What will an appreciation of China’s currency do to inward and outward FDI?

by

Karl P. Sauvant and Ken Davies*

What will an appreciation of the Chinese yuan do to China’s inward and outward direct investment? The discussion so far has been almost exclusively about the impact on China’s trade balance. But it is at least as important to see what effect it may have on the country’s inward foreign direct investment (IFDI), which plays such a crucial role in China’s economic development, and its outward FDI (OFDI), which is receiving increased attention worldwide.¹

China has been the developing world’s largest recipient of IFDI since the mid-1990s, attracting US$95 billion in 2009.² A revaluation of the yuan will make it more expensive for foreign firms to establish themselves (or expand) in China (the world’s most dynamic market), giving an advantage to foreign firms already established there over new entrants. At the same time, exports of foreign affiliates, which account for 54% of total exports,³ will become less competitive internationally, although the increased costs will be partly offset by lower costs of imported inputs. Foreign affiliates can also expect to repatriate higher profits from sales in China in terms of their own currencies.

However, the most notable development of recent years has been the take-off of the country’s OFDI since the government in 2000 adopted the “go global” policy encouraging Chinese firms to invest overseas.⁴ China’s OFDI doubled from US$12 billion in 2005⁵ to US$27 billion in 2007, and then doubled again the following year, to reach US$56 billion.⁶ Outflows continued to rise to $57 billion in 2009, even as world FDI flows collapsed by 50%. In 2009, China was the world’s fifth largest outward investor.

The increasing international competitiveness of Chinese firms and an encouraging government policy have been the main drivers of this surge. The 20% revaluation of China’s currency against the US dollar in 2005-2008 undoubtedly provided a favorable condition facilitating this in the case of host countries whose currencies did not also appreciate against the US dollar. There is ample evidence in the academic literature that a weaker exchange rate induces increased IFDI.⁷

China’s OFDI is poised to grow sharply again in 2010, judging by the first half of the year, when it was rising at an annual rate of 44%⁸. Revaluation would accelerate this trend. This is precisely what happened with Japan after the yen was revalued by over 50% against the US dollar between 1985 and 1987, following the 2005 Plaza Accord.⁹ Japan’s OFDI tippled from US$6.5 billion in 1984 to US$19.5 billion in 1986, peaking at US$48 billion in 1990.¹⁰

A renewed yuan appreciation would boost China’s OFDI growth even further by lowering the cost of overseas assets for Chinese firms, which have strong cash reserves from both retained earnings and large-scale state credit allocations that put them in a position to invest internationally. Like competitors elsewhere, they need to invest abroad to acquire a portfolio of locational assets to protect and increase their international competitiveness through better access to skills, technology, natural resources, and markets.

Revaluation would combine with already rising wage pressures inside China. Labor-intensive firms in China’s coastal provinces are under pressure to seek lower labor cost by either investing in China’s interior of abroad. Already more than 700 Chinese affiliates have been established in Vietnam.¹¹  Revaluation would push even more in that direction.

Suspicions of non-commercial motivations behind China’s OFDI are widespread because most of the country’s OFDI is by state-owned enterprises (SOEs). However, there is no systematic evidence that China’s SOEs, like their counterparts elsewhere, are driven by more than normal commercial considerations. At the same time, private or semi-private entities have been investing abroad. As their operations are less visible, it is likely that their OFDI, and therefore China’s total OFDI, is understated.

Fears of Chinese OFDI, as of Japanese and Korean investment in earlier decades, are misplaced. It is good for China and for host countries: Chinese FDI, like all FDI, can bring to host countries a bundle of tangible and intangible assets needed for economic growth and development. While a good part of China’s OFDI initially takes the form of trade-supporting FDI, it can be expected to lead relatively quickly to a shift of some production out of China, including to the US and Europe, thereby reducing exports from China. Moreover, OFDI is a key mechanism for integrating China into the world economy and making it a responsible stakeholder in it.

However, Chinese firms will have to learn from the past mistakes of other emerging multinationals about how to operate in the highly sophisticated developed-country markets and in developing countries. They need not only to overcome the “liability of foreignness” that any multinational faces when establishing itself in a foreign market, but they also need to overcome the “liability of the home country”. In particular, they need to establish a good social brand name so that they are seen as making not only a positive economic contribution to their host countries, but are also seen as good corporate citizens. The Chinese government can play a crucial role by adopting a code of conduct for all Chinese enterprises investing abroad, in line with internationally accepted norms and taking into account the increasing importance of sustainable FDI. For their part, host countries need to accept the “new kids on the block” and not discriminate against Chinese investment, nor establish protectionist barriers against it.

The material in this Perspective may be reprinted if accompanied by the following acknowledgment: "Karl P. Sauvant and Ken Davies, ‘What will an appreciation of China’s currency do to inward and outward FDI?’ Columbia FDI Perspectives, No. 30, October 18, 2010. Reprinted with permission from the Vale Columbia Center on Sustainable International Investment (www.vcc.columbia.edu)." 

A copy should kindly be sent to the Vale Columbia Center at [e-mail].

* Karl P. Sauvant ([e-mail]) is the Founding Executive Director of the Vale Columbia Center on Sustainable International Investment, a joint center of Columbia Law School and The Earth Institute at Columbia University; Ken Davies ([e-mail]) is Senior Staff Associate at the same Center. The authors wish to thank Laza Kekic, Al Litvak and Edward Turner III for their helpful comments on this Perspective. The views expressed by the authors of this article do not necessarily reflect the opinions of Columbia University or its partners and supporters. Columbia FDI Perspectives is a peer-reviewed series.

¹ For a most recent overview of China’s IFDI and OFDI, see Ken Davies, “Inward FDI in China and its policy context”, Columbia FDI Profiles, October 18, 2010, and Ken Davies, “Outward FDI from China and its policy context”, Columbia FDI Profiles, October 18, 2010.

² UNCTAD FDI statistical database http://stats.unctad.org

³ Figure for the first eight months of 2010 from MOFCOM website: http://www.fdi.gov.cn/

⁴ See Qiuzhi Xue and Bingjie Han, “The role of government policies in promoting outward foreign direct investment from emerging markets: China’s experience”, in Karl P. Sauvant and Geraldine McAllister, with Wolfgang A. Maschek, eds., Foreign Direct Investment from Emerging Markets: The Challenges Ahead (New York: Palgrave, 2010), pp. 305-324.

⁵ Not including financial FDI.

⁶ Ministry of Commerce, 2009 Statistical Bulletin of China’s Outward Foreign Direct Investment (2010).

⁷ See e.g. Kenneth A. Froot and Jeremy C. Stein, “Exchange rates and foreign direct investment: an imperfect capital markets approach”, The Quarterly Journal of Economics, vol. 106, No. 4 (1991), pp. 1191-1217; and Kathry L. Dewenter, “Do exchange rate changes drive foreign direct investment?”, The Journal of Business, vol. 68, No.3 (1995), pp. 405-433.

⁸ Invest in China website: http://www.fdi.gov.cn

⁹ Announcement of the Ministers of Finance and Central Bank Governors of France, Germany, Japan, the United Kingdom, and the United States (Plaza Accord) September 22, 1985. University of Toronto G8 Information Centre: http://www.g8.utoronto.ca/ .The yen went from 238 to the dollar in 1985 to 168 in 1986, 145 in 1987 and 128 in 1988. See Zhang Zongbin and Yu Hongbo [张宗斌/于洪波], “Comparative research into China’s and Japan’s OFDI” [中日两国对外直接投资比较研究], World Economy and Politics [世界经济与政治] 2006.

¹⁰ JETRO, Japanese Trade and Investment Statistics, JETRO website: http://www.jetro.go.jp/

¹¹ China Daily, August 31, 2010, p. 14.

For further information please contact: Vale Columbia Center on Sustainable International Investment, Ken Davies, Senior Staff Associate, [phone], [e-mail].

The Vale Columbia Center on Sustainable International Investment (VCC), led by Dr. Karl P. Sauvant, is a joint center of Columbia Law School and The Earth Institute at Columbia University. It seeks to be a leader on issues related to foreign direct investment (FDI) in the global economy. VCC focuses on the analysis and teaching of the implications of FDI for public policy and international investment law.

Most recent Columbia FDI Perspectives View all

No. 34: "The backstory of China and India’s growing investment and trade with Africa: Separating the wheat from the chaff," by Harry G. Broadman.

Common misconceptions about China's and India's increasing FDI in Africa have arisen because of a lack of systematic evidence-based analysis. Empirically-derived data, including on comparator countries, need to be rigorously analysed within an objective and coherent framework so that policy conclusions can be drawn which will benefit the many stakeholders involved.

No. 33: "The pernicious institution of the party-appointed arbitrator," by Hans Smit.

As arbitration has grown by leaps and bounds, so has the role of the party-appointed arbitrator. Surprisingly, this has not led to increased inquiry into the appropriateness of having arbitrators appointed by the parties in general, or in arbitrations against states in particular.

No. 32: "State-controlled entities as claimants in international investment arbitration: an early assessment," by Michael D. Nolan & Frédéric G. Sourgens.

State-controlled entities, including state-owned enterprises and sovereign wealth funds, are increasingly important participants in international investment flows and international trade. As claimants in contractual arbitrations, they may face some unique issues, since it is not always clear whether such disputes may be considered "commercial". Until the status of such claims has been resolved, each case has to be examined on its merits.

No. 31: "How much do U.S. corporations know (and care) about bilateral investment treaties? Some hints from new survey evidence," by Jason Webb Yackee.

New evidence shows that top U.S. corporations are surprisingly unfamiliar with -- and/or lack confidence in -- bilateral investment treaties that are designed to benefit their investments in other countries. To understand whether or not such treaties "work", it is necessary to find out how and why they do, or do not, form part of firms' investment decision-making.

No. 30: "What will an appreciation of China’s currency do to inward and outward FDI?," by Karl P. Sauvant and Ken Davies.

A revaluation of the Chinese yuan would affect the country’s inward and outward FDI, not just its exports and imports. The impact on FDI inflows to China would be both positive and negative. On the other hand, revaluation is likely to provide a strong boost to overseas investments by China’s multinationals, which have been rising rapidly in recent years. Suspicions that China’s outward FDI is politically motivated are not so far borne out by systematic evidence. The rest of the world should learn how to benefit from this investment, not try to raise protectionist barriers against it. 

No. 29: "Mining for facts: PacRim Cayman LLC v. El Salvador," by Alexandre de Gramont.

Responds to Perspective No. 23 by Gus Van Harten by briefly presenting Pacific Rim’s case in Pacific Rim v. El Salvador and defends the international arbitration process by which this case is being adjudicated as fair, neutral and objective for both parties.

No. 28: "Will China relocate its labor-intensive factories to Africa, flying-geese style?," by Terutomo Ozawa and Christian Bellak.

The authors explore the China-side determinants of China’s industrial relocation to sub-Saharan Africa, highlighting several hurdles to substantial translocation that would jump start local economic development.

No. 27: "Political risk insurance and bilateral investment treaties: a view from below ," by Lauge Skovgaard Poulsen.

The author reviews evidence from a survey of political risk insurance providers on the consideration of bilateral investment treaties when assessing the risk of investment projects. He finds that, while BITs are basically aimed at reducing the risk of investing abroad, many agencies that price the risk of foreign investments rarely take them into account.

No. 26: "FDI incentives pay—politically ," by Nathan M. Jensen and Edmund J. Malesky.

The authors find that there are strong political benefits to attracting FDI at the state-level in the United States, and that fiscal incentives for attracting such investment, regardless of their effectiveness, may be a strategic political tool for state politicians.

No. 25: "The response to the global crisis and investment protection: evidence ," by Kathryn Gordon and Joachim Pohl.

The authors, presenting findings of the OECD, challenge the claim that investment policy measures taken during the crisis were driven by a protectionist agenda but caution that crisis response and exit policies pose a potential threat to investment openness.

No. 24: "Foreign direct investment and U.S. national security: CFIUS under the Obama Administration ," by Mark E. Plotkin and David N. Fagan.

The Committee on Foreign Investment in the United States review process slowed during the inaugural year of the Obama Administration. The authors examine the origins of this shift and suggest actions that parties can take to facilitate the process.

No. 23: "Thinking twice about a gold rush: Pacific Rim v El Salvador ," by Gus Van Harten.

Drawing on the case brought against El Salvador by Pacific Rim, the author examines the tension in international investment law between encouraging stability and allowing adaptation to new circumstances and raises a number of resulting concerns about the international arbitration process.

No. 22: "How BRIC MNEs deal with international political risk ," by Premila Nazareth Satyanand.

The author analyzes the results of a survey of political risk concerns of outward-investing Brazilian, Russian, Indian, and Chinese (BRIC) firms and compares the results to the concerns of global counterparts.

No. 21: "Is a model EU BIT possible—or even desirable?," by Armand de Mestral C.M..

The author explores whether the EU is in a position to adopt a model BIT articulating a common policy on FDI.

No. 20: "It's time for an EU investment promotion agency," by José Guimón.

The author proposes an EU IPA that coordinates FDI promotion and support for foreign investors at a regional level.

No. 19: "U.S. BITs and financial stability," by Kevin P. Gallagher.

The author, a member of the State Department subcommittee tasked with reviewing the U.S. Model bilateral investment treaty, addresses the potential impact of BIT provisions on the ability of governments to prevent and mitigate financial crises and makes specific recommendations for the revised Model BIT.

No. 18: "President Obama's international tax proposals could go further," by Reuven S. Avi-Yonah.

The author argues that the Obama Administrations 2011 international tax proposals represent a very cautious first step toward making US multinationals pay their fair share of the tax burden and that coordination with our FDI partners would allow the Administration to go even further.

No. 17: "International investment law and media disputes: a complement to WTO law," by Luke Eric Peterson.

The author suggests that international investment law is a potentially powerful legal tool to protect freedom of expression, at least for foreign-owned media companies.

No. 16: "Can the U.S. remain an attractive host for FDI in the auto industry? New labor policy and flexible production," by Terutomo Ozawa.

The author argues that the proposed EFCA, if enacted, would decrease the attractiveness of the United States for FDI in the auto industry. This Perspective was also printed in the Shanghai Daily.

No. 15: "The global economic crisis and FDI flows to emerging markets: for the first time ever, emerging markets are this year set to attract more than half of global FDI flows," by Laza Kekic.

For the first time ever, emerging markets are set to attract more FDI inflows than developed countries in 2009. This Perspective examines this prospect, based on an analysis of the severe downturn of investment flows worldwide this year. This Perspective was also printed in the China Daily.

No. 14: "Sovereign wealth funds: much ado about some money," by Charles Kovacs.

This Perspective makes the point that sovereign wealth funds constitute only one of the pools of anonymous capital, and for that matter, not even one of the most important ones. However, the author recognizes that issues of national security are involved and require attention.

No. 13: "The growth of Brazil's direct investment abroad and the challenges it faces," by Luis Afonso Lima and Octavio de Barros.

Brazil's FDI outflows reached $21 billion in 2008; in the first five months of 2009, however, Brazil's OFDI declined by 87% due to the global economic crisis. The authors note that while Brazilian companies, like companies elsewhere, have sought markets and natural resources abroad, they have also in part been pushed to escape the investment climate at home. The authors end by suggesting some rethinking of key government policies.

No. 12: "Outward investment by Trans-Latin enterprises: reasons for optimism," by Michael Mortimore and Carlos Razo.

Despite the global crisis, outward FDI by Latin American firms grew by more than 40% in 2008. The picture for 2009 is less clear, due to the expected regional GDP contraction, falling commodity prices, and tightening credit markets. Nonetheless, the authors argue that many countervailing factors make Latin American investment more resilient in the crisis than other regions may be.

No. 11: "Indian FDI falls in global economic crisis: Indian multinationals tread cautiously," by Jaya Prakash.

After growing faster than other emerging markets for some time, Indian investment abroad declined in 2008 and will decline further in 2009. The global slowdown has made a difference, as have the credit crunch and a depreciating Indian currency. The stronger than expected domestic GDP growth in the first quarter of 2009 is a positive sign in this context, as is the fact that not every Indian firm with foreign interests is cash-poor.

No. 10: "National security with a Canadian twist: the Investment Canada Act and the new national security review test," by Subrata Bhattacharjee.

This perspective discusses issues raised by the new national security test for proposed investments in Canada, including the ambiguity of the “national security” term and the possibility of politicized national security reviews. The author cautions the government not to adopt an over-expansive approach to the application of the new test. The Extended Note includes a detailed summary of these amendments to the Investment Canada Act and the recently published draft regulations that provide the details of the new national security review process.

No. 9: "Are SWFs welcome now?," by Veljko Fotak and William Megginson.

This perspective documents the change in attitudes of Western governments to foreign direct investment from sovereign wealth funds. The authors propose an analysis of sovereign wealth fund investments and their impact on target firms in order for recipient governments to formulate the proper regulatory response to sovereign direct investment.

No. 8: "Land grab or development opportunity? International farmland deals in Africa," by Lorenzo Cotula.

This perspective discusses the increasing number and size of large-scale farmland acquisitions in Africa by foreign investors over the past five years, including the opportunities and risks created by this trend.

No. 7: "International investment arbitration: winning, losing and why," by Susan D. Franck.

This perspective reviews recent empirical research about investment treaty arbitration in order to help create a more accurate framework for policy choices and dispute-resolution strategies.

No. 6: "Improving infrastructure or lowering taxes to attract foreign direct investment?," by Christian Bellak and Markus Leibrecht.

This perspective compares the impact of improving infrastructure versus lowering taxes on attracting and keeping FDI and discusses the policy implications for countries seeking to attract FDI, especially countries currently debating the relative merits of cutting taxes versus increased spending. (Also available in Chinese.)

No. 5: "While global FDI fails, China's outward FDI doubles," by Ken Davies.

This perspective examines the drivers behind the surge in FDI from China in 2008 and the salient features of this outward investment. Davies also discusses how the global financial crisis is affecting China's outward FDI. A shorter version of this perspective was also printed in the Shanghai Daily.

No. 4: "A new geography of innovation - China and India rising," by Gert Bruche.

This perspective explains the factors behind the sudden shift toward China and India for MNE R&D centers and explores how the financial crisis will affect China’s and India’s ability to continue to capture the R&D market. (Also available in Chinese.) A shorter version of this perspective was also printed in the Shanghai Daily.

No. 3: "The global financial crisis: will state emergency measures trigger international investment disputes?," by Anne van Aaken and Jürgen Kurtz.

This perspective evaluates the possibility that emergency measures that countries are currently taking to mitigate the effects of the global financial crisis will give rise to liability under international investment law. (Reprinted in Chinese in the International Economic Cooperation Journal.)

No. 2: "The revised national security review process for FDI in the US," by Mark E. Plotkin and David N. Fagan.

This perspective explains the new regulations governing the US government's national security review process for foreign mergers and acquisitions of US businesses which became effective December 22, 2008. (Also available in Chinese.) A shorter version of this perspective was also printed in the Shanghai Daily.

No. 1: "The FDI recession has begun,," by Karl P. Sauvant.

This first perspective forecasts an FDI recession in the coming year. (Also available in Chinese.) A shorter version of this perspective was also printed in the Shanghai Daily.