The long-term potential of Chinese outbound investment
While there are plenty of challenges that may cause greater volatility in China’s outbound M&A trajectory in the coming years, it is important to peg expectations about future Chinese outbound investment to an analysis of economic fundamentals. These fundamentals suggest that China is still only at the beginning of a secular catch-up in global investment, and Chinese companies can be expected to spend hundreds of billions of dollars on overseas deals in the coming decade if short-term speed bumps are overcome.
Inflection point: China only recently became a net exporter of FDI
History has shown that countries’ external investment patterns closely follow their economic development trajectories. In the early stages of economic development, most countries build a deeply negative net position in foreign direct investment (FDI) as they draw foreign capital, while domestic firms do not yet have significant capabilities and interests to invest overseas. As per capita GDP increases, inward FDI growth tends to level off, and local firms start investing abroad. At some point, typically around a per capita GDP of US$15,000, FDI outflows overtake inflows and the net outward FDI position eventually moves into positive territory. Once countries surpass the middle income threshold, their investment position fluctuates depending on macroeconomic fundamentals and other factors (Figure 8). China’s FDI trajectory is so far in line with these patterns. It has absorbed large amounts of FDI since the beginning of its opening up reforms in the 1980s and had an inward FDI stock (the cumulative value of previous investments) of US$2.8 trillion by the end of 2015. OFDI has been limited in the past but has been expanding fast in recent years, slowing the growth of the net FDI deficit. In 2015, outward FDI flows surpassed inward flows for the first time, turning the tide toward a narrowing net FDI deficit position. In the coming years, China will likely move toward a more balanced position. But with a net FDI position of negative US$1.7 trillion in 2015, it will take China hundreds of billions of dollars of additional outflows to get close to a balanced OFDI-FDI stock ratio.
Figure 8: Countries’ net FDI positions typically move from deficit to surplus as per-capita GDP increasesRatio of outward FDI to inward FDI stock against per capita GDP, 2015
Source: International Monetary Fund; Rhodium Group. Blue line is a logarithmic best fit line inserted to show the general uptrend seen in countries; OFDI-FDI stock ratios as per-capita GDP increases
Ample headroom: China’s OFDI stock is low by all measures
In gauging the magnitude of future outflows, it is important to emphasize just how small China’s current outward FDI position is compared to other economies. Chinese outbound FDI flows have grown spectacularly in recent years, but China’s total stock of OFDI is still among the smallest in the world.
This sense of scale is amplified when considering the size of China’s GDP. The growth of China’s GDP has averaged in the double digits for the past decade, turning China into the world’s second-largest economy. Compared to this rapid increase in GDP, China’s OFDI stock growth has been small. With an OFDI stock of US$1.1 trillion and US$11 trillion in GDP, China’s OFDI-to-GDP ratio was only about 10 percent in 2015, far below developed economies, such as the UK (72 percent), France (65 percent), Germany (58 percent) and the US (39 percent), and less than many emerging markets, including South Africa (49 percent) and Brazil (16 percent) (Figure 9).
China’s outward FDI intensity is also low compared to other modes of global economic integration. After three decades of absorbing FDI, China’s inward FDI stock-to-GDP ratio amounted to 26 percent in 2015. China also rapidly expanded its foreign trade, with imports reaching 15 percent of GDP and exports 20 percent of GDP in the same year. At 10 percent, the ratio of outbound FDI to GDP is still lagging behind despite a rapid increase in recent years (Figure 10).
Projections for Chinese outbound investment under various scenarios
It is clear that China is punching below its weight in terms of global outward FDI. But what is the magnitude of the upside? A number of academic studies have tried to map out China’s OFDI trajectory in the context of broader Chinese external liberalization, but they have yielded either abstract results or numbers that have already been surpassed by reality.1 Historical data from other countries illustrate why this might be the case; while a demonstrable positive relationship exists between per-capita GDP and OFDI stock, there is considerable country-specific variance in the expression of this relationship (Figure 11).
Recognizing that no two countries are identical, one illustrative way to project the magnitude of future Chinese outbound investment is to model assumptions based on the historical OFDI stock of different economies along their economic development paths. Applying these historical OFDI stock trajectories to potential scenarios for China’s GDP growth supplies a range of possible trajectories for the growth of China’s OFDI stock through 2025 (which will mainly consist of outbound M&A).
Concept and definition of foreign direct investment
Foreign direct investment (FDI)is a type of cross-borde capital flow that results in significant long-term control of a company, as opposed to shorter-term portfolio investments and cross-border lending. FDI can come in two different modes: the establishment of new subsidiaries (greenfield FDI) or the acquisition of existing assets (mergers and acquisitions or M&A).
Inbound or inward FDIrefers to foreigners making investments in the respective nation.
Outbound or outward FDI (OFDI)refers to residents of the respective country investing overseas.
FDI flowsrepresent investments made during a specific period of time.
FDI stocksrepresent the cumulative value of historical investments at a specific point in time.
In 2015, outward FDI flows surpassed inward flows for the first time
Figure 9: China’s OFDI stock remains tiny as a percentage of GDPRatio of OFDI Stock to GDP, Percent
Source: International Monetary Fund; Rhodium Group
Figure 10: Chinese OFDI remains underdeveloped relative to inward FDI and trade integrationPercent of GDP, 2015
Source: International Monetary Fund, Rhodium Group
Our optimistic scenario assumes that successful implementation of structural reforms helps China to rebalance its economy with minimal disruption. As a result, real GDP growth rates follow current projections by the International Monetary Fund through 2021 and then continue gradually stepping down, corresponding to an average annual real GDP growth of 5.5 percent from 2015 to 2025. China’s GDP increases from US$11 trillion in 2015 to US$18.8 trillion in 2025, which is similar to the size of the US economy today, and per-capita GDP reaches US$15,554.
This scenario also assumes that a favorable growth trajectory further boosts the OFDI intensity of China’s economy. Stable growth patterns allow Beijing to reverse recently implemented measures to control outflows and to continue liberalizing China’s OFDI regime. Marketoriented reforms also help to appease foreign concerns about economic risks from Chinese investment. As a result, China’s OFDI stock-to-GDP ratio doubles from 10 percent in 2015 to 20 percent in 2025, bringing it close to South Korea’s level today, but still well below the current average for high-income economies.
Under these optimistic assumptions, China’s OFDI stock increases 270 percent from US$1.1 trillion in 2015 to US$3.8 trillion by 2025.
Figure 11: OFDI intensity tends to increase as countries become richerOFDI Stock-to-GDP ratio against per capita real GDP level (2015 US Dollars)
Source: International Monetary Fund, World Bank, Rhodium Group
- See, for example, Cheng, Leonard K. and Zihui Ma “China’s Outward Foreign Direct Investment” in Feenstra and Wei, eds. China’s Growing Rolein Trade (2007): 545-578; He Dong et al. “How Would Capital Account Liberalisation Affect China’s Capital Flows and the Renminbi Real Exchange Rates?”,HKIMR Working Paper No. 09, and Bayoumi, Tamim and Franziska Ohnsorge “Do Inflows or Outflows Dominate? Global Implications of Capital Account Liberalization in China”,(2012)IMF Working Paper No. 13/189 (2013).
Economic fundamentals suggest that Chinese outbound M&A will remain strong in the coming decade if China can successfully manage short-term challenges
Our base-case scenario assumes a soft landing for China’s economy with more near-term volatility as delays in reforms make their eventual implementation more disruptive. Growth rates between now and 2020 fall below current IMF projections before bouncing back to a more sustainable trajectory after 2021, resulting in average annual GDP growth of 4 percent from 2015 to 2025. This trajectory brings China’s GDP to US$16.3 trillion and per-capita GDP to US$14,214 in 2025.
In this scenario, it is also assumed that a phase of greater domestic volatility requires Beijing to maintain outbound investment controls for longer, slowing down the outbound investment ambitions of Chinese companies. China’s OFDI stock-to-GDP ratio only increases moderately to 15 percent, which is in line with the current average for emerging markets and just below Brazil today.
Under these base-case assumptions, China’s OFDI stock grows by almost 140 percent to US$2.5 trillion by 2025.
Our pessimistic scenario assumes that China further postpones necessary structural adjustments and instead continues its debtfueled growth path. Consequently, a few more years of high growth ultimately give way to a hard landing with severe economic disruptions. The ensuing recession drags down the average annual GDP growth rate between 2015 and 2025 to just 2.5 percent, and China’s GDP rises to only US$14 trillion in 2025 with a corresponding per-capita GDP of US$12,143.
Under this scenario, many of the shorter-term challenges facing OFDI further deepen, including balance of payments pressures, growing corporate debt levels, and foreign concerns about negative economic spillovers. As a result, China’s OFDI stock-to-GDP ratio does not catch up with other middle income economies, but stagnates at 10 percent through 2025.
Under these pessimistic assumptions, China’s OFDI stock only increases by about 40 percent to US$1.4 trillion by 2025.
Breaking down these OFDI stock figures into annual averages illustrates that there is still significant potential upside for Chinese outbound investment, even from record levels in 2015 and 2016. In our optimistic scenario, China’s annual OFDI rises to an average of US$275 billion per year, nearly three times the average of US$101 billion that was achieved from 2010 to 2015. In the base-case scenario, annual OFDI flows average US$140 billion from 2015 to 2025, well above the 2010 – 2015 average. Only under the most pessimistic scenario do we see a substantial drop in annual flows below recent levels (about US$40 billion on average per year).
The majority of future outbound FDI flows will come in the form of mergers and acquisitions. If we assume that the share of M&A in total outbound FDI remains about the same as it was in 2016 (70 percent), then average annual M&A value reaches US$190 billion in the optimistic scenario and US$100 billion in the base-case scenario. In short, the record levels of M&A seen in recent years are likely just a floor for the coming 10 years, unless China’s economy experiences a hard landing.
Figure 12: Projections for Chinese outbound FDI stock by 2025 under various scenariosTotal stock (2015 US$ trillion)
Source: Rhodium Group. This chart combines three scenarios for China’s GDP and OFDI stock to GDP ratio to estimate different trajectories for China’s outbound FDI stock in 2025. All numbers shown are in 2015 US dollars.
In our optimistic scenario, China’s annual OFDI rises to an average of US$275 billion per year, nearly three times the average of US$101 billion that was achieved from 2010 to 2015
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