Chinese Investment in the United States: Time for New Rules?
Last month, Tesla announced that it sold a 5% stake to Tencent, a Chinese conglomerate that might best be described as a cross between Facebook and Zynga, with the Huffington Post, Pay-Pal (two Pay-Pals, to be precise), and VC-giant Andreissen-Horowitz thrown in for good measure.
Tesla and Tencent executives did not have travel far to hammer out the details—both are located in Palo Alto. Tesla has been a fixture in Silicon Valley since its 2003 founding, while Tencent opened its U.S. outpost a few blocks from Stanford’s campus in 2010.
The Tesla-Tencent deal is only the latest high-profile example of Chinese investment in U.S. startups. Indeed, even as the U.S.-China relationship darkens, Chinese investment of all kinds in the United States has surged, much of it concentrated in high-technology sectors and much of it (61%) in new companies. China’s foreign direct investment (FDI) stock in the U.S. increased some 800% between 2009 and 2015. Within the past two years alone, Chinese FDI in the U.S. has climbed nearly four-fold, reaching roughly $45.6 billion in 2016, up from just $12.8 billion in 2014. Investments in new companies account for the majority of these transactions (61%). R&D operations and even greenfield investments are attracting interest; in 2015, Chinese greenfield investment in the U.S. amounted to $1.8 billion, a seven-fold increase from 2010.
These developments have not been reciprocal. Foreign investors—including U.S. investors—do not enjoy similar openness inside China. China maintains a dizzying array of formal and informal barriers to foreign investment—from outright restrictions and quotas to domestic licensing regimes, forced localization measures, and mandatory joint ventures. Despite years of negotiations, these restrictions are, if anything, growing more onerous in several sectors. U.S. businesses paint a darkening picture of the business climate they face inside China. Perhaps unsurprisingly, growth of U.S. FDI stock in China has slowed considerably in recent years. Notwithstanding the surging Chinese investment in the United States, U.S. FDI in China, after growing roughly 180% in the five years between 2002 and 2007, grew just 11% in the subsequent five years (2008-2013).
The unprecedented increase in investment from a non-ally comes against a backdrop of increasing tension between Washington and Beijing and raises questions of whether the time has come for U.S. policymakers to rethink the country’s open stance toward inbound Chinese investment. Compared to other forms of economic ties, foreign ownership of local assets amounts to a more intimate form of economic integration, and thus has traditionally been subject to greater government oversight. The United States’ current investment framework was built for an era when foreign investment was predominately the domain of developed countries, which were themselves largely open to foreign investment. As a result, the United States’ current framework simply does not contemplate many of the challenges specific to this influx of Chinese investment.
Beijing’s U.S. Buying Spree
According to estimates by the Rhodium Group, Chinese firms invested roughly $18.4 billion in the United States in the first half of 2016—nearly three times the amount invested in H1 2015, and more than total Chinese FDI into the U.S. for all of 2015 ($15.3 billion). Chinese FDI in the EU-28 followed a similar pattern, with more than $20 billion in annual FDI in each of the past two years, and a total of $81 billion since 2000.
Never before has the United States seen an increase in investment of this magnitude, especially from a non-ally, and especially where the lines between state- and private-ownership are so inherently blurred. For all the concerns and debate surrounding Japan’s influx of investment into the United States in the 1980s—coming as it did amid fierce economic competition between the U.S. and Japan—those debates ultimately remained within the umbrella of the U.S.-Japan military alliance.
And it is still relatively early days. Certainly this increased Chinese investment in the U.S. is partly a cyclical story—the result of Chinese investors parking money abroad to ride out turbulence in China’s domestic economy. But it is mostly a structural trend, with a long way to go. China’s global outbound FDI stock could triple to $3 trillion (up from today’s $1 trillion) by 2025.
As mentioned above, most of the “strategic investment” originating from China—that is, investment in sectors directly tied to the core business sectors of the investor—is funneling into technology goods (especially semi-conductors), R&D networks, and advanced manufacturing. Take semiconductors, for example, where in 2015 alone, Chinese investors were party to 21 different deals attempting to acquire an overseas chipmaker (up from 8 such deals in 2010). Among the most high-profile of these bids involved Fairchild Semiconductor International. Hailed as “one of the companies that first brought silicon to Silicon Valley,” Fairchild ultimately remained in American hands, rejecting what it called a “superior offer” worth about $2.5 billion from Chinese state-backed buyers in favor of a smaller bid from an American rival, citing concerns that federal regulators might reject the Chinese deal.
The unsuccessful Chinese bid for Fairchild was just one of more than a dozen such offers in recent months for international semiconductor businesses, mostly in the United States. The recent interest in semiconductors traces back to direct orders from Beijing. China’s most recent Five-Year Plan explicitly identifies semiconductors as a “core industry.” Since the Plan’s release, Chinese companies with varying ties to the government have focused intently on acquiring foreign technology in the sector.
These investments may or may not be good bets. What is clear: they align well with directives from Beijing. China’s most recent five-year plan and its official outbound FDI catalogue express appetite for greater outbound investment into primary resources and technology sectors, both of which would naturally point Chinese investors toward the United States. The general uptick in Chinese investment, accentuated by several high-profile, high dollar-figure deals—as well as the disparity between market access in the United States and China (more on that below)—will likely sharpen political and economic sensitivities to this investment in the United States.
The policy debate over the U.S. response seems to be heading in two, somewhat overlapping directions. Most immediately, there is growing bipartisan momentum in Congress and the Trump Administration for reforming the U.S. national security review process for foreign investment, known as “CFIUS” (short for the Committee for Foreign Investment in the United States). But broader economic security considerations, while valid, should not be shoehorned into the existing CFIUS framework; rather, they should be pursued on their own terms, through reforms aimed at achieving reciprocal access in the U.S.-China investment relationship.
Revamping CFIUS to respond effectively to the surge in Chinese investment will require several fixes.
To start, the notification process, currently voluntary, should instead be made mandatory for certain categories of filings (those involving certain kinds of technologies, for instance, or parties from a certain designated list of countries). This way, all investments by Chinese firms would be automatically flagged for U.S. officials. To address the varied scope of Chinese investment, the scope of “CFIUS-covered” transactions requiring notification should be extended to green-field investments and minority stakes (at least in certain sectors), not simply M&A activity. There should also be notification requirements whenever an existing investment undergoes a material change (e.g., changes to projected manufacturing plans, R&D, technology transfers and integration).
This list of CFIUS reforms could go on. But it is equally important to highlight what shouldn’t change. Namely, CFIUS’s current mandate should remain limited to national security concerns, which to date have not been construed to include considerations of economic security. To solve for broader, economic security concerns by introducing them as considerations within the CFIUS review process would be to undermine years of diplomacy aimed at assuaging the fears of China and several other countries that CFIUS is simply a pretext for curbing certain foreign investments on largely economic grounds.
To oppose introducing economic security considerations into the CFIUS process is not, however, to suggest that such economic concerns do not exist. It is precisely because such economic concerns do exist that Washington should address them squarely and in their own right—not smuggle them into a pre-existing, ill-fitting framework for national security concerns.
This brings us to the second area of potential reform. The U.S. should also begin insisting upon reciprocal access in the U.S.—China investment relationship—in effect, shifting away from the U.S.’ traditional ‘open-door’ stance to Chinese investment, toward a policy of ‘overall balance.’
The Case for Reciprocity
A policy shift toward reciprocity raises several questions, not least of which is how to go about it. The most effective tool for such a shift is probably Section 301(b) of the 1974 Trade Act, which was designed to deal with challenges not adequately covered by existing international agreements. Section 301 (b) gives the President authority to address “an act, policy or practice of a foreign country [that] is unreasonable or discriminatory and burdens or restricts United States commerce…” Notably, restricting foreign investments under 301(b) would not violate U.S. obligations under the WTO.
The U.S. might also look to its antitrust laws. U.S. antitrust officials could, for example, begin considering foreign government treatment of U.S. firms in overseas markets as part of its merger review, for example. Congress might also amend antitrust authorities to waive recoupment requirements for price-fixing claims in cases where foreign firms receive heavy state subsidies (since such firms could sell below cost for years, even indefinitely, so long as large state subsidies allow it—just as what’s left of the U.S. solar industry).
But in many ways, the larger question is not so much how to shift toward reciprocity—after all, new tools can always be created where Washington is sufficiently motivated (as it seems to be)—but why such a shift makes sense for the United States in the first place.
To start, it is important to recognize that reciprocity may not be much of a shift from present U.S. practice. Though some economists prefer to believe otherwise, reciprocity has long been an established principle of U.S. international economic policy—and indeed even a recognized element of its investment policy. Former Secretary of Commerce Elliot Richards openly prefaced the importance of U.S. openness to inbound FDI on reciprocity grounds, noting that “[i]t is patently impossible to open doors for American business abroad while we slam shut the doors to foreign business in our own country.” In fact, recent work by Adam Chilton, Dustin Tingley and Helen Milner recounts how the United States’ entire statutory framework for regulating the inflow of foreign investment grew out of concerns about the influx of FDI from Japan at a time when Japan maintained policies that denied reciprocal market access. “The largest underlying cause of friction over Japanese FDI in the 1980s,” Stanford law professor Curtis Milhaupt reminds, “was the perception that, while the U.S. was wide open to Japanese investment and imports, U.S. firms faced substantial barriers to investment and trade in Japan.”
In fact, reciprocity may be especially important in adversarial relationships (if “adversarial” feels too pessimistic to describe ties between Beijing and Washington, it certainly seems directionally true). For IR scholars like Robert Keohane, not only is reciprocity crucial for explaining state behavior, but under low-trust conditions, it can even allow “cooperation to emerge in a situation of anarchy.” Most of the interactions between the United States, the Soviet Union, and China during the Cold War were reciprocal in the extreme— each country’s action carefully calibrated to match prior actions that one or another major player in the Cold War had visited upon it.
Most U.S. economists argue against reciprocity on the grounds that inbound investment is economically beneficial, especially for countries like the United States, which have large and persistent current account deficits. Traditionally, most of the arguments in favor of reciprocity tend to argue some variant of the “golden rule”––or, as Beijing-based journalist Michael Schuman has put it, Confucius’ advice to “not do to others … what you do not want done to yourself.” “More and more,” Schuman continues, “Chinese companies are taking advantage of the openness that the U.S.-led global economic system ensures, but Beijing isn't reciprocating by allowing foreign companies similar liberties in China.”
However, there is more than just a “golden rule” logic to reciprocity. As an economic matter, the two are related: China’s lack of openness impedes current account rebalancing between the U.S. and China, depriving the U.S. of a crucial form of rebalancing. As Pegfei Wang, Yi Wen, and Zhiwei Xu argue, America could forego the two traditional (and painful) methods of rebalancing its current account deficit—increasing its savings rate or lowering investment—by instead recycling the financial capital inflows from China, re-exporting them back to China in the form of FDI. Indeed… if it were actually an option. Yet, so long as China substantially remains closed to U.S. FDI, the United States is left with only comparatively more painful remedies to correct for Chinese financial inflows.
The link goes beyond accounting identities. For several years now, China has converted a portion of its excess reserves—effectively, the byproduct of these financial inflows into the U.S.—into financing designed to help China’s state-owned enterprises (SOEs) and private firms break into new markets overseas (e.g., SAFE’s new Co-Financing Office, charged with supporting Chinese banks as they lend to domestic firms investing overseas). So long as China sees fit to link its export-led growth policies to its outbound FDI—in effect recycling Chinese purchases of U.S. treasuries (purchased in order to facilitate a favorable exchange rate for Chinese exports) into state subsidies for Chinese FDI back into the United States—this suggests that issues of Chinese and U.S. market openness are also linked as a matter of current Chinese policy.
Second, it is largely by shutting out foreign competition in China’s domestic market that China has managed to build up national champions—and once created, these national champions do not tend to stay at home. Firms like China Union pay, China’s credit card monopoly, which owe their market stature directly to the years of protection they enjoyed in China’s home market, are now world leaders and are venturing abroad, driving much of China’s current outbound investment. Having enjoyed years of exclusive access within their home market, China’s largest banks—known as the “Big Four”—are now among the largest in the world and are growing rapidly overseas. A similar story can be told for China’s mining and telecommunications sectors. Thus, China’s protection of its home market is very much causally linked to the outbound investment the world is now witnessing.
Third, the problem is not just that this discrepancy in market access violates basic understandings of fairness; it is that this in turn undermines the U.S. public support necessary to sustain the current U.S.-led open global economic order. To many Americans, allowing China to discriminate against U.S. investors without consequence is one more example of Washington putting principles above its interests, leaving the costs to fall upon the disaffected pocketbooks of broad swaths of the country. Chilton et al. find that a lack of reciprocity does increase public opposition to foreign acquisitions of domestic firms. Indeed, lack of reciprocity produced a larger increase in opposition than other economic considerations that Chilton et al tested (such as domestic economic conditions, degree of exposure to foreign competition, etc).
Fourth are what I call “hourglass issues,” or the way in which the closed nature of China’s economy forces concessions onto U.S. firms that then reverberate back, changing the political economy of the United States in ways that make it harder for Washington to press for needed reforms. U.S. corporations that once pressed Washington to address distortions favoring Chinese SOEs often find far less reason to protest after pairing with these same SOEs as the only means of entering local markets. And, as mentioned above, often partnering is not an option. In such cases, when a U.S. firm wants access to China’s market badly enough and partnering isn’t on the table, the only way to enter the Chinese market is to be acquired. Take, for example, Smithfield Foods. Investment restrictions prevented any sort of joint venture, leaving Smithfield executives with the view that the best way to expand into China was to be acquired by the Chinese firm. Smithfield CEO Larry Pope insisted the deal would preserve “the same old Smithfield, only with more opportunities and new markets and new frontiers.” Apparently the acquiring firm, Shuanghui Foods, was keen to acquire American pork to capitalize on growing demand for foreign food products in China after recent food scandals. It would have been far better—for Smithfield and for U.S. interests more broadly—had Smithfield simply been permitted to import directly into China.
With changes to business and investment flows tend to come shifts in market incentive—especially when the markets in question remain heavily fortified against foreign competition. “[U.S.] companies are intimidated against filing cases or even being seen as supportive,” as one American trade attorney with a long history of Sino-U.S. disputes put it. “They are either intimidated or bought off, and usually a combination of those two things.” Taken together, the steady erosion of U.S. domestic pressure (as U.S. firms are forced into Chinese joint ventures and inherit mixed incentives), China’s looming claim to market economy status, and its rapidly growing economic influence all suggest that U.S. leverage and the window for constructive pressure may be steadily diminishing.
Finally, China is the second largest—soon to be the largest—market in the world. U.S policy should be doing everything it can to help U.S. investors compete effectively for a piece of the action. This includes creating new leverage where existing leverage is found wanting. Of course, China could—and may well—retaliate. But the fact that Washington would be shifting to reciprocity within the context of negotiating a bilateral investment treaty (BIT) with China gives the U.S. much-needed leverage for that negotiation while also taking advantage of a bounded time horizon (that is, given the United States’ model BIT, completion of a BIT with China will necessarily mean lifting the vast majority reciprocity-related restrictions, and could well entail lifting all such restrictions), thereby containing the possibility for spiral.