China's Domestic Economic Activity Conundrum

 | Nov 07, 2012 | 4:30 PM EST
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On Tuesday, I wrote about the importance of foreign direct investment to China's economy and what investors should watch for as the Chinese begin forming their new government tomorrow. In this column, I'll discuss the domestic economic needs in China and how they may impact the national policies on trade and currency management by the new government.

The relationships China has with the U.S. government and the U.S. private sector are not the same. In fact, in some ways, the goals pursued by each relationship are diametrically opposed.

The Chinese economy is shifting away from an export driven model to a domestic growth model so, by necessity, the country's reliance on foreign direct investment (FDI) for capital intensive projects increases. In order to continue to attract FDI, the government must make the country more attractive than other parts of the world, including the U.S. They've accomplished this by providing a very investor friendly regulatory environment.

The result is that even though FDI going into China has decreased by about 4% this year, it has decreased by almost 40% in the U.S. So, even though the actions taken by China are pleasing to U.S. investors, they are seen as antagonistic by U.S. government leaders.

This is not a situation that is going to change -- regardless of any punitive actions, such as trade sanctions or tariffs, which the U.S. may attempt to pursue against China. The only way to preclude capital flight from the U.S. is for the U.S. government to pursue reducing regulatory and tax burdens on U.S. businesses domestically and to reduce taxes on the repatriation of foreign earnings of U.S. businesses.

Neither of these actions is likely to occur in the near future, but I am monitoring the situation and will write about it when appropriate.

As FDI in China has steadily increased over the past 30 years, the value of China's foreign reserves have as well. They now stand at about $3 trillion, with about $1 trillion of that invested in U.S. Treasuries. This is the largest foreign reserve pool in the world, and it is 3x larger than the second largest pool in Japan.

This money has all accumulated in China's foreign reserves as an almost sole result of the manufactured goods exports portion of the economy that was made possible by foreign investors bringing money into the country to capitalize on cheap labor.

Now that this labor arbitrage has been exhausted (as labor costs in China have risen), many in Chinese officials are advocating using the foreign reserves to stimulate domestic economic activity. This is a very risky thing to do, though, because one-third to one-half of those foreign reserves represent FDI brought into the country by principally U.S. investors, and the profits they've accrued since. Using these reserves now to stimulate domestic economic activity may be viewed by foreign investors as the Chinese government competing with them for business using capital that is owned by the foreign investors!

Just as the need to stimulate FDI in China has caused tensions between the governments, the need to stimulate domestic economic activity now risks aggravating the investors who provided the FDI.

Equity investors considering China must be aware of these issues and watch for the decisions that the new government will begin making about them in 2013.

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