A 2018 Financial Times article began making the rounds again as part of a growing debate over China’s role as an exporter of capital. This topic may be of particular interest in the context of Italy’s recent efforts to position itself to increase its share of Chinese investment abroad. The article’s title, “Chinese Investments in the UK Fail to Materialise,” broadly summarizes its main point: British expectations of substantial Chinese investment have led to disappointment.
The article starts with the following lines:
Four years ago, when George Osborne visited Beijing, there was enormous optimism that investment from China would help to regenerate Britain’s northern cities. More recently, Downing Street said this week that more than £9bn of business deals would be signed between the two countries during UK prime minister Theresa May’s three-day visit to China.
But in many cases, the UK government’s optimism about Chinese investment has proved unfounded. . . . Such disappointments have taken some of the lustre off the “golden era” in Sino-UK relations promised by Mr Osborne and Mr Cameron. Theresa May, the current prime minister, who will finish a three-day visit to China on Friday, has been more circumspect.
The fact that many in the UK may or may not feel disappointed or frustrated with China’s failure to comply with what they believed was its proposed investment in the UK reflects a fairly substantial point of confusion about the role and benefits of foreign investment, Chinese or otherwise. This confusion is not limited to the UK. It is widespread, affecting opinions and policies in almost every country in the world, as much in Rome, for example, as in London. In fact the UK was never likely to benefit from substantial Chinese investment except to the extent that the Chinese were willing to invest foolishly. The fact that they chose not to do so should not have come as a surprise.
The idea that a country automatically benefits from foreign investment is based on the assumption that productive investment in any country is always constrained by a shortage of capital. That is why when foreigners promise to invest in a country, it is assumed that this will lead to an increase in productive investment.
But like many other widely shared assumptions among economists about what is or isn’t good for the economy, this assumption is too rigid. Foreign capital inflows into any country can lead to an increase in productive investment only under certain circumstances. Under other circumstances, these inflows are more likely to lead to either more unemployment or more debt. What matters are the underlying conditions in a given country and, to a lesser extent, conditions in the country from which the investment originates. In fact, as I will show below, while Chinese investment can cause developing economies to grow faster, it is unlikely systematically to benefit the UK or other advanced economies.
This extremely unintuitive conclusion seems to fly in the face of many years of policy direction and behavior, but it follows automatically from working logically through the ways in which foreign investment affects recipient countries. The key is to recognize that an assumption that implicitly governs much classical economics—that capital is a scarce resource—while probably true for most of modern economic history is now obsolete, at least for most advanced economies. Because countries like the UK do not suffer from a scarcity of investible capital, the benefits of foreign investment are not nearly what once was believed.
The Ins and Outs of Foreign Capital Inflows
Any discussion of Chinese investment in the UK must start with an understanding of why foreign capital inflows might benefit a country. For the sake of convenience, the rest of this essay will refer to China as the originating country and the UK as the recipient country, but this discussion is about capital flows between any two countries, not just between China and the UK.
To begin with the basics, there are only five conditions under which the UK might in principle benefit from Chinese investment, of which the middle three overlap substantially:
- Capital is scarce. If productive domestic investment in the UK is constrained by a lack of domestic savings, and if viable British credits are unable to access foreign capital cheaply, then the Chinese decision to export Chinese savings to the UK is likely to be positive. It will allow the UK to increase its stock of productive investment and so will increase the country’s wealth by more than enough to repay the Chinese investment. This is true whether the foreign investment is in the form of direct investment (foreigners building factories, research facilities, logistics systems, and other assets) or portfolio investment (foreigners issuing loans or buying stocks, bonds, and certificates of deposit).
- Technology is scarce. If Chinese direct investment brings advanced technological and managerial skills that can increase British productivity but which the UK does not possess and cannot otherwise obtain, the UK’s stock of investment will become more productive and so will increase the country’s wealth by more than enough to repay the Chinese investment.
- Locals are dumb. If Chinese businesses or investors can find ways to invest productively and directly into the British economy that the British themselves are unable to figure out (and that U.S., European, and Japanese investors and businesses are also unable to figure out) then, again, the Chinese decision to invest in the UK will allow the UK to increase its stock of productive investment and so will increase the country’s wealth by more than enough to repay the Chinese investment.
- Foreigners are dumb. If Chinese investors and businesses systematically overpay for domestic assets, the British owners of those assets will receive a one-off wealth transfer from Chinese investors and businesses.
- The country needs restructuring. Massive amounts of Chinese direct investment can effectively regenerate a depressed area, like the northern UK, or can stimulate competition in sectors in which competition is limited.
These five conditions cover every reasonable way in which the UK, Italy, or any other country can benefit from private or public foreign investment by another country, whether China or some other one.1 In the rest of this essay, I will consider each in turn, although for convenience’s sake they will be examined in reverse order. I will refer specifically to circumstances in the UK and China in discussing investments under these conditions, but the conversation can be expanded to cover all foreign investment, and I will occasionally refer to Italy specifically as a possible recipient country.
Condition 5: The Country Needs Restructuring
Starting with the fifth of the aforementioned five conditions, while it is possible that a depressed area will rebound after massive amounts of new direct investment in infrastructure, housing, and manufacturing, in cases involving large economies, like that of the northern part of the UK, the total investment must be massive. More importantly, so large a share of the benefits of these investments will consist of externalities that cannot be captured by commercial entities that it is hard to take seriously any claim that foreign investors and businesses would be willing to foot the bill. Regenerating a region or eliminating constraints to competition would really be something for which the British government should take responsibility, not a foreign government.
Some might argue that London does plan to make the necessary investments, and that it is only looking to Chinese investment to bear part of the burden. In that case, however, Chinese investment would only be necessary to the extent that Chinese businesses and investors were willing to take losses to benefit the British economy that other investors would be unwilling to take, or that Chinese investors were willing to take risks that other British and foreign investors were unwilling to take. Either way, this would entail reverting to the third or fourth conditions above.
I suspect there was a great deal of wishful thinking in London if this was indeed what was expected of Chinese investment. Most governments generally do not prioritize the economic development of a foreign country except under extraordinary geopolitical circumstances, and even then they do so only when the amount of investment is relatively small.
Condition 4: Foreigners are Dumb
It is obvious how the UK would benefit from having Chinese investors, whether as direct investors or as portfolio investors, systematically pay more for a British asset than the value of the goods and services that asset can generate for the UK. Chinese overpayment would simply transfer wealth by the amount of the overpayment from a Chinese entity to a British entity.
Of course, this type of foreign investment only matters from a policy point of view if it occurs systematically and not just in cases of randomly occurring bad deals. This outcome isn’t as unlikely, however, as it may at first seem. There are at least four ways it can occur.
First, there is a fairly ample history of investors systematically overpaying for foreign assets when their countries first go out into the world to recycle large trade surpluses, especially for trophy projects. This is what happened with U.S. foreign investment in the 1920s, for example, as well as in several subsequent cases, including the Soviets in the 1950s, Arab members of OPEC in the 1970s, Japan in the 1980s, and even some developing countries in the early 1990s. This is almost certainly also the case with Chinese investment abroad in recent years.
Second, a systematic tendency to overpay for foreign assets may have to do with the UK as a destination for flight capital leaving China. If that is the case, Chinese investors would bid for assets abroad, and because these are among the limited assets approved for foreign exchange transactions, they would bid aggressively. For example, a few years ago an Australian colleague told me that Chinese investors were regularly winning auctions for distressed Australian agricultural assets, paying more than expert Australian investors deemed reasonable for a fairly specialized class of assets.
This could have represented serious Chinese investment interest, but it is more likely to have occurred because Beijing encouraged the purchase of agricultural assets abroad as a strategic objective and was willing to provide the foreign exchange needed. In that case, Chinese purchases were probably designed primarily to help wealthy Chinese take money out of the country, and the extent of overpayment needed to win a given auction was treated simply as the cost of taking money out of the country.
Third, it is also possible that Chinese investors are willing to overpay for British assets mainly because this overpayment is knowingly or unknowingly subsidized by the Chinese government. Such subsidies are most likely to take the form of artificially low interest rates, especially favorable access to capital, or an overvalued renminbi. While the first two forms of subsidies may have indeed occurred in the previous decade, when debt levels for Chinese state-owned enterprises were still manageable and when real interest rates were still very low or negative, this has no longer been the case since at least 2012. To the extent that some investors are concerned that the renminbi is overvalued, however, or that the currency is likely to depreciate because of Beijing’s response to trade war concerns, some Chinese investors may continue to be interested in acquiring foreign assets, even at excessive prices, mainly because it is the only legal way to protect themselves from expected devaluation.
Finally, there may also be legitimate reasons for overpaying—such as paying too much for an asset because it can create synergies for the buyer. For example, a Chinese manufacturer of white goods may pay handsomely for a British manufacturer mainly to establish a distribution system through which it can sell domestically produced white goods to British customers. While this kind of arrangement occasionally occurs, however, it is much easier said than done: history suggests that these synergies tend to be heavily exaggerated.
Whatever the reason, the benefits of this tendency for foreigners systematically to overpay for assets are likely to be small in the grand scheme of things, and these benefits tend to disappear with experience anyway. What is more, it is hard to believe that Beijing‘s negotiations concerning Chinese investments in the UK were based on the assumption that Chinese investors would systematically overpay for British assets, even in the case of highly synergistic acquisitions. It is unlikely, in other words, that London was expecting to receive economic benefits from China based on this particular condition.
In the case of Italy, a large economy that also has so-called trophy assets, nearly all of the conditions above that apply to the UK would also apply. The only exception may be Italy’s role as a haven for flight capital. Given the much deeper, more sophisticated, more flexible, and better governed British financial markets, Chinese flight capital is less likely to flow to Italy than to the UK.
Condition 3: Locals are Dumb
It is unnecessary to spend much time examining the third of the five conditions listed above. Given their long history of investing in British markets (and the sophistication of British banks and investors), it is hard to see why Chinese investors would be able systematically to find investment opportunities in the UK that British (or indeed U.S. and other European) investors were too ignorant or uninformed to have noticed.
Some might argue that Chinese investors, unlike their British counterparts, are better at creating value because of their long-term orientation toward investment. This claim, however, is based mainly on Asian stereotypes and has no empirical support at all. This is basically the same Orientalist explanation used to justify the bad investment decisions made in the Japanese bubble of the late 1980s, and it is trotted out in every East Asian country that experiences an investment bubble. While it is possible that Chinese investors can somehow find value more easily in the UK than British investors, this certainly hasn’t been proven.
In fact, it is becoming increasingly evident that the investments abroad that Chinese investors have made are suffering the same fate as those the countries mentioned above made when they first went out into the world to recycle large trade surpluses. Like their predecessors, most recently Japan in the 1980s, Chinese investors seem to have overestimated economic potential and undervalued risk, and they are already beginning to take large losses on developing-country investment. It is very unlikely, in other words, that Chinese investment into the UK is based on a superior ability of Chinese businesses and investors to ferret out profitable investment opportunities that are not being exploited by local investors. The same is likely true of Italy.
Condition 2: Technology is Scarce
Foreign investment can bring technological and managerial skills that are not otherwise available. There may indeed be certain sectors in which Chinese technology is superior to British technology, such as internet retail or, more likely, heavily subsidized trophy technology areas like high-speed railways, areas in which Chinese investment, supported by substantial political and financial capital, creates economic benefits for the world (even if not for China).
But all the hype about China’s technological prowess notwithstanding, it is hard to believe either that British technology isn’t superior almost across the board or that British management techniques are less suited to the UK than the techniques of Chinese managers. What is more, it would be easy enough to see if Chinese investment in the UK is concentrated in such technology-heavy areas. China has not prioritized exporting its technological advantages in the past and, certainly from what I have read, there is no reason to think that they plan to do so in the UK.
Given Italy’s less technologically advanced economy relative to the UK’s, there may be more areas in which Chinese technology can boost Italian productivity, although, again, exporting technology has not to date been part of China’s investment strategy. If China were to do so, Italy may draw more advantage from Chinese investment than the UK would, and it should be easy enough to see if that turns out to be the case.
Condition 1: Capital is Scarce
If investment in the UK is limited by the scarcity of capital available to businesses, increasing the capital available for investment, whether that capital is from China or anywhere else, is always a good thing. This implicit notion is the most important of the assumptions that justify foreign investment.
But while it generally holds true in most developing countries, where investment needs are high and investable domestic savings are low, it doesn’t hold true for the UK. While as late as the mid-nineteenth century it was probably safe to assume that investment in any country is always constrained by limited savings, over the past three decades—and by some measurements perhaps as far back as the late 1970s—this assumption has clearly become obsolete among advanced economies. With interest rates at historic lows, consumption demand weak, asset prices soaring, and companies sitting on hoards of unutilized cash, it is pretty clear that investment in advanced economies is no longer constrained by the scarcity of capital or savings. On the contrary, probably because of huge trade and capital flow imbalances as well as high and rising income inequality, the world suffers from too much savings and too little consumption. This is especially true in the UK, where sophisticated, flexible, and well-governed capital markets make the country a haven for excess savings from around the world.
The story may be different in Italy. Ever since the 2008–2009 crisis, Italy has suffered from extremely high debt levels that discourage investment and keep capital costs high. This being the case, Chinese investors’ decisions to invest substantially in Italy may boost growth and productivity. If that is the case, however, what really may be happening is a version of the fourth of the conditions listed above, in which Chinese investors are expected to overpay for Italian assets because they underprice risk.
This may make sense for Chinese investors if they are able to reduce their risk by negotiating a waiver of Italian sovereign immunity. Otherwise, by investing in Italian assets or lending funds for Italian projects, Chinese investors, like any other investor, must accept the conditions of risk imposed by Italy’s substantial debt burden and the impact this debt might have on its future capacity to repay foreign investment.
There’s More: There Are Costs to Capital Inflows
What seems even less well understood than how a country benefits from foreign investment are the conditions under which foreign investment inflows, as the obverse of current account outflows, can damage developed economies. Specifically, foreign investment inflows pose two potentially large costs to the UK. First, in the case of foreign direct investment, foreigners may buy British companies to acquire and transfer advanced technology. This may or may not harm British economic growth over the medium term and the long term depending on the specific circumstances, which I probably don’t need to rehash as journalists have discussed this issue quite a bit.
The second cost is potentially even greater. Countries that receive net foreign investment inflows, whether direct investment or portfolio investment, by definition will necessarily see either domestic investment rise or domestic savings drop.2 If net foreign capital inflows don’t cause investment to rise in advanced economies like the UK, (and may even cause it to decline if these inflows export consumption demand), they must force down the domestic savings rate.
This very important point is almost always misunderstood and so worth repeating. If any country sees an increase in its net foreign investment inflows, there are corresponding changes in three accounting identities which, precisely because they are accounting identities, must occur simultaneously and are simply different ways of saying the same thing: (1) the country’s capital account surplus will rise by the amount of the increase in net foreign investment, (2) its current account deficit will also rise by exactly the same amount, and (3) the excess of domestic investment over domestic savings will rise, again by exactly the same amount. Because the UK is an advanced economy in which investment is unconstrained by scarce capital, the country’s investment level will not rise with an increase in net foreign inflows, in which case its savings must automatically decline, as the gap between the two rises exactly by the amount of the net foreign investment inflow.
Economists and policymakers still find it hard to understand how foreign capital inflows can automatically depress domestic savings. But as I have discussed several times before (for example, here, here, and here), there are many ways in which they can do so. These, broadly speaking, always result in either higher unemployment or higher debt, neither of which the UK is likely to see as a good thing.
It isn’t a coincidence at all, by the way, that countries with the most open and flexible capital markets and the best financial-market governance (basically the Anglo-Saxon economies) have run permanent or nearly permanent deficits driven by low savings since the 1970s: capital inflows have depressed domestic savings. That is why when analysts argue that their low savings prove that the UK (and similar countries, like the United States) need foreign capital, they have it exactly backwards. If foreign capital does not drive up investment, it must drive down savings.
These economies receive the excess savings generated abroad not because they need the money (in which case they would have been driven by rising interest rates) but rather because the excess savings were forced into countries that could best accommodate them (in which case they should drive down interest rates, as they seem to have done). This means that foreign capital inflows into the UK—whether from China, the United States, elsewhere in Europe, or anywhere else—force the UK to accept either rising debt or rising unemployment (or some combination).3
In the case of Italy, assuming that the story may be different because the country suffers from extremely high debt levels that discourage investment and keep capital costs high, a decision by Chinese investors, supported by Beijing, to invest substantially may boost growth and productivity because it would boost domestic investment. If, like in other developed economies, things do not turn out this way, then Italy must bear the same costs—rising unemployment, rising debt, or some combination—that the UK would bear.
The UK Does Not Need Foreign Investment
It is hard to argue, in other words, that any benefit the UK gets from investment originating from China (or from Saudi Arabia, Russia, and perhaps even technologically advanced economies in North America and Europe) match or exceed the costs associated with these inflows. While individual groups, sectors, or businesses in the UK can benefit from specific investment projects, the economy as a whole doesn’t benefit. It follows that benefits that accrue to some players must be matched, or more than matched, by costs borne by the rest of the country.
This isn’t to say that the UK should block all foreign investment. Most economists would agree that larger markets create greater efficiencies, and if the benefits can be fairly distributed, all participants will be better off. This is also true for investment markets. To the extent, in other words, that the UK forms part of a larger investment sphere in which investment capital flows in a balanced way among countries that can both export and import technology, all the countries in that sphere benefit.
But these are important conditions: all countries in the system benefit only to the extent that capital flows are roughly balanced, that technology and managerial transfers are also roughly balanced, and that no entities are large enough to distort the natural flow of investment capital. Only if all these conditions hold would reality approach Adam Smith’s ideal of perfectly competitive markets in which resources flow to their most productive use.
Why Do So Many Countries Welcome Foreign Investment?
If the UK doesn’t benefit from Chinese or other foreign capital inflows, why are local governments and businesses in recipient countries so effusive in the welcome they offer any kind of foreign investment, and why are they subsequently horribly disappointed when it fails to materialize?
The answer is that their joy mainly reflects the skewed incentives at the local level. Even if the UK overall doesn’t benefit from Chinese investment, individual local governments and businesses in the country can nonetheless benefit, in the same ways in which they benefit from any investment, whether the capital comes from British investors or foreign ones.
The FT article mentions, for example, a real estate developer who was able to bid on a project only with Chinese investment backing. It is clear why this particular developer wanted Chinese investment: without it, he perhaps would not have had the necessary financial backing to put in a bid. But, presumably, if the project were economically viable, there were other British- and foreign-backed entities just as capable of bidding. Assuming, reasonably, that there is capital available for viable British real estate projects, Chinese backing would have only benefited the UK economically under the following two conditions, which restate the third and fourth of the conditions listed above:
- One possibility is that the project was clearly economically viable but, for some reason, only the Chinese investor and the local government were able to understand this: no British investor had the skill or intelligence to recognize the project’s viability. Locals, in other words, were dumb. While this may be true occasionally, it is hard to believe that it could be true often enough to justify significant amounts of Chinese investment.
- The second possibility is that everyone equally understood the viability of the project, but the Chinese likely proposed a much higher price than any British investor, in which case it must be assumed that Chinse investors were expected to take significant losses on the project to benefit the local community and the UK. It is the foreigners, in other words, who were dumb. Again, Chinese investors might be expected occasionally to pay excessively for trophy projects, or for politically important projects, but it is hard to believe that this would be overall Chinese policy.
This is why the systemic consequences of foreign investment should be treated separately from the local consequences. This logic also applies to more complicated cases. One notable example is when Japanese car manufacturers decided several decades ago, in response to concerns about trade imbalances, to build automobile plants in Tennessee. These fairly substantial investments received an enormous amount of favorable press at the time, but it was also noted that Japanese car manufacturers chose Tennessee rather than Michigan probably because of lower wages, laxer regulations, and weaker labor unions.
Their investment in Tennessee was definitely a boon for the local economy. This infusion of capital lowered local unemployment, increased tax revenues for local governments, and—by delivering income locally to workers and managers—boosted demand for goods and services provided by local businesses. U.S. consumers, who were able to buy cheaper cars, also gained from this investment.
But the impact on the U.S. economy overall was much more complex. If all of the cars produced in the Tennessee plants had been sold abroad, or displaced U.S. automobile imports, the Japanese investment would have also benefited the United States economically. To the extent that the cars manufactured in the Japanese factories mainly displaced cars sold by U.S. factories in Michigan, however, the gains to Tennessee were at least partly balanced by losses in Michigan. Whether or not the United States overall benefited economically at all depends in large part on the secondary impact of the Japanese investment:
- These investments helped weaken labor unions and lowered the wages of automobile workers overall. This probably damaged the U.S. economy, especially to the extent that these investments caused overall U.S. wages to decline. That said, economists disagree about whether or not it benefits the United States if the lower wages improve U.S. competitiveness in a globalized world economy and about whether or not weakening labor unions is positive for long-term economic growth.
- The result of the transfer of automobile manufacturing from Michigan to Tennessee was to create jobs in Tennessee while relieving labor shortages and other rigidities in Michigan that could not be resolved by labor mobility. This doesn’t seem to have been the case, but if it were, the loss in wages in Michigan would have been more than countered by wage gains in Tennessee.
- Japanese investment spurred competition among U.S. automobile manufacturers and forced them to become more efficient. This may well have been the most important benefit to the U.S. economy.
- The way in which efficiency improved, however, matters. Many economist will argue that, by improving manufacturing efficiency, the Japanese factories were unambiguously positive for the overall U.S. economy. This depends, however, on the extent to which the improvement took the form of lower wages or of higher labor productivity. The former probably would harm the U.S. economy by increasing income inequality and weakening domestic demand. The latter almost certainly would benefit the U.S. economy over the long term.
Notice how the above considerations fit within the original five conditions listed above. The Japanese investment benefited the U.S. economy mainly to the extent that it introduced advanced technological and managerial skills, or restructured U.S. manufacturing, in ways that were otherwise not available. Beyond that, this investment mostly resulted in income transfers from one set of groups to another, and it should be no surprise that the receiving groups strongly supported the foreign investment inflows.
It was always very unlikely that Chinese investment would be positive for the British economy, unless London was expecting the Chinese systematically to overpay for British assets. The UK is not a developing economy. British businesses are not capital constrained and so they do not need foreign capital to support productive investment opportunities. What is more, Chinese businesses are unlikely to bring technological or managerial advances that can improve the productivity of British economic activity or that can change the orientation of British industry. Finally, while it is always possible that there are productive and profitable investment and business opportunities in the UK that British businesses and investors are incapable of seeing for themselves, opportunities that can only be identified by Chinese businesses and investors, it is extremely unlikely that there will be many such opportunities.
In other words, in the UK, capital is not scarce, technology is not scarce, the British are not dumb, and the Chinese are not dumb, so why would London expect Chinese investment to benefit the British economy? The only way for the Chinese to justify direct investment (ignoring portfolio investment, which benefits China by allowing it to run trade surpluses) would be if there were a very large number of synergistic investments, which would be easy to determine by looking at the investments under discussion.
Because ultimately Chinese investors and businesses were not interested in overpaying for British assets, this lack of interest, I would argue, explains British disappointment at the actual extent of Chinese investment. Unlike in developing countries, it simply never made much sense for Chinese investors and businesses to invest massively in the UK. More generally, foreign investment into the UK only makes sense for the British to the extent that it embeds the country within a wider competitive area in which investment freely flows both ways across borders.
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1 I should add that there may also be benefits that accrue simply from increasing competition and raising the number of bidders on a project, but I assume that British markets are fairly competitive anyway. And even if they are not, the right solution is not to bring in foreigners but rather to eliminate the conditions that restrict competition.
2 The net amount of investment inflows (the country’s capital account) is by definition equal to its current account deficit and to the excess of domestic investment over domestic savings.
3 Some economists might argue that there is an alternative to rising unemployment and rising debt, and this is for the British government to embark on large-scale rebuilding of productive infrastructure. This misses the point. While it may be to the UK’s benefit to do just this (and it almost certainly is), this is something that should be done anyway as a domestic political decision, and it neither can nor should be done as a way of making foreign investment inflows less harmful.