(What’s Left of) Our Economy: U.S. and Other Foreign Investors Keep Funding the China Threat

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bonds, China, decoupling, delisting, FDI, Financial Times, foreign direct investment, investment, Joe Biden, pension funds, Phase One, portfolio investment, Steven A. Schoenfeld, stock markets, stocks, Trade, trade surplus, Trump, Wall Street, {What's Left of) Our Economy

Here’s one of the most depressing articles I’ve read in a long time, and it deals with a (big) piece of U.S.-China economic relations to which I haven’t paid enough attention so far:  flows of financial investment.

It’s depressing because it shows that, although the Trump administration has (rightly, in my view) begun to decouple America’s economy from China’s, and made impressive progress in trade and foreign direct investment (purchases of “hard assets,” like factories and labs and enterprises and real estate), portfolio investment (purchases of stocks and bonds) into China from around the world is not only continuing – it’s booming. And these capital flows, including resources from Americans, are already much bigger than direct investment flows and are  rapidly approaching even the mammoth scale of trade flows.

According to this Financial Times piece, in total, investors outside China this year have bought about $150 billion worth of Chinese stocks and bonds – including Chinese government bonds. (Not that the debt of Chinese entities practically speaking differs fundamentally from national and local Chinese government debt, since there’s no private sector worthy of the name in China.)

The Financial Times reports that the vast majority of these inflows are bond purchases, meaning that investors outside China are lending to all manner of borrowers inside the People’s Republic. But buys of stocks in the Chinese entities commonly and misleadingly described as “companies” that presumably closely resemble their counterparts in genuine free market systems matter as well, because they, too, make new resources available to the Chinese regime. And after suffering from net outflows earlier this year, when Beijing locked down much of the country’s economy after the CCP Virus broke out, Chinese stocks are enjoying net inflows once again.

Moreover, China is starting to enjoy this foreign capital windfall just as its own ability to generate the savings needed to finance the huge debts that have fueled the latest phase of its ongoing economic expansion has begun weakening. Indeed, the need to replace faltering domestic capital sources with foreign capital is exactly what’s behind Beijing’s recent spate of decisions to reduce the barriers to overseas investing in China’s financial markets.

Foreign purchases of Chinese financial assets are still dwarfed by China’s global trade surplus (i.e., its profits) this year, which stands at just under $500 billion through November. But they’re now twice as great as global direct investment in China (about $115 billion through October, Beijing reports).

Obviously, the Trump administration can’t directly control non-U.S. foreign investment into China. But capital coming from the United States hasn’t exactly been chump change. I haven’t been able to find official data, but Steven A. Schoenfeld of the investment research and advisory firm MV Index Solutions, who has been investigating this issue for several years, has written that, in 2019, “nearly $400 billion of new foreign investment into Chinese equities was driven by changes in allocations within benchmark indexes, with American investors accounting for more than a third of these massive portfolio flows.” In addition, he has estimated that the 30 largest U.S. public workers’ pension plans had invested more than $50 billion in Chinese entities as of the beginning of this year. (Full disclosure: Steven is a long-time close personal friend.)

The Trump administration belatedly has tried to curb American portfolio investment in China, and has both forced a big federal workers’ pension fund to halt a planned great increase its China holdings, and has ordered a ban on all U.S. financial investment in dozens of companies linked to the Chinese military.

But unless more comprehensive curbs are enacted, the decisions by Wall Street research firms to boost China’s presence in the stock indices they construct, and which both government pension and private fund managers generally try to track, will still ensure that these investors’ exposure to China keeps rising. And the lure of expanded opportunities in China’s already huge and potentially huge-er financial services market, and its still healthily growing real economy, will continue fueling American and other foreign investors’ appetite for both Chinese stocks and bonds. Ironically, the President’s Phase One trade deal could help sustain and even increase U.S. investments in China via the commitments China has made to ease barriers to entry for American finance companies.

In fact, Steven Schoenfeld’s research makes clear that overall, despite these Trump administration curbs, total foreign holdings of Chinese stocks and bonds could approach and even exceed the half trillion dollar level in the next two or three years. These sums would equal several percentage points of China’s total economy.

Nor does the foreign financial support for China stop there. Although the Trump administration and Congress have been working to tighten the standards Chinese entities must meet to list on U.S. stock exchanges, their presence in the three biggest such financial markets as of October had allowed them to achieve total market capitalization of $2.2 trillion.

Of course, the Trump years seem to be nearing a close, raising the question of whether apparent President-elect Joe Biden will try to tighten the clamps on U.S. capital flows further and even encourage American allies to do the same, or whether he’ll simply let current trends continue, or open the flood gates further.  Something we do know for sure:  Investors in Chinese markets seem awfully confident that Washington will let them continue with their version of selling Beijing the rope with which it can hang the free world.  Why else would Chinese stock prices be way up since his apparent election? 

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Our So-Called Foreign Policy: Long Overdue Curbs on U.S. Financial Investment in China Seem at Hand

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CCP Virus, China, coronavirus, COVID 19, cybersecurity, government workers, human rights, investing, investors, MSCI, national security, Our So-Called Foreign Policy, pensions, privacy, rogue regimes, sanctions, Steven A. Schoenfeld, surveillance, Thrift Savings Plan, Trump, Wuhan virus

A major debate has just broken into the open over some crucial questions surrounding the future of U.S.-China relations. Chances are you haven’t read about it much, but it essentially involves whether Americans will keep – largely unwittingly – sending immense amounts of money to a foreign regime that was long posing major and growing threats to America’s security and prosperity even before the current CCP Virus crisis. The details, moreover, represent a case in point as to how stunningly incoherent America’s China policy has been for far too long.

The controversy attained critical mass this week when the Trump administration on Monday “directed” the board overseeing the main pension plan for U.S. government employees and retirees (including the military) to junk a plan that would have channeled these retirement savings into entities from the People’s Republic. The President can’t legally force the managers of the Thrift Savings Plan (TSP) to avoid China-related investments. But he does have the authority – in conjunction Congressional leaders – to appoint members to the board, and has just announced nominations to fill three of the five seats. 

This afternoon, the board announced that its recent China decision would be deferred. But because it’s still breathing, all Americans need to ask why on earth the U.S. government has ever allowed any investment in shares issued by entities from China (as known by RealityChek regulars, I refuse to call them “companies” or “businesses,” because unlike their supposed counterparts in mostly free market economies, they’re all ultimately agents of and most are massively subsidized by the Chinese government in one way or another). And why doesn’t the board just kill off the idea for good?    

After all, at the very least, Chinese entities often engage in the most fraudulent accounting practices imaginable, thereby preventing outsiders from knowing their real financial strengths and weaknesses. As just pointed out by Trump administration officials, many also play crucial roles in China’s human rights violations and engage in other practices (e.g., hacking U.S. targets, sending defense-related products and technologies to rogue regimes) that could subject them to national or global sanctions. Worst of all, the thick and secretive web of ties between many of these entities and the Chinese military mean that in a future conflict, U.S. servicemen and women could well get killed by weapons made by Chinese actors partly using their own savings.

Further, government workers’ savings aren’t their only potential or even actual source of U.S. financing. Any American individual or investment company or private sector pension plan is currently allowed to direct money not only toward any Chinese entity listed on American stock exchanges (even though regulators keep complaining about these entities’ lack of transparency – while generally continuing to permit their shares to trade). Such investment in Chinese entities listed on Chinese exchanges is perfectly fine, too. In addition, as documented on RealityChek, U.S.-owned corporations have long been remarkably free to buy stakes in Chinese entities whose products and activities clearly benefit the Chinese military.

Still, the idea of the federal government itself significantly bolstering the resources of China’s regimes belongs in wholly different categories of “stupid” and “reckless.” And don’t doubt that major bucks are involved. The total assets under management in the TSP amount to some $557 billion. And about $40 billion of these are currently allotted to international investments. (See the CNBC.com article linked above for these numbers.)

Could there be any legitimate arguments for permitting these monies – most of which are provided by U.S. taxpayers – to finance an increasingly dangerous Chinese rival? Defenders of the TSP China decision (prominent among whom are officials of public employee unions, who seem just fine with underwriting a Chinese government whose predatory trade practices have destroyed the jobs and ruined the lives and jobs of many of their private sector counterparts) maintain that the prime responsibility of the managers is maximizing shareholder value. And since the TSP had decided that the optimal mix of international holdings are essential for achieving this aim, it quite naturally and legitimately decided to move its overseas investments into the MSCI All Country World ex-US Investable Market index.

This tracking tool and the fund it spawned are widely considered the gold standard for good investment choices lying outside the United States, and in early 2019 decided to speed up a previous decision to triple the weighting it allots to China companies. The share is only about three percent, but who’s to say it stops there?

The TSP board unmistakably should be mindful of its fiduciary responsibilities to current and former federal workers. But as noted by the Trump administration, how can it adequately promote them when it’s transferring their savings into Chinese entities that are simply too secretive to trust and that may be crippled by U.S. sanctions?

More important, as managers of a government workers’ pension fund, TSP board members can’t expect to be treated like private sector fund managers. They clearly have responsibilities other than maximizing shareholder value, and undermining U.S. policies toward China (or on any other front) can’t possibly be part of their mandate.

Bringing the TSP in line with the broader emerging U.S. government approach to China wouldn’t solve the entire problem of huge flows of American resources perversely adding to Beijing’s coffers. This article by investment analyst Steven A. Schoenfeld (full disclosure: a close personal friend) details the alarming degree to which MSCI along with other major indexers have increased the China weightings in their emerging markets indices in particular to alarming levels – levels that aren’t easy to reconcile with the imperative of investment diversity, and that haven’t exactly been broadcast to the large numbers of individual investors who rely on them.

Even immediate, permanent new restrictions on TSP would do nothing to address this issue. Nor would they affect continuing private sector investment in Chinese entities that supply that country’s armed forces, and that strengthen its privacy-threatening hacking and surveillance capabilities.

But TSP curbs would be a start. And any TSP managers that don’t like them can quit and go to work on Wall Street.