Why China Will Keep Investing Abroad

BEIJING — Overshadowed by a sparkling economic report card for the second quarter, the leap in China’s official currency reserves last week is yet one more reason to bank on a transformative surge in the country’s investments abroad.

But the diplomatic storm whipped up by charges leveled by Beijing against four employees of Rio Tinto shows just how bumpy the journey overseas may be if it triggers a backlash against Chinese interests.

China has long been scouring the globe for energy and commodities to feed its thrumming economy. What is new is the leadership’s determination to increase outbound foreign direct investment, or O.F.D.I., as it weans the economy off low-value, export-oriented manufacturing. The deal by Sinopec, the largest Chinese oil refiner, to buy the Swiss oil explorer Addax for $7.24 billion last month was China’s largest overseas acquisition yet.

The government is not throwing caution to the wind. Beijing blocked Bank of China’s purchase of a stake in La Compagnie Financière Edmond de Rothschild, the French merchant bank, and has responded tepidly to a bid by Sichuan Tengzhong, a little-known machinery maker, for General Motors’ Hummer unit.

But the first half of 2009 may prove to be an inflection point for Chinese outbound foreign direct investment, said Daniel Rosen, a visiting fellow at the Peterson Institute for International Economics in Washington.

“Despite short-term anxieties, Chinese O.F.D.I. is poised to grow markedly in the medium and long term, and the importance of these investments to Chinese firms is changing fundamentally as the nation confronts the need to rebalance its growth model,” Mr. Rosen wrote in a paper whose co-author was Thilo Hanemann.

With domestic economies of scale largely exhausted, companies will have a powerful incentive to move abroad to upgrade their manufacturing and compete in more profitable areas like distribution, design and branding. “Made in China” will increasingly give way to “Made by China — abroad,” Mr. Rosen and Mr. Hanemann argued.

On top of the commercial motives, greater capital outflows would make monetary policy easier to conduct by reducing China’s balance of payments surplus. Because the central bank buys most of the foreign currency entering China to cap the yuan’s exchange rate, every dollar that can be recycled as outbound investment is one dollar less that must be bought and added to reserves.

Those reserves jumped $177.9 billion in the second quarter to $2.13 trillion, helping to generate record credit and money supply growth that economists fear may be creating asset bubbles.

“We don’t know what the right amount of domestic monetary creation is, but it’s pretty safe to say it’s much, much lower than the increase in central bank reserves,” said Michael Pettis, an economics professor at Peking University.

Hence the significance of new government rules issued last week that will make it easier for companies to finance outbound foreign direct investment.

“On top of China needing to invest — they need to secure energy supplies, they need to acquire technology — there’s also the element of recycling dollar revenues,” said Qu Hongbin, chief China economist at HSBC in Hong Kong.

China’s outbound foreign direct investment has increased steadily this decade, and the outflow of $52 billion last year was a record. Still, the historical stock of the outbound direct investment of $170 billion is puny next to China’s foreign exchange reserves and its inward foreign investment stock of $876 billion.

Mr. Qu, however, said that outflows could reach $100 billion to $150 billion a year as soon as 2012. And Mr. Rosen said in an e-mail message that sum would be “entirely conceivable” if there were no political interference from Beijing.

Mr. Rosen and Mr. Hanemann identify four areas where progress, now blocked by the state’s reluctance to take its hands off the economy, is needed to promote outbound investment.

The government must completely pull back from companies’ investment decisions. It must further liberalize access to foreign exchange and O.F.D.I. funding. It must let all companies invest overseas. And it needs a strategy that serves China’s long-term interests — defending pariah states where China has invested hurts the image of the country’s companies among consumers.

Similar reputational damage is where the detention by China of Stern Hu, an Australian and Rio’s chief negotiator in fractious iron ore pricing talks, may dim China’s ambitions to expand abroad. The perception that Beijing is exacting revenge on Rio for being outsmarted in the ore talks risks hardening attitudes far beyond Australia.

After all, critics already complain that foreign companies in China cannot trade and invest on a level playing field. So why should the West roll out the welcome mat for Chinese investors?

Mr. Pettis of Peking University said he expected outbound foreign direct investment to keep growing despite “political noise” generated by trophy transactions, but he acknowledged that Chinese attitudes toward overseas investors would hardly encourage foreigners to welcome Chinese investment.

“It’s too easy if you are opposed to a Chinese acquisition to point out the things that have happened here in China,” he said.

The “callousness” with which Beijing has blocked some inward investments raises questions about its seriousness toward cross-border investments both ways, Mr. Rosen and Mr. Hanemann said. Yet the implications of the Rio case are not clear-cut.

The charges laid at Rio’s door reflected China’s immaturity on matters of commercial regulation, Mr. Rosen wrote in his message. “On the one hand, that immaturity is an impediment to cross-border investment flows both ways. But on the other, and somewhat counterintuitively, it is one of the reasons China is so attractive as an investor and as a place to invest.”