The flight from China

China was once a magnet for foreign investment. Foreign firms were eager to use it as a low-cost production location to manufacture goods that they then exported elsewhere. Over time, more businesses have adopted the “in China for China” strategy, meaning they produce in the country to serve the vast and growing domestic market.

But as China’s economy slows down and tensions with the US rise, foreign investors are pulling out from China at a speed unseen in decades. China’s leaders have responded by pledging further opening of the economy to foreign investment. Yet it is proving difficult to overcome an overall atmosphere of apprehension.  

A Reversal of Fortune 

According to China’s balance of payment data, net FDI inflows (FDI inflows minus FDI outflows) plummeted from its peak of $344 billion in 2021 to merely $42.7 billion in 2023, the lowest level in more than two decades. In the first half of 2024, net FDI inflows turned negative and was -4.6 billion dollars, suggesting foreign firms might have repatriated more earnings back home than adding to new investments in China.

In the meantime, US dollar funding from global investors in China’s venture capital and private equity industry is now drying up. This is demonstrated by the other official data series on FDI inflows from the Ministry of Commerce. The Ministry’s series on new actually utilised foreign investment, a measure of gross FDI inflows that does not consider earning repatriations, shows a 30 percent year-on-year decline through July 2024. 

The sharp drops in direct investment were also accompanied by declines in foreign portfolio flows into China’s equity market. Reportedly, international investors have pulled more than $12 billion out of Chinese onshore equities since June this year, and if such large-scale withdrawals continue, this year may become the first year of net outflows since investors were first allowed to trade Chinese onshore assets through the Stock Connect in Hong Kong a decade ago.  

A Grand Reckoning

This exodus of foreign capital is driven by multiple factors. The growing interest rate gaps between China and most other major economies, as a result of their divergent monetary policy paths, have made investing in China and its assets less attractive.

China’s gloomy economic outlook, its prolonged real estate downturn, and the persistently weak demand at home are not helping. Competition with domestic private firms is getting ever more intense, forcing foreign producers to recalibrate their China strategies. In sectors like electric vehicles, fierce price wars are already forcing some foreign producers who cannot afford to sell below cost out of the market.  

In the meantime, tensions with the US are making multinationals wary of expanding in China. Various export controls and investment restriction measures imposed by the US against China, coupled with China’s own anti-foreign sanction legislation, can put foreign businesses operating in China—whose activities are closely scrutinized by both Washington and Beijing—in a bind.

Compliance with both American and Chinese rules can be both tricky and costly. Moreover, multinationals are increasingly concerned about a potential military conflict in the Taiwan Strait, and many have been busy drawing up contingency plans, and some have already moved production capacity elsewhere in Asia.  

Beijing’s growing obsession with security in recent years has also taken its toll on the business environment. The authorities clamped down on several foreign consultancies and due diligence firms last year, ordered government officials not to use Apple’s iPhone and other foreign-branded devices for work, and banned Tesla cars from entering government buildings and compounds. The bans on Tesla cars were not lifted until April this year.

Also, the growing practice of not allowing foreign executives to leave China, known as exit bans, have alarmed foreign business communities. Foreign expatriates are departing and wary of making even short visits. The rise of xenophobia and nationalism in China since the Covid-19 pandemic, which was arguably instigated by the Chinese party-state to legitimise its draconian zero-Covid policy, may have also contributed to such biases against foreign businesses.  

The Chinese leadership appears worried about the ongoing exodus of foreign capital and has therefore been rolling out a charm offensive to lure back foreign investors since last year. Even though China, with its massive savings, is by no means a capital-scarce economy, the leadership has long seen foreign investment as an important proxy for confidence in the Chinese economy.

They also want foreign investors to continue to bring advanced technologies that can enable China to continue to move up value chains. At the Communist Party’s third plenum in July, China’s leaders endorsed a series of measures, including opening more service sectors to foreign investment. Wholly foreign owned hospitals will soon be allowed in several major coastal cities including Beijing and Shanghai, for example.  

Challenges Ahead

While Beijing is trying to shore up investor confidence, a new company law has just come into effect in the country in July this year, which has brought a series of substantial changes that can add an extra layer of complexity for foreign firms operating in China. For one, the new law for the first time clearly defines the duties of care and loyalty expected of directors, supervisors, and senior executives of a company, and those who fail to perform such duties can be held personally liable.

The new requirement about having a worker representative on the boards of companies with more than 300 employees has also raised concerns about whether the Communist Party’s cells may dominate the nomination process, thus allowing greater party influence over corporate decision making.  

What is perhaps more worrying is Beijing’s ongoing clampdown on access to Chinese data, which makes it difficult for investors to make decisions. Beijing seems to have picked up a habit of restricting access to data once a series starts to reveal China’s economic weaknesses. Stock exchanges in Shanghai and Shenzhen, for example, have recently discontinued the release of real-time data showing foreign inflows into China’s onshore equities, possibly out of concerns that the drastic declines could hurt confidence of domestic investors.

Moreover, foreign access to certain business and economic data in China has been severely curtailed in recent years, as the authorities try to control the global narratives about China through controlling the sources of information. But such attempts to conceal information can only make investment sentiment worse. Investors tend to assume the worst when a data series suddenly disappears. 

At a time when the Chinese economy is struggling with low growth, deflationary pressure, weak private demand, and a distressed property sector, China’s propaganda chiefs are urging officials across the country to “sing loudly the bright prospects of the Chinese economy” through downplaying the headwinds that the economy faces and highlighting the tailwinds.

But that is not going to revive business confidence. If anything, as warned by the Economist recently, suppressing information about the state of the economy selectively can do more harm than good. It risks damaging price signals, threating the efficient allocation of resources, and further dragging down productivity growth. At a time when China is in search of new growth engines, it cannot afford to let those happen.  

This article was written by Tianlei Huang, a research fellow, and Zhuowen Li, a research analyst at the Peterson Institute for International Economics (PIIE) in Washington, DC. It was published by the Australian Institute for International Affairs.