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1949 marked the birth of the People’s Republic of China. What ensued was a three decade long selfimposed isolation which impoverished the nation economically and on many other fronts. The decade from 1966 to 1976, also known as the “Cultural Revolution,” saw a total destruction of traditional values and established order. Barely two years later, in 1978, socialist China opened its doors economically for the first time to the outside world. That unleashing of the entrepreneurial spirit of the world’s largest workforce has created an economic miracle. Thirty years later in 2007, China unseated Germany to become the third largest economy in the world. A mere three years later in 2010, China overtook Japan, who had been the world’s second largest economy for the past four decades, to become second only to the U.S.
Today, with 1.4 billion people and an economy valued at $11 trillion, which represents 14.8 percent of the world economy, China is a force to be reckoned with.
China’s explosive domestic growth also fueled its overseas investments. In 2015, China surpassed Germany as the world’s top net capital exporter with a value at $293 billion. In 2016, China’s overseas direct investment (ODI) reached a record high at more than $200 billion. In the same year, China overtook Singapore to become the largest source of Asian capital in the global commercial real estate market, according to CBRE, accounting for nearly half of the total $60 billion investment.
China's ODI in the U.S.
According to the American Enterprise Institute and the Heritage Foundation’s China Global Investment Tracker, the United States is the leading recipient of China’s ODI for deals worth $100 million or more. Over the past 12 years, the U.S. has received over $160 billion beginning with Lenovo’s acquisition of IBM’s ThinkPad business. In 2016, China’s FDI into the U.S. reached $55.6 billion. Due to tightening measures implemented by the Chinese government since late 2016, investment by the Chinese in the U.S. saw a 50 percent decline in the first half of 2017, down to $17.7 billion. Some believe that annual investment of $25 billion should be the norm unless the U.S. takes action to limit the inflow of the Chinese capital.
China is increasingly emerging as an engaged United States investor and business partner. There is tremendous opportunity in these collaborations across multiple industries that can lead to job creation and growth in the U.S. Political, economic and human factors have created a perfect storm of motivation on the part of Chinese consumers and businesses to acquire a piece of the U.S., particularly real property.
Chinese investors are the largest foreign buyers of U.S. real estate. According to the Chinese Global Property Investment Report released by Juwai, in 2016, more than $50 billion went into the U.S. real estate sector, including both commercial and residential properties. As of March 2017, China tops the list in sales dollar volume for four straight years in the U.S.
While this trend is expected to continue, there are some regulatory and geopolitical realities at play to temper the Chinese enthusiasm. Attorneys in the U.S. preparing to work with Chinese investors must have legal, business and cultural fluency in order to accommodate their Chinese clients. They should also be prepared for a bit of a roller coaster ride, with a possible pullback in deals for theToday, with 1.4 billion people and an economy valued at $11 trillion, which represents 14.8 percent of the world economy, China is a force to be reckoned with.foreseeable future.
Why China Now?
China’s economic transformation has helped it accumulate tremendous wealth, both in the public space and private sector. Conversely, its economic growth has also resulted in overcapacity and declining profit margins domestically. That dichotomy accounts for China’s strong purchasing power and pent up demand for overseas acquisitions. Part of that has been driven by a strong interest on the part of the Chinese to diversify their portfolios and to invest overseas in order to hedge against asset and currency devaluation at home. The relative economic stability of the United States, with its long established, transparent legal and regulatory framework for conducting business, is particularly appealing.
For Chinese manufacturers, there is also the issue of rising labor costs at home. Investing in established manufacturing hubs and supply chains closer to the enduser make good business sense. And the appeal of the “made in the U.S.A.” label remains strong when selling to Chinese consumers. As China’s economy evolves from a manufacture heavy model to one that is focused on consumption, services and technology, acquiring U.S. targets by Chinese businesses will help them leapfrog.
Chinese consumers have money to spend and are increasingly interested in the finer things in life. According to the World Tourism Organization, in 2012, China’s expenditure on travel abroad reached $ 102 billion, making it the first tourism source market in the world in terms of spending. The U.S. is the fourth most popular tourist destination for the Chinese, and often this exposure leads to a desire to invest in something more permanent such as a second home. In addition, many successful middle class Chinese families want to send their kids to schools in the United States. Investing in real property can be a practical as well as strategic endeavor. For those more adventurous, the United States remains the top destination for immigration. That explains why, from 2012 to 2015, more than 80 percent of the EB5 Visa investors have come from China, based on a research done by CBRE.
In the global luxury market, wealthy Chinese consumers are brandloyal and priceunconscious, unlike the generations before them. In the 2017 China Luxury Report published by McKinsey, they are forecasted to account for 44 percent of the total global luxury goods market by 2025, representing RMB 1 trillion in global luxury sales, an amount equal to the size in 2016 of the U.S., U.K., French, Italian and Japanese markets combined.
In terms of investment destinations, California and New York have been the most popular for the Chinese. Although Hawaii remains yet to be fully discovered, according to Rhodium Group, it still managed to attract roughly $890 million commercial investments over the past 17 years. The launching of direct flights between Hawaii and two of China’s major cities, Beijing and Shanghai, has helped Hawaii attract an increasing number of affluent Chinese travelers. The synergy between China’s outbound tourism boom and Hawaii’s bestinclass tourism resources will eventually manifest itself. Hawaii’s low crime rate, cultural similarity with Asia, racial diversity and geographical location will help it score high when compared against other destinations.
Legal and Regulatory Challenges
The regulatory landscape in China and the U.S. has presented challenges for deal makers in the past year however. China has instituted tough measures restricting capital outflows starting from late 2016. For example, overseas investments of more than $10 billion as well as mergers and acquisitions of more than $1 billion outside of core business are now forbidden. Also, foreign real estate deals by state owned enterprises involving more than $1 billion outside core business are also halted.
On Aug. 18, 2017, the State Council issued the Guidelines on Further Guiding and Regulating Overseas Investments to restrict investments in property, hotels, cinema, entertainment and sports clubs. Meanwhile, a number of China’s most aggressive overseas acquirers have been under investigation by the government.
Obviously it would not be sensible for the central government to blindly halt all ODIs. After all, the percentage of China’s aggregate foreign asset ownership compared to GDP is only 12 percent, far below the 42 percent average enjoyed by OECD countries, as observed by Juwai. Those measuresseem to have been driven by three considerations. First, they are intended to reign in those overly active private players to better align with the investment agenda set by the central government. They also reflect the Chinese government’s efforts to prevent a system credit bubble as some of the largest overseas acquirers have overleveraged themselves. Last but not least, to prevent capital flight out of China and money laundry is the third major driver behind those measures.
On the other hand, the U.S. government’s scrutiny of deals, particularly large transactions, has increased. The average deal size has contracted, which has in turn affected the overall deal volume for the first half of 2017.
The Trump administration has adopted a protectionist foreign investment policy. It has initiated investigations against China on acts, policies and practices related to technology transfer, IP and innovation under Section 301 of U.S. Trade Act of 1974, bypassing the World Trade Organization (WTO).
The Committee on Foreign Investment in the United States (CFIUS) is also poised to create additional roadblocks as its purview expands beyond national security concerns.
Both the tightened outbound approval regime by the Chinese government and the heightened scrutiny from the U.S. side have aggravated the risk scenarios for overseas Chinese investors and as a result increased their transaction cost. With the added uncertainty on their ability to fulfill funding obligations or to meet the closing timeline, Chinese buyers are being edged out in the bidding process. Even when they win the bid, sellers would require a hefty reverse termination fee to hedge against the risk of buyer’s failure to obtain requisite government approvals. To secure seller’s ability to collect reverse termination fees upon such a termination event, letters of credit, offshore guarantees or funds in escrow have been commonly used. If the transaction involves debt financing, typically a seller would require the delivery of a commitment letter from the buyer’s lender before the signing of the definitive agreements, setting forth material terms of the financing and also conditions the buyer must satisfy for the lender to fund the transaction. This has significantly deterred those without sufficient offshore sources of funding from entering into or consummating transactions.
Inasmuch as China’s domestic economy has always been dictated by the government, it should not surprise anyone if the visible hand of the state also plays a central role in China’s ODI. While the momentum of China’s capital export is too strong to be halted, the Chinese government is certainly best positioned to channel where, when and how the spending should occur. Although the market itself gravitates towards the U.S. as a popular destination and does so for good reasons, the central government views it as imperative to do what it takes to accomplish the objectives set out by them, such as those under the very ambitious one belt one road initiative.
The pendulum swings between the free will of the market players in China and the state’s interference with the capital flow. That to a large degree determines when China’s ODI into the U.S. will ebb and when it will flow.
The Chinese Communist Party's 19th National Congress is scheduled to convene on Oct. 18. Many expect it to be an event with unprecedented importance and will set important objectives, policies and strategies far beyond the next five years. It remains to be seen how the party chooses to balance China's ODI policies with other competing priorities.
China and the U.S. now make up more than one third of the world economy. It would be unthinkable for Chinese capital to abruptly stop flowing into the U.S. given how entrenched the world’s largest and the second largest economies have been with each other. The push and pull will be the new normal.
Those market players who are nimble navigators will be able to win out in this new normal. Those legal professionals who possess best practice in their respective subject matter areas and cross cultural ChineseU.S. fluency will be able to thrive in this new normal.
- This article originally appeared on Law360.