Abstract
We analyze shifts in the structure of China’s capital outflows over the past decade. The composition of gross outflows has shifted from accumulation of foreign exchange reserves by the central bank to non-official outflows. Unlocking the enormous pool of domestic savings could have a significant impact on global financial markets as China continues to open up its capital account and as domestic investors look abroad for returns and diversification. We analyze in detail the allocation patterns of Chinese institutional investors (IIs), which constitute the main channel for foreign portfolio investment outflows. We find that, relative to benchmarks based on market capitalization, Chinese IIs underweight developed countries and high-tech sectors, respectively, in their international portfolio allocations but overinvest in high-tech stocks in developed countries. To further examine Chinese IIs’ joint decisions on destination country–sector pairs, we construct continuous measures of revealed comparative advantage and disadvantage in a sector for a country based on trade patterns. We find that, in their foreign portfolio allocations, Chinese IIs overweight sectors in which China has a comparative disadvantage. Moreover, Chinese IIs concentrate such investments in countries that have higher comparative advantage in those sectors. Diversification and information advantages related to foreign imports to China seem to influence patterns of foreign portfolio allocations, while yield-seeking and learning motives do not.
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Notes
An important complement to our paper is the recent work of Horn et al. (2019), who analyze China’s official overseas lending.
We build on the work of Karolyi et al. (2019), who use this dataset to shed light on the international portfolio allocation patterns of institutional investors domiciled in major emerging markets.
The 2018 annual report of the State Administration of Foreign Exchange, which manages China’s international reserves, for the first time revealed that 58% of its foreign exchange reserves were held in dollar-denominated assets in 2014. Prasad (2019) discusses why that number might have gone back up above 60% in the succeeding years.
The 2018 SAFE annual report indicates that China earned an average annual return of 3.68% (in dollar terms) on its foreign exchange reserve portfolio over the period 2005–2014.
Scissors (2018) documents that the private sector share of China’s outward FDI has risen from about 10% in 2010 to about 45% in 2018. He et al. (2012) make the case that China’s private sector will turn its external net liability position into a balanced position, and that the official sector will reduce its net asset position significantly, relative to the country’s GDP.
Technically, the capital was raised through the issuance of Ministry of Finance bonds in the amount of RMB 1550 billion. One subsidiary of the CIC, Central Huijin, undertakes equity investments in key state-owned financial institutions in China. It is not clear from the CIC’s annual report how much of its investments are domestic rather than foreign.
Stock market capitalization is based on the valuation of all stocks listed on the Shanghai and Shenzhen exchanges. The USD equivalent is calculated using the end-December 2018 exchange rate of 1 USD to 6.876 RMB. Bonds issued by financial corporations are not included in the calculations reported here. At the end of 2018, the market value of those bonds was $4.7 trillion.
There is a widely held view that deposits in the banking system, which is mostly state-owned, are implicitly fully backed by the government. The government has fully liberalized bank deposit rates to foster competition among deposit-taking institutions and, in 2017, the government introduced an explicit deposit insurance system with the aim of creating more market discipline. It is not clear these policy changes have had the intended effect—most banks still pay a deposit rate close to the PBC’s benchmark rate. It is not clear whether WMPs issued by commercial banks are covered by deposit insurance. Shadow banks have also issued WMPs.
Bayoumi and Ohnsorge (2013), using evidence from capital outflow liberalization episodes in other countries, argue that China could experience significant outflows from domestic equity and bond markets if outflow restrictions were eased. Hooley (2013) suggests that, conditional on further capital account opening, China’s gross international investment position could increase from about 5 to 30% of world GDP by 2025. Kruger and Pasricha (2016) provide various scenarios for the size and composition of capital flows that would ensue if China were to open its capital account and its gross international investment position were to begin converging to the G-20 average. Cunningham et al. (2018) argue that, if China had had no restrictions on portfolio outflows, its overseas portfolio assets in 2015 could have ranged from $1.5 trillion to $3.2 trillion in 2015, relative to the actual figure of $281 billion.
See Miao and Deng (2019) for an overview of China’s motivations for opening its capital account and the approach it has followed.
According to Scissors (2018), BRI has had a relatively minor impact on China’s FDI and, thus, its overall foreign investment. He notes that the set of countries involved in the BRI accounts for less than 25% of China’s FDI since the program’s inauguration in 2013, amounting to a total of about $150 billion. He argues that BRI partially amounts to a rebranding of projects that were already underway before the initiative was announced. The Belt and Road Tracker of the Council on Foreign Relations estimates that, from 2014 through 2017, loans totaling over $120 billion have backed BRI-related projects ranging from highways to railroads to power plants. See https://www.cfr.org/article/belt-and-road-tracker According to EIU (2017), Chinese SOEs are likely to remain the main participants in the BRI. Private companies are more aware of the risks associated with BRI investments and lack the insurance buffers that the government can provide to SOEs.
There is little literature studying the motives of Chinese IIs’ foreign portfolio investments but there are a few studies examining the determinants and motives of their domestic equity investments. For instance, Chan et al. (2014) find that Chinese mutual funds can effectively monitor domestic corporate decisions and enhance Chinese firms’ financial reporting quality, especially for privately owned enterprises. They conclude that Chinese mutual funds’ investments appear to be return driven for the investors, rather than being driven by government strategic objectives.
A related initiative, the ETF Connect, which would give Chinese investors exposure to overseas assets through exchange-traded funds (ETF) listed in Hong Kong, was proposed in 2016 but remains stalled for “technical reasons.”
The relevant press releases can be found on the SAFE website: http://m.safe.gov.cn/safe/2007/0105/5320.html; https://www.safe.gov.cn/fujian/2017/0417/431.html; http://m.safe.gov.cn/safe/2017/1230/8129.html.
See “Background Information: Overview of China’s Major Foreign Exchange Policies Since 2015,” Reuters, March 21, 2017.
Institutional holdings of US-traded securities are sourced from 13F filings with the Securities and Exchange Commission. For the USA, data on mutual funds’ holdings come from regulatory filings (N-Q, N-CSR, and form 485BPOS), while for non-US funds, data on funds’ holding positions are from a combination of regulatory filings, funds’ annual reports, the regulatory authority or mutual funds association in the country.
We use the terms fund and institutional investor interchangeably in this paper.
For securities traded in the USA, we use CUSIP as the primary identifier to merge FactSet with Worldscope data. For international securities, we use ISIN or SEDOL as main identifiers.
The assets under management include domestic as well as foreign investments.
This number also includes those institutions for which we have information only on their generic positions (those that do not disclose the securities in which they invest).
These numbers have been rising slowly but steadily. As of February 2019, there were 123 fund management companies registered with the CSRC with a total capital of 3.6 trillion RMB.
Sino-foreign status is determined based on CSRC data for 2017. Hang Seng Qianhai Fund Management Co. Ltd acquired the Sino-fund joint venture status in 2019 so it is not classified as Sino-fund joint venture in our sample. The Chinese Securities Regulatory Commission requires foreign ownership in the Sino-foreign joint fund venture to be capped at 49%. This limit was relaxed to 51% in April 2018. See http://www.csrc.gov.cn/pub/zjhpublic/zjh/201804/t20180428_337509.htm for more details.
This number includes funds’ generic investment positions.
Trade flows have also been shown to be an important factor influencing international equity investment in general (Lane and Milesi-Ferretti 2008).
2009 is the earliest year for which we have outward direct investment data for China in the CDIS database. Hong Kong was a key source of inward FDI for China due to “round-tripping” of funds in order to take advantage of the lower corporate income tax rate for foreign-financed versus domestically-financed firms (16% versus 33%). In 2008, this differential was removed and the corporate income tax rate was unified at 25%. We are not aware of such tax or other incentives that could account for the earlier concentration of China’s outward direct investment.
Casanova et al. (2015) contend that the reported allocations of Chinese outward direct investment flows in 2013 may have been distorted by flows to “stop-over destinations” such as Hong Kong and offshore financial centers. They conclude that, after correcting for these distortions, China’s actual outward direct investment may be more diversified than suggested by official data, with developed markets such as Europe and North America featuring more prominently.
Similar to what we see in the CPIS database, Hong Kong and the USA together account for about 70% of total portfolio allocation of Chinese IIs in 2017 and almost all the top 20 destination countries in 2017 based on the FactSet data also appear in the top 20 list based on the CPIS database. This gives us some reassurance about the coverage of the FactSet data. Even though the coverage may be limited in terms of absolute amounts, at least the patterns of investment seem to be consistent across the two databases.
Figure B2 in the online appendix shows the top ten underweighted and overweighted countries in 2008 and 2017. The top ten underweighted countries include one emerging market country in 2008 (South Africa) and two in 2017 (India and South Africa).
Ramaswamy et al. (2012) analyze the outward direct investment location decisions of Chinese firms and find that while local government-controlled firms are attracted to natural resource-rich countries which may have weak political systems, private Chinese firms are more risk averse and more likely to provide value added services rather than to exploit the resource itself.
As an additional robustness test, we used the lagged share of a source country in China’s total inward portfolio investment stocks in a given year as a proxy for information endowments. The results, reported in appendix Table B10, show that the coefficient on this variable is positive and statistically significant, notwithstanding the restrictions on inward portfolio investment over much of the sample period.
Trade credits are not counted as part of external equity investments. Hence, the estimated impact of trade flows does not reflect their impact on trade financing, but, rather, the impact of information transmitted through trade-related activities.
While the focus of our paper is on portfolio equity allocations, it is of interest to examine in parallel the determinants of the patterns of China’s overall direct investment allocations. FactSet does not have information on direct investment flows, so we explore the determinants of outward direct investment from China using the IMF’s Coordinated Direct Investment Survey (CDIS) database, which has data on bilateral FDI stocks. Country-level results are reported in Table B7. The dependent variable is excess outward direct investment from China, defined as the share of a destination country in China’s outward direct investment relative to the share of the destination country in world direct investment. The country-level analysis of FDI allocations shows results similar to those for portfolio equity allocations for variables such as contiguity, the rule of law, regulatory burden, and trade. There are some differences—for instance, unlike in the case of equity allocations, FDI allocations are influenced by common language, GDP per capita, and financial market variables. We leave a more careful exploration for future research.
We include institutional investors from the following emerging markets (based on the MSCI index) to compute the benchmark ratio: Argentina, Brazil, Chile, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.
Firms with two-digit SIC codes in the range 01–09 are in the agriculture sector, range 10–14 corresponds to the mining sector, range 15–19 is for the construction sector, 20–39 corresponds to the manufacturing sector, 40–49 is for transport and communications sector, 50–59 is for trade and retail services, 60–67 is for finance and real estate, 70–89 is for services, and 90–99 is for public administration services.
Stocks are classified as high-tech or low-tech based on Kwon (2002).
See Figure B4 for the top 10 RCD sectors for China and the USA in 2017.
Table B5 in the online appendix estimates this equation using an alternative benchmark ratio based on investment from emerging markets. Similar to its definition in the country-level analysis, the alternative excess investment ratio at the sector-level is defined as the share of a given sector in total portfolio allocation of a Chinese fund in a given destination country relative to the share of that sector in total portfolio investment of all emerging markets in that country. We find that our results remain robust to this alternative benchmark ratio.
When including both China’s sectoral RCD and RCA variables in the same regression (see Table B11 in the online appendix), the coefficient on RCD remains significantly positive and the coefficient on RCA is significantly negative as in Table 8. Here, we investigate the relation with RCD variable first, and RCA in a latter section.
Price volatility in the Worldscope database is a measure of a stock’s average annual price movement to a high and low from a mean price for each year. For example, a stock’s price volatility of 20% indicates that the stock’s annual high and low price has shown a historical variation of +20% to − 20% from its annual average price.
High RCD sectors in China are those that have an average RCD value higher than the median RCD value for the sample.
FPI is seen as a passive form of investment while FDI provides managerial control. When a foreign investor’s equity interest in a foreign firm exceeds 10% of the ownership interest, which usually confers some degree of managerial control, such investment is classified as FDI. Thus, FPI can eventually turn into FDI when it exceeds a certain threshold.
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Acknowledgements
We are grateful to Gian Maria Milesi-Ferretti and participants at a Banco Central de Chile-IMF conference for helpful comments. We thank Thomas Bowen, Brandon Lang, Michael Wenye Li, and Kaiwen Wang for research assistance.
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