for a number of reasons. These include fear of insolvency within the Board as the psychological legacy of the financial crisis, uncertainty about what will make money in a volatile economy and the current lack of inflation in the economy.

In 1-3 years the world’s economy will stop sputtering and stabilize. There will be a tipping point and a shot of confidence that CNN and Reuters will make sure is heard around the world. The inflationary effects of monetary policy will begin. This will likely push the major players in the industrial, manufacturing and service sectors to invest.

China, at that point may lose its current status as the main kid in town and have to compete for opportunities through merges and acquisitions or possibly due to the internal approval process slowing down its state players pace of reaction to a deal may stay on the sidelines. China’s resource companies, infrastructure and manufacturing players will face increased competition for deals in Africa, South America and its border states.  

The overall result will be that the China’s investment focus will like shift from active investors as companies to passive investors as fund managers.  The National Social Security Fund, funds held by securities firms, mutual funds and insurance companies that are invested abroad through quotas allocated to Qualified Domestic Financial Institutions will more likely the lead conduits of funds being placed offshore. These portfolio investors and the key existing players; State Administration of Foreign Exchange and China Investment Corporation, will ideally provide new liquidity to major European, Asian and North American markets.

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