Debt levels and corporate leverage
A second serious threat to sustaining high levels of Chinese outbound investment is the indebtedness of China’s corporate sector. From 2010 to 2016, total outstanding debt in the Chinese economy increased by 166 percent to more than US$24 trillion, with the majority of the growth attributable to sharp increases in lending to state-owned enterprises and, to a lesser extent, private firms. This brought China’s corporate debt-to-gross domestic product (GDP) ratio to more than 160 percent and China’s total debt-to-GDP ratio to more than 220 percent in 2016 (Figure 5). China’s elevated debt levels are widely viewed as dangerously high. A tightening of domestic monetary conditions in China (for example, in response to rising interest rates in the US) could have a significant impact on the ability of Chinese companies to service their existing debt and raise additional funds for outbound M&A transactions.
A phase of serious deleveraging or a slowdown of economic growth could also disrupt established financing mechanisms for outbound M&A at state-owned banks and weigh on the appetite of international banks to participate in financing. Japan provides a sobering historical precedent: Outward financial direct investment OFDI by Japanese companies soared in the 1980s on the back of strong GDP growth and asset price increases, but then tanked subsequently as the asset bubble burst and Japan entered its lost decade (Figure 6).
Host countries are also increasingly anxious about potential negative economic impacts from Chinese M&A activity. One of the main concerns is the lack of reciprocal market access for foreign firms in China. While Chinese OFDI has grown rapidly in recent years, China has only made limited progress in further leveling the playing field for foreign companies in China, which still face numerous formal investment restrictions as well as alleged informal discrimination. This lack of reciprocal openness is fueling particular frustration in advanced economies, which follow principles of openness and nondiscrimination for Chinese and other foreign investors (Figure 7). Another set of economic concerns are related to the unusual role of the state and industrial policy in China’s economy. Host economies are increasingly worried that outbound investment could become a channel through which distortions in the Chinese marketplace such as asset price bubbles and misallocation of resources spill over into overseas markets. Policymakers are also nervous about potential unfair advantages through subsidies and access to preferential loans for state-owned companies, and acquisitions of technology assets driven by industrial policies such as “Made in China 2025.” Several countries are in various stages of reevaluating their inward investment policies in response to these new concerns, including Germany and the US. This has also been discussion in Europe and the US about the appropriateness of introducing so-called “net economic benefit tests” and “reciprocity tests,” in addition to a narrower national security analysis. While such tests have not yet been put in place in major European jurisdictions or the US, the discussion marks a trend toward greater emphasis on such policy considerations, at least within the political debate.
Figure 5: The recent explosion of Chinese corporate debtCorporate debt growth and levels in China compared to selected other nations
Source: Bank for International Settlements, Rhodium Group. Includes all countries included in the Bank of International Settlements dataset on total credit to the non-financial sectors except Luxembourg (363%), Hong Kong (233%) and Ireland (264%).
Regulatory and political backlash in host economies
A third major risk factor for the future trajectory of Chinese outbound M&A is changing attitudes toward Chinese capital in host economies. There is increasing anxiety in host countries about the potential impacts of Chinese takeovers on national security. Foreign control over local assets can elicit specific national security concerns, and many countries have specific investment review regimes in place to assess and mitigate these kinds of concerns. These regimes typically have review processes that consider factors such as foreign control over strategic assets, influence over production of critical defense inputs, transfer of sensitive technology, and possible on-the-ground espionage and sabotage actions. In addition to worries about proximity of Chinese-owned companies to military installations and other critical infrastructure, Chinese companies’ increasing appetite for high-tech assets with potential military dual-use applications has elicited concerns, which has contributed to the collapse of a number of Chinese takeovers in recent years. In a November 2016 report to the US Congress, the China Economic and Security Review Commission recommended changes to the CFIUS statute that would empower CFIUS to block Chinese SOEs from acquiring US companies.
Figure 6: The case of Japan illustrates the impact of a sharp growth slowdown on outbound investmentJapanese 3-year average OFDI flows (left, US$ million); Japanese 3-year average GDP growth (right)
Source: United Nations Conference on Trade and Development, World Bank, Rhodium Group
One of the concerns abroad is the lack of reciprocal market access for foreign firms in China
In the US, the Committee on Foreign Investment in the United States (CFIUS) reviews transactions for potential security threats. CFIUS is chaired by the Secretary of the Treasury, and includes the heads of various other US Government agencies and certain other key Executive Branch representatives. The CFIUS review process is ostensibly voluntary, though CFIUS actively looks for transactions of interest that were not notified and can “invite” parties to file or initiate reviews directly.
Approaches to screening foreign investments for national security risks
The process consists of a draft “prefiling” that typically takes several weeks and allows CFIUS staff to provide initial feedback on a filing; an initial 30-calendar-day review period; a potential additional 45-calendar-day investigation phase (which is required in more than a third of all cases); and, in rare instances, a 15-calendar-day Presidential review period. In cases in which CFIUS has national security concerns, it can impose mitigation requirements to address those issues, recommend the parties abandon the deal if no mitigation is deemed acceptable, or refer the case to the President with a recommendation to block the transaction if the parties will not abandon it.
Cases in which Chinese deals were prohibited or canceled as a result of the CFIUS process have included acquisitions of US companies in close physical proximity to sensitive military installations, those that are part of US critical infrastructure, and US companies with technology with both military and civilian applications. While CFIUS’s scope is legally limited to national security only, national security is not defined by law and CFIUS tends to interpret its jurisdiction broadly. There is also a chance of tougher scrutiny under the new US administration, including the potential for new legislation, making the CFIUS process more aggressive and possibly having a reach beyond national security concerns. Canada and Australia both employ review mechanisms based on criteria that are not limited exclusively to national security. With respect to Canada, if financial and other thresholds are exceeded, the investor may be required to obtain approval by showing that the investment is of “net benefit” to Canada. Net benefit criteria include economic, antitrust, Canadian participation and national security elements. Even if no approval is required, the investment could be subject to Canadian review based on national security considerations, which an investor may choose to address prior to implementation. Australia requires a wide variety of transactions involving foreign persons to be reviewed and approved before completion, including any acquisition by a foreign person of a substantial interest (20 percent or more) in an Australian entity and the acquisition of residential or vacant land. Historically, there have been few rejections by the Treasurer of Australia on the grounds of national interest, but recently the Treasurer has blocked three high-profile investment proposals. Also, the Foreign Investment Review Board, which advises the Treasurer and examines foreign investment proposals, has been increasingly willing to use conditions and undertakings to increase the government’s oversight of more complex or sensitive investments. The European Union does not have a supranational framework for reviewing foreign investment, and approaches vary greatly between countries.
Germany generally provides for a liberal investment climate and limited restrictions on foreign investments. However, there is a growing scrutiny by the Federal Ministry for Economic Affairs and Energy (BMWi) on acquisitions by investors that are not members of the European Union or European Free Trade Association (especially in the tech sector). This may also be seen as a direct response to another peak of Chinese M&A activity into Germany seen in 2016 and the lack of reciprocity in M&A market access to China voiced by German government officials. Pending further changes in the current legislative environment, the threshold for blocking decisions by the BMWi remains high, requiring an actual and sufficiently serious threat to public order or security.
Figure 7: China is One of the most restrictive countries for foreign direct investmentIndex based on formal investment restrictions, ranging from 1=Closed to 0=Open
Source: Organization for Economic Cooperation and Development. The index is compiled by measuring restrictions on foreign equity, screening and prior approval requirements, rules for key personnel, and other restrictions on operating foreign enterprises. These factors are weighted and scored for all industries, which are then aggregated and weighted into an overall index for each country.
Near-term risks to China’s outbound M&A
In 2016, China became the second-largest global source of completed cross-border M&A. However, Chinese investors now face a number of significant near-term risks, which may lead to greater volatility in outbound M&A patterns going forward. The three main risks are capital controls related to balance of payments pressures, corporate and broader debt levels in the Chinese economy, and growing regulatory and political backlash against Chinese investment from host economies.
Balance of payments and capital controls
One major driver behind the recent growth in Chinese outbound M&A has been the far-reaching liberalization of administrative controls on corporate outward investment. After the latest round of reforms in 2014, most overseas investments now only require registration with local authorities, with formal approvals limited to large-scale transactions and investments in politically sensitive countries and industries.
This liberalization was predicated on a structural surplus in the financial account of China’s balance of payments. However, China’s financial account position has moved from significant surpluses to substantial deficits in the past two years (Figure 4). Capital outflows accelerated after the one-off yuan depreciation in mid-2015, and by early 2017 China’s foreign exchange reserves had dropped by US$1 trillion, or about 25 percent from the peak in mid-2014. Additional currency pressure looms with expectations of an expansive US fiscal policy and further rate hikes by the Federal Reserve in 2017. In reaction to these pressures, Chinese authorities began to retighten administrative controls for capital outflows in 2016, including those for outbound M&A transactions. While publicly reaffirming support for legitimate outbound investment, Beijing issued informal guidance to regulators and local banks to scrutinize certain types of outbound investments. Beijing’s new stance on outbound acquisitions is unlikely to bring deal flow to a halt, but it will slow down certain types of transactions. Moreover, the new policies have
Figure 4: Accelerating capital outflows are pressuring Chinese policymakersFinancial account by component in China’s quarterly balance of payments (US$ billion)
Source: People’s Bank of China, State Administration of Foreign Exchange, Rhodium Group. Data for 4Q 2016 is preliminary, and a full breakdown by category is not yet available.
By early 2017, China’s foreign exchange reserves had dropped by US$1Tr compared to the 2014 peak
further raised the bar for Chinese companies in terms of reverse break fees and other concessions when competing for foreign assets, which could impair the ability of Chinese investors to continue the pace of buying seen in 2016.
China’s regulatory framework for outward foreign direct investment (OFDI) approvalChina has significantly liberalized and streamlined the regulatory process for OFDI in recent years. Under current rules, most companies only have to register their investments with local offices of the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC) before securing foreign exchange for their transactions from banks. Transactions involving more than US$300 million are subject to more stringent requirements and must be submitted to the NDRC for pre-approval. Deals involving sensitive countries, regions and industries must also go through a special approval process that involves MOFCOM, the NDRC and, in some cases, the State Council.
In reaction to rapid capital outflows, China increased scrutiny on certain transactions in 2016. The government did not formally change OFDI regulations, but it has taken additional steps to increase scrutiny for certain kinds of transactions. Most at risk are transactions that would require the transfer of large amounts of foreign exchange offshore, investments that are outside of the investor’s primary area of business, investments in real estate and other assets that primarily function as a store of value, transactions by over-leveraged companies or companies that rely heavily on domestic debt financing, takeovers aimed at taking private Chinese companies that are listed on overseas exchanges, and investments by limited partnerships.
In the first half of 2017, the government is expected to issue new rules to clarify and formalize new outbound investment policies for market participants.
China’s future outbound investment trajectory is contingent on the implementation of domestic reforms
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