Building a Global Portfolio: What China Owns Abroad
The People’s Bank of China just released China’s 2011 Balance of Payments (BOP) and International Investment Position (IIP) data. This note summarizes the most important changes in China’s global balance sheet in 2011 and comments on the policy developments and real economy trends that will shape China’s international investment position going forward. The key points are:
China further built out its net creditor status: China’s net foreign assets reached a record high of $1.77 trillion, cementing China’s status as one of the world’s largest creditor countries. However, the growth of net foreign assets slowed down from last year, due to reduced reserve accumulation, challenges expanding outward investment and solid growth of the foreign investment stock in China.
China’s global investment position continues to be dominated by low-yielding assets: Despite the goal to diversify its global portfolio, China’s international investment position continues to be dominated by reserves and other low-yielding asset classes such as debt instruments, bank loans and cash. Direct investment and portfolio investment in equities remain a small part of China’s global portfolio.
A new momentum for capital account liberalization: The recent push for financial sector reform will give investors greater flexibility to move money in and out of China. The latest measures will particularly boost outward direct investment, inward portfolio investment and cross-border lending. However, reforms will remain gradual and changes in China’s net investment position will continue to be incremental.
China’s Net International Investment position
In 2011 China added another $600 billion of assets to its global balance sheet, bringing its total assets to $4.72 trillion (Figure 1). However, the pace of asset accumulation further slowed; the 15% year-on-year (y0y) growth rate was the lowest since 2004, the first year PBOC published detailed IIP data. This is mostly due to a slowdown in new investments abroad: a smaller trade surplus meant fewer new reserves for the central bank to manage, and firms’ outward direct investment dropped slightly from the previous year. In addition to a decrease in new investments, the value of existing assets declined due to valuation losses and exchange rate effects.
In the same period, China’s international liabilities – assets owned by foreigners in China — grew by $500 million to $2.94 trillion at year-end 2011, an increase of 21% compared to the previous year. Despite concerns about the health of China’s economy in the second half of 2011, the inflow of foreign capital remained strong on an annual basis, particularly in the form of direct investment and cross-border loans. The value of assets held by foreigners in China was also boosted by the appreciation of the renminbi against the US dollar and other valuation effects.
The faster growth on the liabilities side slowed down the expansion of China’s global creditor position. The country’s net foreign assets (NFA) — international assets minus liabilities – grew from $1.69 trillion in 2010 to $1.77 trillion in 2011, a year-on-year increase of 5%. The pace of net foreign asset growth has come down from an annual average of more than 50% in the years before the crisis (2004-2008) to an average of 6% in 2009-2011. However, China remains one of the largest creditors in the world and is a unique case among non-resource exporting emerging economies (Figure 2).
Despite rhetorical and real efforts to diversify its global portfolio, China’s global assets remain dominated by reserves holdings and “other investments” — trade credit, bank lending and currency holdings. Historically higher yielding asset classes such as portfolio investment in equities or direct investment stakes still account for only a small share of China’s global assets. The picture is reversed on the liability side, which is dominated by foreign direct investment and portfolio investment in equities – assets that historically have higher returns. This explains why China’s investment income balance remains negative despite its significant net creditor status. In 2011, China paid $157 billion in investment income to foreigners while receiving $145 billion in investment income from abroad. This implies an average 3-4% lower effective rate of return on Chinese assets abroad as compared to foreign assets in China (Figure 3).
Reserves: Slower Growth, increasing attempts at diversification
Reserves managed by the central bank’s State Administration of Foreign Exchange (SAFE) dominate China’s global portfolio. In 2011, China’s already huge reserves grew by another $342 billion to $3.26 trillion. However, this 12% year-on-year growth is the lowest increase of China’s reserve stock in seven years. There are two reasons for the slump. First, accumulation of new reserves fell to $388 billion, the lowest figure since 2006. China’s current account (CA) surplus dropped to $202 billion, or 2.8% of GDP – the lowest since 2005 – due to a lower trade surplus ($244 billion) and a higher services trade deficit ($55 billion) (Figure 4). Second, the difference in reserve accumulation and mark-to-market increase in reserve stock also suggests valuation losses on existing reserves.
The overwhelming majority of China’s reserves are foreign exchange reserves (98%), with the remaining 2% held in gold, special drawing rights (SDR) and deposits at the International Monetary Fund. The composition of foreign exchange reserves by asset class or currency is a closely guarded state secret. SAFE has generally favored greater diversification of these holdings, but the stark reality is that European distress and the risks associated with other currencies have left Beijing with far fewer alternatives to the US dollar than it would like.
In the absence of serious rebalancing efforts, China’s reserve accumulation is expected to continue going forward. The weak external environment and resilience of global commodity prices will keep China’s trade surplus down in the short term. For 2012, the International Monetary Fund (IMF) expects China’s current account surplus to shrink to 2.3% of GDP. In the medium term, however, the surplus is expected to swing back up if progress on structural adjustment policies remains limited. In its newest World Economic Outlook (WEO), the IMF estimates the current account surplus will climb to 4.25% in 2017. While that’s a significant reduction from the 2007 peak of 10.1%, in dollar terms it means tripling the surplus from its current $200 billion to $540 billion in 2017.
Other Investment: Expanding fast
The second biggest asset item on China’s global balance sheet is the “other investment” category, which consists of trade credit, loans, deposits and currency holdings. With a 33% increase, this was the fastest-growing asset class on China’s global balance sheet, driven by a massive expansion of trade credit (34% yoy) and cross-border lending (90% yoy) assets. Some of these outflows might have been hot money leaving the country amidst fears about a hard landing of the Chinese economy.
At the same time, all sub categories also experienced a massive expansion on the liabilities side in 2011, which pushed the “other investment” balance into negative territory (Figure 5). Trade credit liabilities continued to expand to $250 billion. Inward cross-border loan liabilities expanded by 50% yoy to $372 billion as the credit squeeze in China caused firms to increase borrowing abroad. Amid moderating but still positive renminbi appreciation expectations, currency and deposit liabilities increased by 56%.
The current momentum for accelerated capital account and financial sector reforms will likely further boost cross-border lending flows. Overseas expansion of cross-border lending already enjoys top-level policy support as it allows Chinese banks to lend out abundant foreign exchange at stable interest rates, in many cases with additional political benefits in recipient countries. Policymakers have historically been skeptical toward foreign lending, but recent policies indicate a greater readiness to let foreign loans into the country. In March, the National Development and Reform Commission (NDRC) substantially increased the quota for foreign banks for long-term debt. Export credits are likely to continue to be strong as well, as they not only provide stable returns on FX outflows but also yield other benefits such as export growth and foreign policy leverage. China’s recent commitment to comply with OECD export credit rules could change China’s export credit patterns, but its exporters’ goal to move up the value chain will generate continuous demand for export credits.
Direct investment: Taking a break, but structural growth Ahead
Outward foreign direct investment (OFDI) remains a small part of China’s global assets. In 2011, China’s OFDI stock grew from $317 to $364 billion, an increase of $47 billion. Net outflows in the BOP were slightly higher ($50 billion), suggesting valuation losses on the existing OFDI stock. Overall, the pace of outward FDI has slowed down from $58 billion in 2010 to $50 billion in 2011.
At the same time, inward FDI continued to be strong. According to China’s BOP, foreign firms invested $220 billion in China in 2011 — a slight drop from last year’s record volume of $244 billion, but still more than four times what Chinese firms invested abroad. In 2011, China’s inward FDI stock grew by $235 billion to $1.8 trillion, five times China’s outward FDI stock. The higher figure suggests an exchange-rate related appreciation of foreign assets in China. The gap between inward and outward FDI stock widened further in 2011, to $1.44 trillion (Figure 6). These figures are markedly higher than the FDI figures published by the Ministry of Commerce (MOFCOM) as they include reinvested earnings by foreign-invested firms in China and other flows, such as intra-company transfers. This is common international practice, but China just recently revised its BOP/IIP methodology to account for such flows, resulting in a sharp upward correction of the FDI stock in China.
Firms’ outward investment interests are increasing and further policy liberalization will promote OFDI growth in coming years. Recent reforms include a new scheme in Wenzhou for outward FDI by individuals. Bureaucrats are also reportedly working on a new comprehensive outward FDI regulatory framework. New guidelines by the State-owned Assets Supervision and Administration Commission (SASAC) will force state-owned enterprises (SOEs) to become more prudent in outward investment, but these rules are unlikely to materially impact their outward investment motivations and financial resources. At the same time, private sector investors – Sany, Huawei or Haier, for instance – are gaining importance in the outward investment arena. The lack of experience and capacity at Chinese firms remain major problems. Looking forward, we see the expansion of outward FDI as structural growth story and expect China to export 1-2 trillion in OFDI by 2020.
Portfolio Investment: on a tight leash
Portfolio investment – investment in debt securities and equity stakes below the 10% FDI threshold – remains the smallest position among China’s global assets at $260 billion. China’s portfolio investment assets have been virtually flat for the past five years at around $250 billion (Figure 7). Outward portfolio investment is tightly controlled by regulators due to fears of capital flight, and the few private investors with outward investment quotas have been cautious due to the volatility of global equity markets in recent years. After a sharp pullback in 2010, portfolio investment started to flow out again in 2011 ($6.2 billion), but valuation effects dragged down total growth of the portfolio investment stock to only $2.9 billion.
Foreign portfolio investment assets in China increased constantly since 2004, bringing China’s total liabilities to $249 billion in 2011. The expansion of quotas for inward portfolio investment under the Qualified Foreign Institutional Investors (QFII) scheme was on hold throughout most of 2011 due to concerns about speculative hot money inflows. In reaction to the sharp slowdown of foreign exchange inflows in the second half of 2011, regulators have reversed course, boosting QFII quotas from $20 to $25 billion in the first few weeks of 2012. There are reportedly plans to increase this quota to more than $80 billion this year.
The overall portfolio investment position is approaching equilibrium, but the composition of assets and liabilities fundamentally differ. Mirroring the structure of China’s global investment position, China’s foreign portfolio investment holdings are dominated by debt securities (76%), which require less sophistication and risk taking, but have lower returns historically. Foreign holdings in China, on the other hand, are dominated by equity positions (85%). Recent initiatives to reform China’s archaic corporate bond market and lift restrictions for foreign investment in these markets could help push up the share of debt securities in the liabilities position in the medium term.