A crackdown on business tycoons and restrictions on outbound foreign investment signal an end to China’s global spending spree, with the private sector now seen as a threat to the control of its economy.

Jack Ma, the founder of tech giant Alibaba, is arguably China’s most celebrated entrepreneur. Speaking last September, he described an innovative entrepreneur as someone who always sets their sights on the future: ‘Being innovative means you look at today from a viewpoint of tomorrow.’

It’s an approach that has certainly been working for China. The country has been focused on nurturing mass entrepreneurship and innovation ever since 2014, when Premier Li Keqiang first promoted a national campaign at a World Economic Forum gathering in Tianjin. Believing that entrepreneurship and innovation significantly contribute to an increase in incomes and the creation of new jobs, the Chinese government has escalated policy support through generous financial incentives and simplifying the registration procedure for startups.

But, although government initiatives appear to be having the desired effect, Brookings Institution Fellow Ryan Hass believes that China’s leaders will always prioritise greater control over greater openness to innovation. ‘Expect economic policies to continue favouring state control and stability, even at the cost of some economic growth,’ he wrote in the Nikkei Asian Review last August.

Beijing’s preoccupation with control and stability were clear at the 19th National Congress of the Communist Party of China in October, when President Xi Jinping’s name and political ideology – part of his sweeping global vision for China – were included in the Party’s Constitution. In the context of recent economic indicators, it is perhaps understandable.

Capital flight

Since the turn of the millenium, China has sought to employ its huge foreign exchange reserves – and deflate calls to float its currency – by encouraging the country’s state-owned enterprises and private sector companies to ‘go out’ and acquire assets and develop businesses overseas.

Although the government continued to amass reserves at an astonishing rate to protect itself against potential economic headwinds, money started to leave the country at an even faster rate. When China’s foreign exchange reserves fell below $3tn in 2016 (from a high of $4tn in June 2014) and the value of the RMB depreciated over six per cent against the United States dollar that same year, Beijing decided to act.

In early 2017, the Chinese government commissioned a study that recommended an end to the global buying spree. The arrest last June of Wu Xiaohui, Chairman and Chief Executive Officer of Anbang Insurance, as part of an investigation of economic risks, sent a clear message that Beijing agreed with the findings.

China’s rich list – the ten wealthiest individuals in the country

Prior to that, from November 2016, the government started to restrict outbound foreign investment through a tightening of its approval and filing regimes. By August 2017, the State Council had effectively codified previous restrictions on certain types of outbound investment and classified types of investment and sectors as ‘encouraged’, ‘restricted’ or ‘prohibited’.

Yun Zhou, a partner at Zhong Lun and Newsletter Vice-Editor of the IBA’s Corporate and M&A Law Committee, says the new guidelines have generally been welcomed by Chinese businesses. ‘Targeting overseas assets is still a big thing for Chinese companies, but they are now feeling a lot more comfortable engaging in strategic overseas activities that are “encouraged” by the guidelines.’

Beijing’s principal concern was capital flight. At an individual level, the government suspected that China’s upper and middle classes were investing in foreign residential and commercial real estate simply as a means of moving funds out of the country. At a company level, it believed that some privately-owned corporations were doing likewise by deliberately overpaying for speculative investments in non-core assets.

For example, China’s outbound mergers and acquisitions (M&A) volume reached an all-time high of $225.4bn in 2016 – more than double the previous record high of $102bn the year before. Private companies Anbang Insurance, Dalian Wanda, Fosun International and HNA Group, which were known to use very aggressive financing structures, accounted for nearly one-fifth of all overseas purchases in 2016.

William Chua, a partner at Debevoise & Plimpton and Asia Pacific Conference Coordinator of the IBA’s Corporate and M&A Law Committee, says Beijing’s concerns around capital flight are due to the leadership’s heavy emphasis on promoting financial stability. ‘The concern is that private companies are doing too many things outside their core competencies and may be overpaying for foreign assets.’

While most outbound activity has been funded with traditional loans from Chinese and foreign banks or from state reserves – meaning it can be tracked by Chinese regulators – some private entrepreneurs have sought financing through a number of potentially risky channels. This might have been overlooked at a less sensitive time, but the government is increasingly mindful of the country’s growing debt dependency, particularly following criticism by the International Monetary Fund (IMF) in December.

In its annual health check of China’s financial system, the IMF concluded that corporate debt had reached 165 per cent of gross domestic product (GDP), and household debt, while still low, had risen by 15 percentage points of GDP over the past five years and was increasingly linked to asset-price speculation.

‘Credit growth has outpaced GDP growth, leading to a large credit overhang,’ stated the IMF. ‘The credit-to-GDP ratio is now about 25 per cent above the long-term trend, very high by international standards and consistent with a high probability of financial distress.’

The IMF’s rebuke followed credit rating downgrades in 2017 by all three of the major rating agencies over worries about the rapid build-up of debt in China.

China’s restrictions on capital outflows

Lessons from Japan

Uppermost in Beijing’s mind is the experience of Japan in the 1980s. Off the back of a surging domestic economy, many of Japan’s most high-profile companies started to spend freely on US real estate and other non-core assets. Not only did a good number of these investments ultimately result in losses, they also condemned Japan to two decades of economic stagnation.

Some recent acquisitions by Chinese companies appear to have similar characteristics. For example, Hollywood studio Legendary Entertainment has produced several loss-making movies since Dalian Wanda paid $3.5bn for it in 2016; perhaps a reminder of Sony’s 1989 acquisition of Columbia Pictures for $3.4bn, most of which was subsequently written off.

Zhou says: ‘Beijing is mindful of the Japanese experience, but it’s not really monitoring Chinese companies. Rather, the government is trying to formulate policies that discourage certain irrational activities that are believed to be focused more on “investing abroad” than the merits of the investment.’

Some Western vendors are known to have constructed two tracks in the sales process: one for Chinese entrepreneurs and the other for international buyers. This was discussed at the IBA Asia Pacific Mergers and Acquisition Conference in Hong Kong in early November 2017. Chua, one of the Conference Co-Chairs, says the conversation focused on the difficulties of getting money out of China, enabling Western buyers to move more quickly.

‘Regulatory approvals and financing sources are key seller considerations in transactions involving Chinese buyers,’ he says. ‘Sellers want deal certainty and Chinese bidders sometimes have to offer a substantial premium to make their bids more attractive in an auction context.

‘The Chinese government has been studying very closely the lessons learned from Japan’s acquisition spree in the 1980s,’ says Chua. ‘But these lessons are not just for China. They apply to all fast-growing economies.’

Growing backlash

While Beijing was able to rein in the spending spree of individuals through greater enforcement of tighter capital controls, imposing new requirements in early 2017, it viewed the activities of many private sector corporations as a threat to its control of the economy and the soft power strategy central to its global aspirations. Particularly problematic was the fact that these activities were causing significant irritation abroad.

Although outbound investment fell by 41.8 per cent in the first eight months of 2017, the damage had already been done. Whether via the Committee on Foreign Investment in the US or the German parliament, China’s quest for more strategic assets started to face growing resistance overseas (see box).

The key issue for many overseas governments was one of reciprocity. While China’s entrepreneurs, supported by their government, vigorously pursued trophy assets abroad across a range of industries – including in sensitive sectors such as IT – many of its sectors were kept strictly ‘off limits’ to foreign entities.

China’s top ten global M&A deals in 2016

In an effort to reduce the tension, Beijing took the opportunity – immediately following a state visit by US President Donald Trump in November – to redress the balance by announcing the easing of limits on foreign ownership of financial services groups.

‘Beijing was clearly waiting for the optimal time to release that, but whether it will have an effect on US and European resistance remains to be seen,’ says Zhou. ‘Anything can be framed as a national security “risk”. European countries have different approaches to this and are generally more friendly than the US.’

Foreign firms will be allowed to hold a majority stake in joint ventures with Chinese security companies and life insurers. In addition, caps on foreign bank stakes in Chinese banks and asset managers are to be removed.

Chua describes the move as an olive branch that has more to do with World Trade Organization commitments. ‘The easing of these ownership limits are a welcome first step, but the long-term impact remains to be seen.’

Push for soft power

Although China is becoming increasingly assertive with its hard power (that is, military might) on issues such as territorial integrity in the South China Sea, it has also invested huge financial resources to expand its soft power.

In an effort to present itself as a generous, cooperative and friendly power, the country has successfully developed bilateral relations with governments from developing countries that depend on Beijing for financing and know-how to build large infrastructure projects.

Developing its soft power is also the reason the government has upgraded the status and power of the Party’s United Front Work Department. Described by President Xi as crucial to realising the ‘great rejuvenation of the Chinese people’, the United Front has a brief to secure influence overseas, gather key information and gain approval for the country’s political aims.

In the eyes of Xi, by antagonising governments overseas and contributing to the country’s currency woes, China’s entrepreneurs were jeopardising the nation’s push for soft power. The subsequent crackdown on outbound investments is a timely reminder that economic control and stability will always trump support for innovation.

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Stephen Mulrenan is a freelance journalist formerly based in Hong Kong. He can be contacted at stephen@prospect-media.net