According to the United Nations Conference on Trade and Development’s latest World Investment Report Overview 2014, foreign direct investment (FDI) inflows to China reached $124 billion last year, while outflows rose to $101 billion. The Report anticipates that outflows will surpass inflows within the next few years, changing China from a net recipient of FDI to a net supplier. This change will affect China’s external balance sheet, and its response to financial crises.
China’s foreign assets have traditionally been overwhelmingly concentrated in foreign exchange reserves. In 2011, for example, reserves accounted for two-thirds of all the country’s foreign assets. While the central bank’s holdings of foreign currencies (mostly held as U.S. Treasury securities) allowed it to deter any speculative currency attacks, they carried a low rate of return. That return fell even further during and after the global financial crisis as the Federal Reserve drove down interest rates, both short- and long-term. Therefore, China’s assets have not been very profitable. In addition, the foreign exchange reserves have lost value over time as the dollar depreciated. Menzie Chinn has pointed out that the political theater in Washington, DC only heightened Chinese concerns about their holdings of dollars.
A very large proportion of China’s foreign liabilities, on the other hand, has consisted largely of FDI; in 2011, the share of FDI in foreign liabilities was 59%. These investments were very profitable for the foreign firms that held them, producing a substantial stream of income. Consequently, as Yu Yongding, director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences has emphasized, China’s net return on international investments has usually been negative, despite its status as a net international creditor. China’s net international investment position in 2011 represented +21% of its GDP, but it recorded a negative net primary income flow of about -1% of its GDP.
More assets held in the form of FDI, therefore, will raise the income that China receives from its assets. Holding FDI in other countries will also give China a chance to diversify the currency composition of its assets. But there is a downside: equity holders share the risks of the ventures they own. In the past, this meant that China’s negative net FDI position acted as a crisis buffer. China’s net primary income turned positive in 2007 and 2008; its foreign exchange assets continued to pay returns, while the return on domestic FDI fell due to the global financial crisis. Moreover, a decline in the value of FDI as well as portfolio equity lowered China’s liabilities, contributing to an improvement in the net international investment position.
China is not unique in the composition of its foreign assets and liabilities. Philip Lane of Trinity College/Dublin has written about the “long debt, short equity” position of many emerging markets, which helped them ride out the economic turbulence of the global crisis. Many advanced economies, on the other hand, were “long equity, short debt,” which while profitable in normal times, exacerbated the decline in their economies when the crisis hit.
China’s situation will change if there is a shift towards a net positive FDI position. The flow of income from foreign assets will become more pro-cyclical. Moreover, those assets will lose value in the event of a downturn. A depreciation of the renminbi would only increase this valuation effect.
Chinese firms traditionally moved abroad to secure reliable supplies of natural resources. More recently, the surge of outward FDI has also reflected aspirations to venture into foreign markets. The movement outward will eventually raise China’s net investment return and provide it with the ability to hold assets in currencies other than the dollar. But it will also diminish the role of FDI liabilities to act as a crisis buffer. This is one factor that should be added to the list of benefits and costs of a change in China’s net FDI position.