Double take on China: FDI

The word “cautious” comes to mind when describing the mood on investing in China. A three-year downcycle got global investors ruminating on the investment case amid uncertainty about the country’s economic trajectory and tensions with the West. That hesitation is reflected in a stock market slump as allocations to China in global portfolios fell to their lowest levels in years (source: EPFR).

But perhaps more unexpectedly, foreign direct investments (FDI) registered a quarterly deficit last year for the first time since records started in 1998, after decades of strong flow. FDI ultimately returned to positive territory on a net basis, though the eventual annual increase was the smallest ever recorded.

According to balance of payments data from the State Administration of Foreign Exchange (SAFE), China’s direct investment liabilities, which is a broad measure of FDI, rose by $33 billion in 2023. It is a dramatic fall from $180 billion in 2022 – and completely overshadowed by the $344 billion historic high reached in 2021.

Chart 1: FDI into China retreated significantly

Balance of payments data in billions (USD) of the past 10 years

Source: State Administration of Foreign Exchange, as of 3/28/2024.
This chart shows balance of payments data from 2014 to 2023.

This downtrend in foreign investments in recent years invites plenty of questions. Are global investors really deserting China? Can China stem this capital outflow?

In the first of a new data-led series, we did a double take. Instead of hastily filing this in the ‘China in decline’ drawer, we look behind the headlines with a view to challenge myths and misconceptions surrounding China. Specifically, we look into how much this actually hurts China and where things might be headed. Here are some of our findings.

It is hard to predict if and when foreign direct investments would pick up again, but some of the immediate factors that led to last year’s downturn do appear to be changing.

Chiefly, the tone of the Chinese regulatory environment has turned as the government takes a more pro-growth stance with fiscal and monetary policy. This shift in direction can seem slow and will take time, but it should support a potential rebound in the economy and markets – and ultimately foreign investments.

The temperature of the fraught China-US relation has also arguably come down since last year; any step towards stabilization is good for cross-border investments. More importantly, as the Federal Reserve (Fed) raised its key interest rate to the highest level in 22 years, the risk-free rate has more than doubled from the 2022 level. This significantly reduces the excess return on FDI, effectively lowering the appeal of investing abroad for American companies. However, these circumstances are likely to change soon as the Fed appears close to cutting rates, meaning the risk-return profile of FDI could improve again.

Chart 2: Largest sources of FDI for China, 2022 vs 2021

Realized FDI excluding Hong Kong and Macau in 100 millions (USD)

Source: National Bureau of Statistics, China, as of 3/28/2024.
This chart compares realized FDI data of top 10 countries for 2022 and 2021.

And capital does not just come from the West. The Middle East, specifically the Gulf Cooperation Council (GCC) countries, could become a new source of capital and help fill the FDI gap. In fact, strengthening trade flow could point to where FDI is headed. Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates are all expected to invest more in China as diplomatic ties become closer.

Chart 3: Will GCC countries invest more in China?

Trade exchange between GCC countries and China in billions (USD)

Source: GCC-STAT, as of 3/28/2024
This chart highlights the strengthening trade flow between China and GCC countries from 2020 to 2022.

All said, the impact of FDI outflows on China’s economic growth is small, since FDI makes up less than 5% of the country’s total investments. With a well developed and relatively ‘closed’ banking system, China does not depend on foreign liquidity to fund its development.

Besides, the broader link between FDI and economic growth is elusive and complicated. FDI can certainly support growth but it is not a panacea. Often touted by policymakers as an important measure of economic and political success and widely covered by media, FDI’s direct impact has been challenged in recent academic papers as limited and far from conclusive.

FDI is significant for other reasons. It provides a channel through which international industry knowledge and experience are shared with China. Foreign investments bring best practices and market discipline that could help Chinese companies to compete in global markets. The benefits go beyond money.

We are encouraged by the government pledging and taking some steps to make it easier for foreign companies to invest in China. Whether it is able to restore confidence and capital flow, we would have to wait and see.