Break-through or Break-up? U.S.-China Negotiations and the Financial Account
October 4, 2019
The latest twist in U.S.-China trade negotiations came last Friday when multiple news outlets reported the Trump administration is considering delisting Chinese companies from U.S. stock exchanges as “part of a broader effort to limit U.S. investment in Chinese companies.” While a subsequent report quoted a U.S. Treasury spokeswoman as saying, “the administration is not contemplating blocking Chinese companies from listing on U.S. exchanges at this time,” it also acknowledged weeks of interagency meetings on the topic (making clear the option is not entirely off the table). With the next round of trade talks between the United States and China scheduled to begin next week, the possible inclusion of expanded financial account issues (e.g., policies impacting foreign direct investment (FDI) and investment in debt and equity securities), raises the stakes for both sides. It also adds a new element to possible “decoupling” scenarios, which previously had focused on supply chains and access to sensitive technologies.
Until now, financial account issues have played a limited role in the 18-month trade war. They have mainly been discussed in the context of China’s foreign ownership restrictions, such as joint venture requirements and foreign equity limitations, which require technology transfer and therefore “burden or restrict U.S. commerce.” Removing limits on FDI has long been a goal of U.S. engagement with China, as years of “fact sheets” from U.S.-China dialogues will attest. Importantly, these efforts have consistently aimed at opening the Chinese economy to greater foreign investment, which in turn would more deeply integrate China into the global economy.
In contrast, the financial account proposals that came into focus over the past week pertain not to FDI but to investment in equity and debt securities, also known as portfolio investments. These securities typically trade on financial markets, bringing financial market considerations more directly into the debate. In addition, unlike efforts aimed at liberalizing FDI in China, which tend to deepen integration, these proposals would effectively decrease financial linkages between the United States and China. They also demonstrate a willingness to use financial linkages and the U.S. role in the international financial system as leverage.
It’s unclear what specific financial account measures might be part of the negotiations; press coverage has included the de-listing of Chinese firms that trade on U.S. exchanges and preventing U.S. federal retirement accounts from investing in Chinese companies. Both proposals were introduced in different bills earlier in the year, separate from the trade negotiations. Other proposals have been floated outside official government channels and include levies on Chinese assets which could be even more consequential.
Policymakers should carefully evaluate the potential impacts of these and other proposals. First, are proposals to restrict U.S. investment in China likely to change Chinese behavior? (The question raises a more fundamental question—beyond the scope of this commentary—about the objective of financial account restrictions: are they aimed at addressing issues outlined in the Section 301 findings or part of a broader effort to deny finance to Chinese entities of concern?) Second, what are the spillover (contagion) effects of such proposals to U.S. and global markets and to the U.S. and global economies? Third, in a world of global capital flows, can policies be effective when enacted on a unilateral basis?
Regarding the first question, China is actively courting foreign inflows to provide financing to companies that may be capital constrained, to offset capital outflows, and to advance reforms such as building a more discriminating credit (and creditworthiness) culture. Last month, China announced it would eliminate investment quota restrictions for foreign investors, consistent with “meeting the needs of foreign investors in China’s financial market.” This coincides with the increased weighting of Chinese securities in major international indexes, which the International Monetary Fund (IMF) estimates could generate as much as $450 billion in portfolio inflows to China over the next two to three years. These considerations suggest China will be keen to avoid punitive U.S. measures that target portfolio flows.
On the second question, a very imprecise estimate based on data from the IMF, U.S. Treasury, and Bank for International Settlements puts U.S. financial exposure to China at about $400 billion, of which about half is portfolio investment. This is a tiny fraction of total U.S. overseas assets, but limiting financial flows into China could expose weaknesses in financially vulnerable Chinese entities. Such weaknesses could reverberate back to the United States and the global economy as financial linkages play out. In addition, tighter credit conditions in China would weigh on an already slowing economy, while financial stress in China would impact global growth.
Third, there is a question as to whether such policies can be effective when implemented unilaterally; or if the more likely outcome might be a diversion of investment activity to third countries rather than a change in China’s behavior. U.S. Treasury data put U.S. holdings of long-term Chinese portfolio securities at roughly $200 billion, or 16 percent of the $1.6 trillion in China’s total portfolio liabilities. Assuming no change in Chinese policy, diversion of financial activity would be a worst-case outcome for the United States as it would cede the Chinese market to third countries while gaining little in return. This argument applies not just to financial flows, but to other economic tools such as tariffs or technology controls and underscores the importance of the United States working in concert with like-minded countries rather than going it alone. (A recent report from the Government Accountability Office on economic sanctions notes that target states “may examine whether developing or expanding relationships with third parties could mitigate the loss of these economic relationships.”)
These considerations are separate but related to possible risks around China’s financial account integration with the rest of the world. On this issue, U.S. policymakers and regulators should insist on transparency of company financials, as well as ownership structures and lines of business. Finally, when active in U.S. markets, China and Chinese companies should be subject to the same rules and regulations as other participants, including with regard to financial audits.
Stephanie Segal is senior fellow with the Simon Chair at the Center for Strategic and International Studies in Washington, D.C.
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