How Europe Should Respond to Growing Chinese Investment

Europe is experiencing the beginning of a structural increase of outbound foreign direct investment (OFDI) from China. Annual Chinese OFDI flows to Europe grew from less than $1 billion (€700 million) per year from 2004 to 2008 to roughly $3 billion (€2.3 billion) in 2009 and 2010. In 2011, flows tripled again to almost $10 billion (€7.4 billion). Chinese capital is flowing into many European countries and industries, with targets ranging from French vineyards to German machinery makers and British real estate.

Given the magnitude of growth and China’s unique state-capitalist system, these new investment flows have bred anxiety in many recipient countries. Europe is no exception. To many citizens, policymakers, and business leaders, the drivers of this buying spree seem impenetrable. They want to know what the consequences of this new trend are and what policy response is in Europe’s best interest. A new report by the Rhodium Group which analyzes the patterns of Chinese investment in the European Union from 2000 to 2011 helps answer these questions.

Drivers of the Chinese Investment Boom

Contrary to the perception of many observers, the surge in Chinese investment is not driven by a grand government strategy, but mostly by commercial motives. China’s growth model is changing rapidly, and for an increasing number of Chinese firms, continued growth and prosperity is becoming inexorably tied to overseas investment in developed economies. For some firms, the acquisition of rich-world brands and technology is proving to be a crucial element for gaining a competitive edge in the Chinese market. For others, it is often proving more economical to situate higher value-added activities in advanced regulatory locations like Europe or the United States. For yet other Chinese buyers, the crisis in the West presents the prospect of discontinued prices, while an increasingly stronger renminbi is making European assets look more attractive. For Chinese contract manufacturers of the labor-intensive products Europeans consume, defending market share increasingly means expanding market presence in order to relate directly with customers and deliver more of the value-added services that provide greater profit margins today.

The patterns of Chinese investment in Europe to date underscore these motives. Geographically, China’s OFDI preferences in Europe have come to resemble the OFDI patterns of other commercially driven nations, with the three biggest European economies — France, the United Kingdom, and Germany — receiving the most Chinese investment. This pattern supports the notion that China is investing like any other commercially motivated investor, not in some odd and idiosyncratic way. We see practically no evidence of declining OFDI prospects for states which run afoul of China politically over issues such as Tibet or arms sales, or rewards in the form of FDI for states which hew closer to Beijing’s assumed preferences.

The sectoral mix of Chinese investment in Europe likewise confirms the commercial nature of Chinese overseas investment. First, there is breadth and momentum in Chinese investment across all sectors, not simply cherry picking in a handful of strategic industries. Second, Chinese firms are placing a particular focus on technology, brands, human talent and sales channels for higher-value added products and services, instead of just export facilitation and securing resources. Third, several sectors show greenfield projects valued at several hundreds of millions of dollars, indicative of the Chinese commitment to establishing significant long-term European operations across many sectors.

Finally, the importance of non-state firms is increasing. State-owned enterprises still account for two-thirds of the total value of deals from 2000 to 2011, due to a handful of large-scale acquisitions in capital intensive sectors. However, non-government-owned firms are responsible for about two-thirds of all Chinese deals in Europe in the same period, and their weight is increasing. This ownership mix is consistent with a benign model of China’s OFDI story; government-controlled firms continue to target resource and other capital-intensive industries while investment from China’s private sector soars across all sectors.

Looking ahead, the ongoing structural adjustments in China can be expected to sustain future growth of outward FDI. This offers the opportunity for Europe to attract additional Chinese investment in the years ahead. China’s global OFDI can be expected to grow by $1-2 trillion by 2020. If Europe attracts the same share of global FDI as in the 2000s — around 25% — then by 2020 Europe would see $250-500 billion in cumulative new Chinese investment. If Chinese outflows underperform and Europe ceases to attract as big a share, an annual average of $20-30 billion can still be expected for the coming decade.

The Benefits from Greater Levels of Chinese FDI

The increase in Chinese investment is real, but many wonder if these new investment flows are beneficial. Europe’s historical openness to foreign investment is based on the assumption that FDI is overwhelmingly advantageous for the host economy. Chinese FDI should have the same benefits as direct investment from other countries, as our analysis of almost 600 Chinese deals confirms.

From a macroeconomic perspective, FDI increases the welfare of both producers and consumers. It allows firms to explore new markets and operate more efficiently across borders, reducing production costs, increasing economies of scale and promoting specialization. It is particularly important when serving overseas markets requires an on-the-ground presence (for example, in the provision of services). FDI also means better prices for firms looking to divest assets, thanks to a bigger and more competitive pool of bidders. For consumers, it increases the contest for buyers’ attention, leading to more choices, lower prices, and innovation.

At the local level, foreign investment brings tax revenue, knowledge spillovers from worker training, technology transfers and R&D activities, and new jobs. Some of these benefits from increased Chinese investment are already tangible in Europe. We count around 45,000 EU jobs associated with Chinese direct investors today, with room for considerable growth as China’s investment presence grows. Chinese R&D activities in Europe continue to expand as well.

Finally, Chinese direct investment can have positive political spillover effects. Keeping Europe open to Chinese firms leaves Beijing with no impetus to make China more restrictive for European firms. Allowing Chinese firms to operate freely in Europe also exposes them to a regulatory environment with standards much higher than those found within China. Business practices learned in developed economies like Europe will be taken back to China and may help to inspire a better regulatory environment and more level playing field there for European firms. As Chinese firms gain a greater foothold in Europe, China may also become more sensitive to how its foreign policies affect Chinese nationals with European interests, which will likely lead to a more nuanced approach to Chinese-European political relations.

The Risks: How China is Different

While these benefits have begun to be felt, there are also known risks from foreign ownership of assets. And some of these risks are even more pronounced when it comes to investment from China, given the unique characteristics of the Chinese state-economy.

Four major economic concerns are fueling anxiety in Europe. First, a large inward FDI presence could expose Europe to China’s wild macroeconomic swings — both upside and downside. Second, industrial policy or government ownership might cause Chinese firms to ship newly acquired assets back to China rather than maintaining them in Europe. Third, China’s firms could reinforce unfair competitive advantages by operating and investing more freely in Europe than their EU rivals can in China. Fourth, Chinese firms accustomed to lax regulations at home will bring poor labor, environmental and other practices to Europe, and EU governments will be too eager to attract jobs and investments to robustly hold them to account. These concerns spring from the exceptional size and velocity of China’s growth, its residual non-market elements, and the revival of interest in state capitalism and nationalism as alternatives to Western consumer-centric models.

In terms of political risks of Chinese FDI in Europe, many suspect that Chinese officials might threaten to withhold direct investment if they believed doing so could affect European politics. While Chinese firms are less subject to Beijing’s puppetry than many observers believe and the selection of economically feasible investment targets is not undertaken at the behest of back-room political strategists, Beijing indeed has a track record of mixing money with politics. The most recent example is tit-for-tat games with Europe over support for crisis stabilization funds.

Finally, while national security fears related to foreign investment are not new, China presents particular concerns. For one, China will likely be the world’s largest economy within two decades, lending it huge leverage and power to shape global national security. Second, China is a one-party authoritarian state with values at variance and sometimes at odds with those of OECD countries, and state ownership creates special concerns about non-commercial investment motives. Third, China has a stated aspiration to displace the existing global power balance in favor of a greater role for itself, including a greater voting share in international organizations, most likely at Europe’s expense. Fourth, China has a troubled record on export control rules and a reputation as a major proliferator of sensitive technologies to rogue regimes, raising the potential for discord over the obligations of China’s firms in Europe. Finally, the intelligence communities in Europe and North America consider China a heightened threat for economic and political espionage.

Policy Priorities in the Era of Chinese Investment

While the growth in recent years is impressive, many chapters in the story of Chinese EU investment have yet to be written. Securing the right policy response is crucial, given the potential for future investment flows and China’s role as a test case for a wider range of emerging market investors. Policy attention to a number of matters is crucial at this point in time to maximize the benefits from these new capital flows while addressing legitimate concerns:

First, Europe must keep the door open. Europe must not risk losing its hard-earned reputation for openness by imposing additional barriers to capital inflows based on economic security considerations. Several cases have already raised that specter, for example the reactions to Tianjin Xinmao’s announced takeover of Dutch cable maker Draka in 2010. There may be more loopholes for veiled protection in the European framework than admitted, and the reaction to China is not yet fully tested.

Second, Europe must address economic concerns forthrightly. Europeans will only continue to embrace foreign investment if they know a thorough, EU-wide process to address valid concerns is in place. It would be favorable not to burden the investment screening process with “economic security” demands arising from legitimate worries about China’s system. Nor would reciprocity demands be practical or productive. Rather, policy should be in place to protect EU economic interests via internal processes including competition policy review and other instruments such as a bilateral investment treaty with China. A rational and systematic game plan for handling the concerns sure to arise over China’s system without risking investment protectionism is best for Europe and may help to facilitate better international coordination to manage the advent of emerging market OFDI.

Third, Europe must take national security seriously. Europe’s current fragmented approach to screening foreign investment for security threats risks a race to the bottom, fails to address pan-European national security risks, and offers room for protectionist abuse in the name of security. A common European concept and legislative framework for investment review is needed to address these problems and hedge against a protectionist fallback in the false name of security. Greater transatlantic and international coordination is needed to reach a consensus on legitimate investment restrictions and global best practices for investment reviews.

Finally, fixing Europe’s structural problems is the best way to promote and sustain Chinese investment. An EU-China bilateral investment treaty will help to address market access problems on the European side, but it will do very little to promote investment flows from China. Tailored investment promotion approaches that help Chinese investors overcome the hurdles of entering mature market economies are important to sustain the inflow of Chinese investment. In the long run, it is critical that Europe finds a way out of its current crisis. Only a competitive EU economy can sustain foreign investment from China and other places — and in turn better cope with any challenges it raises.

Copyright © 2012 eSharp.