The China Investment Challenge

By Orville Schell

Originally published by Project Syndicate on Aug. 23, 2010

NEW YORK – China now sits atop $2.4 trillion in foreign-exchange reserves, the largest stockpile of any country in the world (Japan stands in second place with $1 trillion). But this bounty comes with one big headache: where should Chinese Communist Party officials park all that money?

International bankers estimate that roughly two-thirds of Chinese reserves have been invested in dollar assets. In other words, China owns a huge chunk of America’s ballooning debt. Chinese reserves invested in these conservative financial instruments are relatively safe, but they yield little return. They have, however, helped support China’s economy by allowing Americans to run up consumer debt by buying more Chinese goods than they rightfully need.

A moment of truth is looming for both sides of this co-dependent, and ultimately dysfunctional, economic relationship. First, there are limits to how many trillions of dollars China can, and should, put into US Treasury bills. After all, should the dollar depreciate, China does not want to have too many eggs in the US basket. Investors should diversify their risk, and so must China.

But with so much capital, the options are limited. Until the euro weakened recently, Chinese bankers had been buying more euro-denominated assets, no doubt recognizing that, despite the frailty of the eurozone economy, Chinese exporters also need European consumers to keep buying their goods. But the reality is that neither the euro nor the yen is capable of soaking up China’s growing foreign-exchange reserves.

It is hardly surprising, then, that Chinese officials have begun to seek more diverse and profitable investment possibilities worldwide. While we have become familiar with China’s ardent interest in natural resources such as oil, coal, steel, copper, and soybeans, we are far less acquainted with other kinds of Chinese investments, including outright acquisitions of foreign companies.

Here the US has not yet shown itself to be a particularly hospitable environment for Chinese investments. This has been especially true when Chinese state-owned enterprises (SOEs) have aspired to buy, or buy into, iconic US corporations that have a blush of national-security significance about them.

Things got off to a poor start in 2005, when the China National Off-Shore Oil Corporation (CNOOC) tried to buy Unocal. Even though almost all of the oil produced by Unocal would have ended up on world markets rather than back in China, the US Congress’s skittishness assured that Unocal was sold to homegrown Chevron.

Although Chinese investors have since made numerous lower-visibility plays in US markets, the failed Unocal deal left a legacy of bitterness. So it is hardly surprising that gun-shy (and miffed) Chinese investors are wary about making further major efforts in the US. Huawei’s recent failed bids for 2Wire and Motorola will only have rekindled this bitterness.

Indeed, a case similar to Unocal arose this summer. The Anshan Iron and Steel Group, a Chinese SOE, tried to buy a 20% interest in the Mississippi-based Steel Development in the hope of setting up a re-bar plant in the US. News of the pending deal caused 50 Congressional Representatives from the US steel caucus to write a letter to Treasury Secretary Timothy Geithner calling for an investigation of the threat the deal posed to US national security and American jobs.

Next: "... The US and 'old Europe' have recently edged closer to becoming 'developing countries'."

When it comes to China, the US does, of course, have legitimate reasons to worry about national-security issues. It was precisely to assess the impact of deals with countries like China on national security that Congress established the Committee on Foreign Investment in the US.

Even though relations with the US have improved, the People’s Republic is far from being trusted. Indeed, it is still unclear where China’s amazing evolution will ultimately lead, so it would be naïve for American leaders to assume that China’s intentions will always be friendly and constructive, or that the two countries are inevitably destined to grow closer.

Nonetheless, this most recent spurning of Chinese efforts to invest in the US comes at a time when capital-poor and job-scarce America (where unemployment is over 10%) could truly benefit from more receptivity to investment from capital-rich China.

Consider a few facts. According to The Wall Street Journal, since December 2007, the US has lost 16% of its manufacturing jobs (many to China), leaving it with the lowest employment in this sector since before World War II. Of those workers still in the private sector, almost 5%, or 5.5 million, are employed by global companies whose headquarters are abroad. These same companies not only pay higher salaries than their American counterparts, but account for 11.3% of capital investment in the US and provide 14.8% of its private-sector R&D.

Given this, one might think the US government would be actively courting Chinese investment, not scaring it away unnecessarily. If American officials do not begin to recognize the realities of today’s globalized world, the US may unwittingly (and self-destructively) find itself cut off from the kinds of new foreign investment flows that are sorely needed to revitalize its manufacturing and infrastructure sectors.

The bitter new reality is that the US and "old Europe" have recently edged closer to becoming "developing countries." Indeed, it may be a painful recognition, but America's share of worldwide foreign direct investment is now half of what it was two decades ago. If the Obama administration and EU officials cannot figure out the proper mix between economic engagement and protecting national security, investment capital from China will go elsewhere. That is a strategy that will leave the US and the EU weaker, not stronger.

Orville Schell is Director of Asia Society's Center on U.S.-China Relations.