Moving Towards MergersC. Lawrence Greenwood , Deputy Assistant Secretary
Keynote Address at the China-U.S. Symposium on Building the Financial System of the 21st Century
Armonk, New York
June 17, 2005
(As prepared for delivery text)
The US has a strong foreign policy interest in China's sustainable, non-inflationary growth. It is naked self-interest, not altruism that drives this interest. Countries that grow are more stable, more peaceful and better customers than countries that stagnate. This is especially so in the case of a country as big and important as China.
China is already adopting policies and undertaking reforms it needs to take to ensure that growth into the future, including, sound macroeconomic policies, trade and investment liberalization, financial sector restructuring, and deepening of capital markets.
These last two -- banking sector and capital market reform -- are key as efficient mobilization and allocation of capital is critical to promoting sustainable growth. So I would like to congratulate Harvard and the China Development Research Foundation for holding this conference on the very important issue of building a financial system for the 21st century.
In an effort to engage more meaningfully with Chinese leadership responsible for ensuring that China finds the road to sustainable growth, in 2003 State Department began a Dialogue with China’s premier economic development agency, the National Development and Reform Commission (NDRC). The State-NDRC Dialogue does not discuss current bilateral economic disputes --- the US and China have many other fora to do that. It addresses instead long-range structural issues that relate directly to China's economic development in areas such as agricultural reform, macroeconomic controls, energy policy, telecommunications advances and investment.
I want to highlight the very good exchanges with the NDRC on investment policy, including a public-private sector seminar held in September 2004 in Beijing on the changes China would need to put in place to facilitate more mergers and acquisition activity. In this and other discussions, we described the important role mergers and acquisitions (M&A) activity has played in the U.S. economy, and our belief that transitioning from greenfield investment toward more M&As is vital to China’s continuing development.
It is this area of FDI and M&A where I would like to focus my comments on tonight.
By many measures, China has been doing a great job of attracting foreign direct investment. In 2004, China kept its place as one of the top two destinations in the world for FDI (the U.S. is the other), adding $64 billion. Over $564 billion of FDI has been invested in China since it opened to the world in 1979.
American investors are an important part of the picture. With over $48 billion invested through the end of 2004, the US is the second-largest source of investment to China after Hong Kong on a cumulative basis.
Foreign-invested enterprises have been a driving force in China's growth, accounting for a disproportionate amount of China’s foreign trade—approximately 55%. Foreign firms also support millions of jobs for Chinese workers.
As impressive as the absolute numbers are, however, as a share of its GDP, China FDI is not significantly higher than many other Asian countries and is on a par with Latin America. In addition, what's striking about China is that FDI accounts for virtually all of its net capital flows; other investment inflows are negligible. Thus while China has plenty of room to increase foreign direct investment, it has only just begun the process of tapping into international capital markets through portfolio investment.
There are other reasons for Chinese officials to avoid complacency in its efforts to attract foreign investment. Recent numbers suggest that the FDI boom fueled by China's WTO accession may have peaked -- according to Chinese statistics FDI fell by 0.79% in the first five months of 2005 to $22.37 billion, the first drop since September 2000.
Moreover, China may be reaching a limit on the kind of FDI it has been attracting to date, which have mostly been:
Such massive investment in export-oriented industries is contributing to oversupply in China, and is contributing to China's trade surplus that exploded to $21.2 billion in the first four months of 2005, in contrast to China’s trade deficit of $10.7 billion in the same period last year. Continued investment in export facilities will do little to alleviate frictions with China’s trading partners.
These new factories are also placing strains on infrastructure, services such as water and electricity and even labor markets within China, as we hear stories of labor shortages in Guangdong that would have been incredible just months ago.
Thus China needs to encourage not just FDI in general, but new types of investment—in particular, mergers and acquisitions (M&A) that can boost productivity and efficiency while phasing out surplus capacity.
M&A transactions, as opposed to greenfield investment, offer important benefits to investors as well as recipients, ultimately leading to stronger and more diversified economic growth:
Indeed some Chinese companies already have a keen appreciation for the value of M&A as they acquire companies overseas, including in the US. Lenovo's purchase of IBM's PC operation allowed China's largest PC maker instant access to global markets. Haier, rumored to be interested in buying Maytag, has the same objectives.
China has some special reasons to find M&A attractive; for example to:
Over the past few years China has issued new regulations governing foreign purchases of stakes in domestic enterprises that have led to an upsurge in M&A activity. A new antimonopoly law, long in the works, could pass as soon as this year and may clarify new procedures for domestic and cross-border M&A.
Although still dwarfed by greenfield investment, M&A activity has been growing. Cross-border M&A deals involving sales of firms in China grew nearly 70% from 2000 to 2003, to reach $3.8 billion.
This is still a small percentage of investment in China: while China garnered 9.6% of global FDI in 2003, China’s foreign M&A accounted for only 1.3% of all foreign M&A activity. M&A activity dominates inward investment in OECD countries.
What is constraining the growth of M&A? While many of the attributes of any good investment climate -- fair legal system, sanctity of contracts, consistent pro-competitive regulation, and transparent, honest government -- apply equally to M&A investment, M&A involves a second generation of regulatory reform needed to underpin a competitive and efficient market for corporate control. An effective regulatory regime needs to allow:
To facilitate M&A China will need to address a number of concerns that foreign investors continue to have about China’s business environment that hinder M&A activity—particularly with state owned enterprises (SOEs) —and that could be addressed by:
It is important to stress that foreign investors are most interested in the legal and structural context for investment: access to markets, good infrastructure, a workable and unbiased court system, and transparent laws and regulations. Ad hoc incentives like tax breaks are less important.
These kinds of changes will have even greater relevance for Chinese companies, both acquirers and the acquired, who will make up the bulk of transactions over time.
Foreign investors can play a pioneer and catalytic role in spurring competition through M&A activity, as we have seen in Japan with Ripplewood's acquisition of the Long Term Credit Bank and Renault's takeover of Nissan.
In fact, we hope that Newbridge's investment in the Shenzhen Development Bank, the first Chinese bank to be controlled by a foreign investor, will have the same positive impact. Newbridge faces major challenges in changing the culture at SDB’s 270 branches, and shedding the high ratio of non-performing loans (officially at around 9%, but analysts estimate it may be closer to 15%)—but there are high hopes on all sides that SDB will become a truly competitive bank.
This was a deal that took years to negotiate, and required approval from the highest levels of the Chinese government. To my mind, this demonstrates that Chinese officials recognize that injecting foreign managerial experience and skills will be crucial to their banking reform efforts, and that the M&A process is too difficult for the majority of investors, and needs to be improved if China is going to reap the benefit of increased M&A activity.
M&A can also facilitate China's reform of its state-owned enterprises. For example, the Organization of Economic Cooperation and Development (OECD) recently started a pilot project in northeast China to examine the role of foreign M&A in promoting the restructuring of SOEs.
Some SOEs are world-class enterprises that can compete globally—but a large number cannot compete at all, and must be restructured. People and capital need to be employed more efficiently, and foreign investment can play a role.
As government officials are laying the groundwork for the next stage of China’s economic development, this is a great moment to ask, "What kind of capitalism does China want?"Is China looking to follow the Japanese model of socialized risk, where companies are relatively static and weighed down by the necessity of providing employment and a social safety net over the long term? That seems to be the direction China is heading, and we have seen the risks involved with Japan’s approach.
A better long-term solution would be to permit a more efficient use of national resources, by allowing viable companies and industries to grow and encouraging market solutions for unviable companies. Specifically, the Chinese leadership faces the challenge of weaning state owned enterprises and others from cheap, government-directed credit.
Restoring banks to financial health and requiring them to adopt market mechanisms to determine lending policies and rates is important. So is deepening capital markets by creating efficient and fair markets for individuals and institutions to invest directly in the productive companies through bonds, equities and other instruments.
Foreign firms are eager to be able to take a controlling interest in Chinese securities firms, for example. China’s equities markets have been in the doldrums for years, depriving new enterprises of access to fresh capital and prolonging dependence on the shaky banking system to fuel growth. The experience and expertise of international securities firms would be of great benefit as China tries to revive its securities markets. We hope China will reconsider its policy in this area.
Rebuilding banks and enhancing equity markets won't be enough, however. As it builds a new financial system for the 21st century, I hope China will also include as a pillar an efficient market for corporate control as a way to ensure the most efficient and productive allocation of China's capital, whether drawn from foreign investors or domestic savings. I think China will find that this approach will create more productive and internationally competitive companies while we lead to continued growth and prosperity for the country.
Finally, to echo Secretary Rice’s words: we welcome China’s continued economic growth and consequent global emergence. We want to work with China and with our partners around the world to ensure that China’s further integration with the international system enhances the peace, prosperity, and stability of the region. This will be one of our main challenges and opportunities over the next quarter century and beyond. Dialogue—like that between the State Department and the NDRC, and like this weekend’s Symposium—will be a key component of our success.
Released on August 12, 2005