Keep an Eye on China

 | Nov 08, 2012 | 4:30 PM EST
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In Wednesday's column, I referenced the decline of foreign direct investment (FDI) flowing into the U.S. About 85% of the FDI flowing into the U.S. comes Europe and is used to manufacture goods for U.S. consumers. It's also quite volatile.

The decline of FDI into the U.S. this year is not principally because of European investors diverting capital from the U.S. to China. It reflects the state of the economy throughout Europe and the U.S. In addition, there were and are concerns about the U.S. fiscal cliff, as well as the monetary, fiscal and tax policies that would be impacted by the results of the U.S. elections.

With the U.S. elections concluded, some of the uncertainty has been removed. The U.S. fiscal cliff and European economic issues remain and I will address them in the future.

I concluded yesterday's column with the concerns about China using its foreign reserves to invest in the U.S. and elsewhere. This will soon become an issue for U.S. policy makers and U.S. businesses. I'll discuss China's investments in other parts of the world at another time.

Chinese investment in the U.S. is still very small and limited. Chinese state-owned enterprises invest principally in mining and mineral concerns in the U.S., while private Chinese investors are almost solely focused on commercial real estate, mostly hotels.

However, it is most probable that the new Chinese government will feel compelled to increase the returns they are earning on their reserves by increasing and broadening their active investment in private sector business in the U.S. as well as in China. This process will cause the goals of the U.S. public and private sector to converge, with both becoming increasingly displeased with Chinese state actions.

It is inevitable that this will cause an increase in U.S. petitions for sanctions throughout the World Trade Organization (WTO), as well as potentially direct sanctions taken by the U.S.

Chinese state-owned banks using foreign reserves to actively invest in businesses would be similar to a bank in the U.S. investing directly into businesses that compete with their depositors. In the U.S., banks are disallowed from being involved in the ownership of businesses that are not specifically related to banking or a bit more broadly to the financial sector.

This is not the case in China, as the Chinese banks are owned by the state. In turn, Chinese banks are the principal route through which the Chinese government makes equity investments in businesses.

One of the only ways of partially alleviating these tensions would be for the Chinese government to open its currency. This would afford foreign investors in China the opportunity to do business in China, but not necessarily with the state-owned banks.

There is a lot of pressure on China to do so; in fact, the country's membership in the WTO requires it. Expectations right now though are that the incoming (and expected to be more conservative) government in China will attempt to postpone doing so even longer because their concerns about their domestic economy remain their first priority. Right now the only thing investors can do is wait to see what the new Chinese government will do as we move into 2013.

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