Chinese Capital Controls Reflect Changing Political Priorities in Beijing

Following a peak of outbound foreign direct investment (‘FDI’ ) at USD 245 billion in 2016, in January 2017 Beijing put in place severe capital controls. These measures, prompted by fears of capital flight, currency devaluation and decreasing foreign exchange reserves as a result of outbound FDI overtaking inbound FDI in 2015, have had dramatic effects. Outward non-financial investments in the period of January to April decreased by 56.1 percent year on year. More importantly, political motives have now become the primary driver for the regulation of outward FDI. Beijing’s latest measure implemented on 1 August highlights this change: stateowned enterprises—and by extension private companies—are now required to defend the financial viability and political risks of overseas investments to the Ministry of Finance before receiving regulatory approval.

Since Xi Jinping assumed office in 2012, power over policy making has increasingly shifted into the hands of “leading small groups”, secretive bodies headed by senior Chinese Communist Party (‘CCP’) officials which are tasked with coordinating work across ministries and government agencies, ensuring that policy conforms to the political priorities of the CCP. “Xi Jinping wants the CCP to have more control over China’s financial resources,” says Andrew Polk of Trivium/China, a research firm in Beijing. “Tighter regulation of FDI partially reflects that changing climate”. In June, the Central Leading Group for Comprehensive Reform, a leading small group headed by Xi, announced that the Party will take a more active approach in supervising outbound FDI, further linking outbound FDI to national security.

So what? Investors with Chinese business partners now need to consider if a potential deal aligns with a transforming government policy framework. Investments that fit within the “One Belt One Road” strategic framework may be encouraged, as will investments in artificial intelligence, resources, technology, and healthcare – sectors which have repeatedly been highlighted as vital growth areas by the government. Indeed, reports indicate that in contrast to overall outward FDI trends, M&A activity by Chinese companies in countries along the One Belt One Road are soaring, with USD 33 billion in projects having been approved so far this year, compared to USD 31 billion in total in 2016.

Xi’s ambition goes beyond channelling investments into political projects. Outward FDI has been identified as a major concern for China’s domestic economic equilibrium, and Beijing has identified over-leveraged domestic companies as a major potential source of instability. Earlier this year a top adviser to President Xi Jinping commissioned a study on the causes of Japan’s ‘Lost Decade’ of economic stagnation in the 1990s, which recommended the curbing of the global buying spree of domestic companies backed by overvaluation at home. Whereas the ‘golden years’ of 2014 to 2016 saw Chinese companies scoop up major deals in real estate, financial services and leisure—termed ‘illogical investments’ by Beijing—going forward we should expect a leaner and more politically focused outward investment regime.

The FDI framework has already been foreshadowed by regulatory action in the past few months. Recent examples highlight this trend: the rolling out of the 1 August policies coincided with a request by the China Banking and Regulatory Commission (‘CBRC’ ), the PRC banking regulator, to a number of banks to provide information on overseas loans granted to several acquisitive private entities, including Dalian Wanda Group Company, HNA Group, Anbang Insurance Group Company, Fosun International Inc., and Li Yonghong, the owner of Italian soccer team AC Milan. In July, retail conglomerate Suning Commerce Group was criticised by state media for the acquisition of Inter Milan, the Italian football club; also in July, Bloomberg reported that Anbang Insurance was asked by the government to sell its overseas assets, including the iconic Waldorf Astoria hotel in New York, and repatriate the proceeds to China. The request reportedly came only a month af ter the detention of Wu Xiaohui, Anbang’s chairman, partly in relation to the source of funds for some of Anbang’s USD 16 billion in overseas acquisitions in the preceding 18 months. (Anbang has denied several aspects of Bloomberg’s initial reporting.)

As recognised by Beijing, investments in non-essential sectors by privately-owned companies have been an important component in capital flight. Reports by Chinese regulators indicate that, in some cases, privately-owned dealmakers have provided inflated values on collateralised assets used to obtain overseas loans, only to default on these loans in an attempt to move assets overseas. Large capital outflows are also caused by investments in property by private citizens, often using what has been called ‘soft’ money laundering methods, such as smurfing – whereby large amounts of money are broken down into smaller sums sent by friends and acquaintances – to circumvent strict rules on capital outflows by private citizens, with a cap of USD 50,000 per year per person. While smurfing is legal in several jurisdictions, including the US and Canada, in January 2017 Chinese regulators moved to restrict transfers using such proxies. 

We are unlikely to see a return to the pre-2017 era of unbridled acquisitions by cash-rich Chinese investors. Political priorities that tie capital flows to national security and economic stability have now become the driving force behind the regulation of outward FDI. For investors with Chinese business partners, this means that potential deals need to be examined against the backdrop of a new policy environment that gives primacy to politically motivated projects. This trend is likely to continue in the mid-to-long term, and we should expect further regulations following the 19th National Congress of the CCP, expected to be held in the autumn.