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US-China Financial Investment: Current Scope and Future Potential

While FDI flows between the US and China have declined in recent years, portfolio investment in equity and debt has grown.

While direct investment and venture capital flows between the United States and China have declined since 2016, “passive” investment in equity and debt has grown. The inclusion of Chinese securities in international bond and equity indices points to additional growth, but policy headwinds are blowing hard from both sides of the Pacific. Recent decisions by the US administration, including an executive order banning American investment in firms with ties to China’s military and the forced delisting of certain Chinese firms from US stock exchanges, demonstrate that US policymakers view financial investment restrictions as part of their toolbox for resetting US-China economic relations. Beijing is allowing more foreign participation in domestic financial markets but only within tightly controlled parameters, and it maintains heavy controls on outflows. The abrupt decision to cancel the initial public offering of Ant Group in Hong Kong shows that political interventions extend to offshore financial markets. As policymakers navigate the complex questions around two-way financial investments, it is important for them to have reliable, comprehensive data on cross-border holdings. This report, by Rhodium Group for the National Committee on US-China Relations (NCUSCR), clarifies the scope and patterns of two-way financial investment in equity and debt securities and discusses key policy questions on both sides. The findings are:

China is a latecomer to financial globalization, but cross-border holdings of bonds and equities are growing faster than traditional capital flows. Beijing lags major economies when it comes to global financial integration due to its reluctance to liberalize short-term capital flows. However, China’s financial ties with the world have grown rapidly from a low base over the past decade as investors have found creative ways around capital controls and Beijing has started to gradually liberalize certain channels. Official statistics do not accurately capture the full scope of China’s external financial investment.

The United States is China’s most important financial counterpart, save for Hong Kong. US markets have been critical to Chinese company fundraising, and America is where government and household savers seek to reinvest surpluses and savings. We estimate there was as much as $3.3 trillion in US-China two-way equity and bond holdings (including securities held in central banks’ reserves) at the end of 2020 — nearly double the official figure of $1.8 trillion. Official under-reporting reflects the complex, multi-modal structures that are often used for international securities investments and the challenges statistical agencies have determining securities issuers’ and owners’ nationalities.

US holdings of Chinese securities neared $1.2 trillion at the end of 2020. We estimate that US investors held $1.1 trillion in equity and $100 billion in debt securities issued by Chinese entities at the end of 2020. That is about five times the holdings captured in official US data, which shows $211 billion in equity and $29 billion in debt holdings as of September 2020. Most of the disparity is accounted for by firms from China using complex legal structures to issue shares out of tax havens that trade on US exchanges. These practices continue despite legal peril in China and US regulatory pressure: in 2020 Chinese equity issuance on US exchanges was higher than in any year except 2014. US holdings of Chinese debt securities are smaller but are growing rapidly thanks to China’s efforts to improve access to its onshore bond market and to widening US-China interest rate differentials.

Chinese holdings of US securities reached as much as $2.1 trillion. We estimate Chinese investors held $700 billion in equity and $1.4 trillion in debt securities issued by US entities at the end of 2020. In comparison, official US data show $240 billion of equity and $1.3 trillion of debt holdings as of September 2020. Most of this difference is accounted for by equity investments misclassified in official sources due to investor efforts to circumvent Beijing’s capital controls or the use of Hong Kong as an investment intermediary. Debt securities account for the bulk of Chinese holdings. These are primarily US Treasury securities and agency bonds held by China’s central bank as reserves. While US investors have tended to prefer ownership of Chinese equities (and been rewarded with higher relative returns), Chinese investors in US securities have preferred lending to the US government and US corporations at relatively low interest rates. They account for a low share of foreign ownership of US equities.

US-China financial integration is at an early stage but faces powerful policy headwinds. Under normal conditions, there would be room for trillions of dollars in additional US-China financial investment before balances reached levels typical of advanced economy pairs. A few years ago, such expansion seemed likely, but policy-related hurdles are rising. Measures have proliferated on both sides which, if current trends persist, could greatly diminish growth prospects. Beijing has stated its preference for greater financial opening to the world but needs to enact far-reaching reforms before it can truly open its capital account without guardrails. Washington has traditionally taken a very liberal approach to financial globalization but a new era of “strategic competition” with China has led to a redrawing of national security boundaries, including in the economic and financial space. A new US administration is unlikely to fully reverse this shift but may strike a better balance between mitigating national security risks, incentivizing good financial governance, and preserving the benefits from benign linkages.

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