From inflated assets to counterfeit FDI

China doesn't want firms to be 'ATMs' to enrich others

China is about to take measures to curb the wave of foreign acquisitions by Chinese companies that has grown rapidly over the last 18 months.

Draft policy papers released online at the end of last month outlined a new policy whereby government approval would be required for foreign acquisitions valued at more than US$10 billion (S$14.3 billion), or US$1 billion if the target was considered to be outside the acquirer's core business.

A moratorium would also be imposed on state-owned companies acquiring real estate overseas with a value of more than US$1 billion.

Furthermore, it was mooted that the State Administration of Foreign Exchange (Safe) would lower the upper threshold for money transfers requiring regulatory approval from the current level of US$50 million to US$5 million.

The new policies have yet to be officially inked but send a strong signal of intent.

For the last two decades, foreign money has been pouring into China. However, a startling trend reversal over the last few years has seen Chinese outbound foreign direct investment (FDI) soar as inbound FDI levelled off, reflecting the global economic slowdown and growing doubts about prospects for the Chinese economy.

The Chinese acquisition of assets abroad has hurt the yuan. The People's Bank of China (above) has used its forex reserves to defend the currency, with the reserves dropping from nearly US$4 trillion in July 2014 to just more than US$3 trillion last
The Chinese acquisition of assets abroad has hurt the yuan. The People's Bank of China (above) has used its forex reserves to defend the currency, with the reserves dropping from nearly US$4 trillion in July 2014 to just more than US$3 trillion last month. PHOTO: REUTERS

A turning point came last year when, for the first time since 1998, Chinese outbound capital flows surpassed those flowing in.

This buying spree has made a substantial dent in China's reserves. This year, China is due to record its first net FDI deficit, just as it surpasses the United States as the largest acquirer of foreign assets, with a total deal size of US$174 billion in the first three quarters, an increase of 68 per cent compared with the previous year.

The deficit has exacerbated downward pressure on the yuan, which has fallen 6 per cent this year against the US dollar, and forced the People's Bank of China to deploy unprecedented amounts of foreign exchange reserves to prop up the currency.

Such reserves fell from nearly US$4 trillion in July 2014 to just more than US$3 trillion last month.

The real challenge, as Beijing sees it, is controlling capital flight - not in the conventional sense of flighty foreigners, but Chinese money seeking to make its way offshore.

Even before last month's announcement, the Chinese system had made moves to try to clamp down on outbound capital.

Anbang Insurance's high-profile US$14 billion bid for Starwood hotels group earlier this year was withdrawn largely as a result of opposition by the China Insurance Regulatory Commission.

The latter has made comments about the dangers of insurers behaving like "ATMs", taking premiums from household savers to invest outside the country.

Regulators have their work cut out - an appetite of this size is difficult to control. Limits on capital movement over the last decade, as well as an extended anti-corruption campaign that has made many feel that their wealth is at risk, have created a great wall of capital that is frantically trying to make its way out of China.

Some of it is strategic - acquisitions of technology and premium brands in the US and Europe, or natural resources and infrastructure in South-east Asia and Africa - but much of it is not.

At the most basic level, there are ranks of would-be outbound investors - from household savers to state-owned banks - happy to take near-zero levels of interest in Europe over guaranteed returns of 6 per cent or more in China.

They will accept lower or zero returns because they believe their assets are safer in Europe.

And even a depreciation of a couple of percentage points is negligible compared with the risk of a market crash in China or having all of one's assets seized as part of an anti-corruption campaign, which has in recent months begun to focus on the family networks of party officials.

As well as non-profitable acquisitions, a growing number are non-strategic ones (such as the purchase for US$300 million of a British video-game developer by a provincial iron-ore miner), and beyond that, there are counterfeits.

"Fake" transactions have been a perennial feature of Chinese outbound investment.

Every year, Safe uncovers billions of dollars' worth of fake trades - which usually have two purposes, to move money offshore and channel company money into private accounts by means of the transaction.

Some deals fall somewhere between the non-strategic and the counterfeit. There is a real asset but its sale value is massively over-inflated, and the purchase rationale is largely spurious.

Such activity is partially driven by the patronage system.

Middleman brokers often appear in accounts of Chinese overseas mergers and acquisitions.

In return for identifying the acquisition target and facilitating the transaction, these brokers have been known to levy fees of up to 5 per cent on the value of the transaction. Subsequently, half may be passed back to the Chinese buyer, with funds landing offshore in a personal rather than a corporate bank account.

The same principle can also apply to loans - and indeed many of these transactions involve a high level of leverage. The average deal size for Chinese outbound acquisitions this year was around US$500 million; the broker fee might be US$25 million or more.

This system of personal kickbacks massively skews incentives for investment and presents a huge challenge to financial stability not just in China but also in the markets where the assets are based.

When transactions are being undertaken with the principal motive of moving money overseas or securing personal kickbacks, it is difficult to assess what proportion of these acquisitions - or the loans arranged to finance them - is based on sound investment theses.

The ballooning of counterfeit FDI comprising inflated asset values and unsound loans should worry regulators not just in China.

Even markets such as Britain, Germany and Australia, which have traditionally been more open to Chinese investment, have recently begun to grow more wary of taking advantage of the Chinese "ATM".

Potential Chinese buyers and foreign sellers are set to face more scrutiny over future deals, both in Beijing and their target markets.

This may be no bad thing.

•The writer is Asia director of Global Counsel, a strategic advisory firm with headquarters in London and offices in Singapore and Brussels.

•An earlier version of this was published on the Global Counsel's blog,

A version of this article appeared in the print edition of The Straits Times on December 13, 2016, with the headline 'China doesn't want firms to be 'ATMs' to enrich others'. Print Edition | Subscribe