I've written several columns on the subject of China, and I will post in the comments section below the URLs for columns that provide context to what we will discuss in this column.
Before getting into China specifically, though, I want to offer a brief observation with respect to the global capital markets and their interactions with monetary and fiscal policy, especially given the Greek bailout.
As I write columns about the world's largest markets, an emerging pattern of commonality between them is becoming increasingly apparent. One could write a generic column concerning age demographics, wealth concentration, capital market activity for stocks, bonds, commodities and real estate, and monetary and fiscal policy, whether the region in question is the U.S., Europe, Japan or China.
As this pertains to China right now, though, I'd like to revisit the country's slowing exports and the declining inflows of foreign direct investment, coupled with the accelerating outflows of this foreign investment.
In previous columns I have explained the mechanics of foreign direct investment and its relationship to China's foreign reserves. Investors who are considering investing in China must understand that their capital, once brought into the country and converted to yuan, is not segregated. It is lumped into the general pool of foreign currency reserves.
That means that the dollars brought into the country are not set aside or even accounted for with respect to particular foreign investors. Nor is there even any legal obligation for the Chinese to manage these foreign reserves on behalf of the foreign investors who provide them.
If China wants to use these foreign reserves to invest on its own behalf, it may do so, essentially using foreign capital for its own purposes without compensation to the foreign investors. This is similar to MF Global using its clients' deposits for the benefit of MF Global and its owners and managers, rather than for the benefit of the clients themselves.
Further -- and this gets to the heart of what foreign investors in China need to be aware of now -- China can use the new inflowing funds from foreign investors to provide the exit capital to previous foreign investors who wish to withdraw their funds from the country. This is a kind of Ponzi scheme.
This also means that the capital brought in by U.S. investors in the form of dollars may be converted to euros or yen to provide exit capital for exiting investors from Europe or Japan. Chinese foreign direct investment, in aggregate, has now declined for three months in a row, November 2011 through January 2012. Although this is clearly attributed to the burgeoning European recession, investors who are considering China need to be aware of it.
Because China uses a closed currency, foreign direct investment flows into the country are principally predicated on these investors' confidence -- not in their ability to make money with their investment while in China but in their ability to take that capital with them when they leave.
That confidence game or scheme, as with a Ponzi scheme, requires more money flowing in that out. In the event that the money flowing in becomes less than the money flowing out, there are few options. China could sell U.S. Treasuries from foreign reserves and use the currency to buy the equity from the exiting investors. It can also print yuan and convert it to dollars to do the same. It is doing both now, by necessity. In the event of an actual crisis of confidence leading to an attempt by many foreign investors to cash out at once, China would have to simply disallow it.
There is another issue to ponder: About half of the private equity in Chinese companies is owned and controlled by the government leaders in China, both national and provincial.
To put this context, consider how the decision making of the U.S. Congress, Federal Reserve and state, municipal, and judicial authorities would be affected if this relatively small group of people owned half of the publicly traded stock of companies in the U.S.
I will hypothesize that their decisions would be weighed more toward their personal interests than national interests. And I will leave it at that for the time being.
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