In June, China’s financial regulator requested banks to investigate several large enterprises actively engaged in overseas investment. The most notable is Dalian Wanda, China’s largest private property developer. China’s Banking Regulatory Commission has ordered banks to cut its credit lines to the company, which is now under investigation for violating new restrictions for overseas investment enacted last year.
These new regulations reflect the Chinese government’s increasing concerns about systematic risks that have built up in its financial market. Officials have noted a growing trend: The composition of China’s capital outflow has gradually shifted from state-owned foreign exchange reserves, typically with low yields, to privately-held foreign direct investments, typically with higher yields. Paradoxically, the investment returns on China's overseas assets have been declining despite the bullish global equity markets, suggesting that many private overseas investment decisions may have been unwise. Since state-owned banks supplied the loans for many of these projects, the poor performance of China’s outbound direct investment could transmit risks to the domestic banking sector. Some of these investments were also suspected to have helped individuals to evade capital controls when transferring funds abroad. The central government has understandably decided to tighten lending to the outward-looking private firms.
A closer look at the composition of China’s external assets reveals that foreign direct investment has become increasingly more prevalent in the country’s external asset portfolio. In 2016, foreign direct investment accounted for 20 percent of China’s overseas assets, rising from a mere 5 percent in 2005 (figure 1). Meanwhile, the share of reserves in foreign assets has been falling since 2011, to below half of the country’s total foreign assets in 2016.
Ownership of foreign assets has also been shifting. While the People’s Bank of China (PBC) continued to be the biggest owner of China’s foreign assets, its share has been declining steadily after reaching a peak of 80 percent in 2008 (see figure 2). Replacing its declining dominance, enterprises and individuals have held an increasing share of China’s total foreign assets, reaching 38 percent in 2016. The decreasing share of state-owned foreign assets seems to go hand in hand with the declining share of foreign exchange reserves.
Returns on reserves are typically very low—and lower than returns on private investment—especially when low interest rates have prevailed in all major economies. Figure 3 shows that the returns on China’s foreign reserves were even negative in some years in the past decade. Direct investment is expected to have a higher rate of return than foreign reserves. However, Chinese outbound direct investments have not been too profitable in the last two years. While the share of direct investment was rising, the return on those investments has been declining, from 15 percent in 2014 to only 0.4 percent in 2016, which is significantly lower than the 4.0 percent return for the country’s foreign reserves.
The Chinese government has been watching the excessive overseas expansion by private conglomerates for quite some time. The credit tightening in June, combined with the recent strengthening of rules on overseas investments that state-owned enterprises can make, may mark the beginning of a significant regime switch: Chinese overseas merger and acquisition activities will slow down substantially this year and possibly in the foreseeable future. In a recent press conference, China's Ministry of Commerce revealed that in the first half of 2017 nonfinancial outbound direct investment had already declined 45.8 percentage points compared to a year ago. It is clear that China has been strengthening its financial regulations, and we should expect a credit growth slowdown and more stable outbound investment at least in the near future. Along with the central government’s “Belt and Road” Initiative, the portfolio of Chinese foreign assets may tilt back to being more state controlled.