China trying to stop river of cash outflows from becoming flood

Over the past year, there has been a distinct deceleration in outbound investment by Chinese companies in countries such as the United States. Last week, official pronouncements from China’s governing bodies have taken the restrictions on outbound investment a step further. Moving forward, the discretion in making investments overseas will be more strictly constrained.

The mechanism by which policymakers will achieve this is through the restriction of foreign currency needed to conduct acquisitions. If Chinese companies can’t get their hands on the dollars that will be needed to fund an acquisition, the transactions would be all but dead.

{mosads}The change in policy begs the question: What are the motivating forces behind this change and why now? The answer to this can be found in two areas: First, China feels the need to stem the outflow of dollars. Second, it feels the need to get a grip on perceived wasteful and value-destroying investments overseas.

Over the past two years, China’s central bankers have been aggressively defending the value of the yuan by tapping into the country’s vast U.S. dollar reserves. The root causes of yuan depreciation are related to significant outflows by way of corporates and wealthy elites sensing a weakening yuan and wishing to diversify and hold assets denominated in currencies like U.S. greenback. Another driver that has been leading the yuan lower is related to a form of financial speculation known as the “carry trade.”

With regard to currency flight, during any impending economic downturn, wealthy elites are usually the first to detect a change in the economic picture. Sensing a decline in the value of the yuan, a flight to safety ensues. This pattern was commonly observed as a precursor to other financial events, such as the Mexico peso crisis and the Russian ruble crisis of the 1990s.

The practical implication of this is that yuan are being dumped for dollars, and the dollars are being transported to places like the United States. As this process accelerates, more yuan are unloaded into the currency market and, as in the laws of supply and demand, the excess supply of yuan leads to a declining exchange rate relative to the dollar.

With regard to financial speculation, since 2008, it is estimated that over $1 trillion dollars were transferred to China in what is known as the “carry trade.” The “carry trade” is a form of financial arbitrage where speculators borrow in a low interest rate jurisdiction such as the United States and then “carry” the amount borrowed and lend it out at higher interest rates in a country such as China.

The U.S. Federal Reserve’s quantitative easing policies brought interest rates in the U.S. to historic lows, thus enabling speculators to transport low-rate credit to China, where it was lent out in the shadow banking sector at interest rates of 8 percent or more.

The carry trade is reliant on low interest rates and stability in the exchange rate. As the U.S. Federal Reserve has begun its path toward higher interest rates, this type of speculation in China began to unwind and a reverse flow back to the United States ensued. The resultant impact? As speculators unwind their trades, they convert yuan back to dollars as the pattern reverses.

To further stem currency outflows, China has imposed a ban on “non-strategic” outbound investments. An investment is considered strategic if it fits within China’s long-term economic objectives. Accordingly, investments that are seen to improve China’s technological capabilities would be seen as good, whereas investment in things such as real estate, hotels, Hollywood movie studios and professional soccer franchises would be seen as bad.

The poster child for “bad” foreign investments would be Mr. Wang Jianlin. Wang is the founder of Dalian Wanda, a conglomerate that operates real estate, hotels, theme parks and movie theaters within China. While Mr. Wang is widely regarded as a high-profile CEO, he serves as a case in point of some of the excesses within China’s economy.

In most parts of the world, credit is allocated on the basis of risk and ability of the borrower to repay. In China, this is not always the case. In many cases, credit is allocated to those who have “connections,” wherein the credit allocation process is political rather than economic.

This model leaves open the door to wasteful spending. Credit is allocated to projects without regard to economic viability or risk. So long as there is an abundant flow of directed capital, a blind eye is turned to questions of viability and the relationship between what something costs and what something is actually worth.

For Chinese companies such as Dalian Wanda and Anbang Insurance, strong arguments can be made that they overpaid for their acquisitions, just as Japanese companies in the 1980s overpaid for Hawaiian and New York City real estate.

As in all things politics, if you find yourself aligned with those who have fallen out of favor, you may wind up on the wrong side of the trade. This is precisely what has happened to Mr. Wang. With proper political support, his company was given access to unspeakable amounts of capital. As the political winds changed, he finds the spigot cut off, and credit has run dry.

Reliance on a steady flow of credit can make the difference between financial life and death. This is especially true for firms that aren’t generating enough cash flow to cover their operations. Today, Mr. Wang is unloading some of his most prized assets — hotels, theme parks, real estate, movie studios — at fire-sale prices. Opportunistic investors can smell blood and have identified a forced seller in Dalian Wanda.

What happened to Mr. Wang should serve as a cautionary tale of what lies ahead. Reckless spending fueled by cheap and abundant capital is coming to an end. China’s model was sustained by enormous inflows by way of foreign direct investment and the world’s willingness to absorb China’s exports. In an era of rising economic nationalism and concern over loss of jobs, there is recognition within China’s governing circles that what worked in the past may not be as reliable in the future.

China’s vast dollar reserves are the piggy bank that China will need to rely on should its economy continue to falter. In order to preserve what is left, it will do what it feels necessary to keep the river of outflows from becoming a flood.

Arthur Dong is a professor at Georgetown University’s McDonough School of Business. He specializes in legal and business engagements between China and the United States. 

The views expressed by contributors are their own and not the views of The Hill.