China
1. COUNTRY
We have chosen China as a country for analysis
2. RECOMMENDATION
We have decided to convert US dollar to Chinese yuan on May 24, 2016. The total cost in dollars according to this option is calculated further in question 9.
3. CHINESE ECONOMY OVERVIEW
China’s role in the international arena has been growing in the recent years. Apart from being the most populous country with over 1.3 billion people and one of the largest countries in the world by territory, it has been experiencing substantial economic development in the past decades (Naughton 3). China is the second largest economy in the world after the USA. Its GDP made up $10.3 trillion in 2014 (The World Bank, “GDP ranking”). If measured by purchasing power parity, the Chinese economy is the largest in the world (Johnston, “5 Things to Know About the Chinese Economy”).
Besides, it is the world’s biggest commercial trader (Moffett, Stonehill, and Eiteman 44). China’s main trading partners are the USA and its neighbors Hong Kong and Japan (Johnston, “China's Top Trading Partners”). In 2014, China’s exports totaled $2.3 trillion and its imports were $1.96 trillion, making it the largest exporter and second largest importer in the world (“Distribution of Chinese exports”). Thus, China exported most of its goods to the Unites States (18%), the European Union (15.64%), Hong Kong (14.58%), ASEAN (12.19%), and Japan (5.96%) (“Distribution of Chinese exports”). In 2014, it main import partners included the EU (14.3%), the USA (12.9%), ASEAN (11.2%), Hong Kong (8.7 %), and Japan (7.3%) (“Distribution of Chinese imports”).
Moreover, it is the fastest growing major economy in the world. According to the World Bank data, its GDP has been growing by 10% a year on average since 1978, however, this growth rate has been slowing down in the recent years (“China overview”; “GDP growth (annual %)”). Despite these unprecedented economic facts, China is still considered to be a developing country. It was a centrally-planned economy prior to 1978, and it is still carrying out market reforms (The World Bank, “China overview”).
It should be also noted that China is one of the largest energy importers. Thereby, it affects global oil demand significantly. Thus, the slowing down of the Chinese economy growth is a major reason for the recent drop in oil prices (Johnston, “5 Things to Know About the Chinese Economy”).
Finally, it should be noted that China has been a closed economy for a long time. It has been opening to foreign investment and international business since not so long ago. That’s why there are some risks and challenges that foreign firms should be aware of when doing business in China. These deficiencies are described in detail further in this paper. However, China is becoming more and more attractive for foreign investors. In 2015, it was the largest foreign direct investment (FDI) recipient in the world. Apart from Chinese economy positive sides described above, it has also the advantage of comparatively low labor costs. Moreover, developing Western provinces promise new investment opportunities (“China: Foreign Investment”).
4. CHINA’S BALANCE OF PAYMENTS
As a rule, there is an inverse relationship between current and financial accounts in the balance of payments (Moffett, Stonehill, and Eiteman 60). The explanation for this rule is that ordinarily countries having deficit on current account need to attract funds from abroad and therefore have surplus on the financial account (e.g. the USA or Germany). Japan has the opposite situation: its current account surplus is accompanied by financial account deficit. However, the Chinese balance of payments is quite unusual and doesn’t conform to this rule. For the last fifteen years, both Chinese current and financial account balances have been positive. This phenomenon is known as China’s “twin surpluses”. The reason is the extraordinary economic growth China has been facing in the recent years, which results in the current account surplus. Positive prospects also lead to huge capital inflows in the Chinese economy, so there is a positive balance on the financial account, too. China has accumulated large foreign exchange reserves, which allows the government to maintain fixed exchange rate of the yuan at present as well as for some years in future (Moffett, Stonehill, and Eiteman 61-62).
The China’s 2014 Balance of Payments Statement is provided in the appendix to this paper. As it can be seen, the current account surplus equaled $219.7 billion. There was a surplus of $476 billion as regards goods trading which is obvious as it is a generally known fact that products manufactured in China are rather cheap. There was a deficit of $192 billion on service trade account (SAFE). Despite its rapid economic growth, China is still a developing country (The World Bank, “China Overview”), and its service sector is not so advanced as in developed countries. However, service trade deficit has been narrowing recently (Xinhua). Income and current transfers reflected in the current account section were in deficit in 2014.
As has been said above, China’s BOP shows “twin surpluses”, and its financial account was also in surplus of $38.3 billion in 2014 (SAFE). Net inflows of direct investments were $208.7 billion, and net inflows of portfolio investments made up $82.4 billion. As regards other investments, they changed from net inflows to net outflows of $252.8 billion in 2014. As for the capital account, it was in a slight deficit in 2014, but the amount of transactions on it is insignificant (SAFE).
China’s reserve assets were $117.8 billion in 2014, including $118.8 billion of foreign exchange reserves (SAFE). China doesn’t have any reserves of monetary gold (SAFE). Such large amount foreign exchange reserves allowed the Chinese government to control the yuan exchange rate (Moffett, Stonehill, and Eiteman 201). However, there was an unexpected devaluation of the Chinese currency in August 2015 (“China Rattles Markets with Yuan Devaluation”). It should be also noted that the figure of net errors and omissions on the China’s BOP is impressive: it was -$140.1 billion in 2014 (SAFE). Goldman Sachs Group Inc. economists believe that these errors and omissions may represent “covert fund outflows” to keep the national currency stable (Lee). Just to compare, the U.S. net errors and omissions were $149.9 billion in 2014 (The World Bank, “Net errors and omissions”). This figure is even larger than the Chinese one, but with the opposite sign.
5. USD TO CNY EXCHANGE RATE
The current USD/CNY exchange rate as at May 18, 2016, is 6.53436 (Exchange-Rates.org). The exchange rate movement in the past two years is presented in figure 1 below. Prior to 2005, China pursued a fixed exchange rate policy. However, the USA claimed that the yuan was undervalued and China used this situation as a competitive advantage to export its goods. The International Monetary Fund was also dissatisfied with such monetary system (Moffett, Stonehill, and Eiteman 201). However, in 2005, the Chinese government decided to switch over to a managed float exchange rate with an allowed fluctuation band growing looser from 0.3% in 2005 to 2% in 2014 (Adinolfi). Thus, the Chinese currency actually appreciated more than 30% against the dollar from 8.3 to 6 during 2005 – 2014. As it can be seen from the graph, the yuan also experienced appreciation in March – July 2015. However, on August 11, 2015, the Bank of China (PBOC) shocked the world. It devaluated the yuan by 1.9% at once (“China Rattles Markets with Yuan Devaluation”).
St+1 = St ×1+ Δ in Chinese prices1+ Δ in U.S. prices (Moffett, Stonehill, and Eiteman 197).
According to OECD data, the projected inflation rates for 2016 are 1.0% and 2.5% for the USA and China respectively (OECD). The USD/CNY exchange rate was 6.51381 as at December 31, 2015 (Exchange-Rates.org). Thereby, in theory, the spot exchange rate as at December 31, 2016, would be:
S = 6.51381 ×1+ 0.0251+ 0.01 = 6.51381 × 1.01485 = 6.61054.
Thus, we believe that the yuan will depreciate against the dollar in the long-run as such position is advantageous for Chinese government. A cheaper yuan gives benefits to the Chinese exporters.
6. CHINESE STOCK EXCHANGES
China has two main stock markets which are the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SHZ). As at August 9, 2015, SSE and SHZ had a total market capitalization of $10.3 trillion making it second in the world after the New York Stock Exchange (NYSE) (Johnston, “5 Things to Know About the Chinese Economy”). If viewed separate, SSE total market capitalization is 24,196 billion CNY, or $3,705 billion, and the SHZ one is 19.342 billion CNY, or $2,962 billion, as of May 17, 2016 (HKEX). There are 1,099 companies, 7,047 securities, and 1,143 stocks currently listed on the SSE (SSE). As for the SHZ, there are 1,770 companies and 3,699 securities listed (SZSE). In February 2016, SSE and SHZ were the world’s third and fifth largest stock exchanges by domestic capitalization respectively (FAS). Besides, there is a significant amount of China’s mainland stocks listed in Hong Kong Exchange with a market capitalization of $1,942 billion as of December 31, 2014 (“China Stock Market Capitalization”).
Figure 3 below shows China’s stock market capitalization dynamics in 2000 – 2015. As it can be seen, the market capitalization has been growing fast since 2006 reaching its boom in the beginning of 2008 and then falling due to global financial crisis. After some years of stagnation, the growth continued, and China’s total market capitalization reached its peak of $12.8 billion in May 2015, but then collapsed in August 2015 (“China Stock Market Capitalization”). Prior to this fall, China has been the world’s most liquid stock market, now it has transferred this title to the USA. The regulators tried to curb bear operations, but their efforts, as well as trading halts, have resulted in a decreased investors’ confidence (“China Dethroned as World’s Most Liquid Stock Market After Curbs”).
It should be also noted that there is a rather strong government intervention in the Chinese stock market. Thus, foreign ownership of Chinese equities is rather small and strictly regulated. Most of the firms listed on the SSE and SHZ are Chinese ones. Besides, according to a Brookings Institution report, “China’s stock markets are more heavily affected by speculative investment that markets in Western countries” (FAS).
7. DOING BUSINESS IN CHINA
Despite all the economic advantages described above, there are some challenges in international business related to this country. Thus, some economic sectors are still closed to full participation of foreign companies. Besides, there is a strong competition from state-owned enterprises (SOE). Moreover, China has high levels of bribery and corruption and uses anti-monopoly legislation against foreign firms to support domestic enterprises. Differences in business culture should be also taken into account (UK Trade & Investment). Finally, China’s weak points include lack of transparency, poor intellectual property rights protection, bureaucratic and administrative complexities, and legal uncertainty (“China: Foreign Investment”). All these factors make the international business in China more difficult. According to the Doing Business 2016 report, China is beyond top 40 countries in 9 out of 10 indicators. For example, it is ranking 136th out of 189 economies for ease of starting a business, and 79th in the world for getting credit. However, reforms have been made recently to ease the business starting process in China. In 2015, requirements for minimum capital and obtaining a capital verification report from an auditing firm were eliminated. Besides, China is 7th in the world for enforcing contracts, or resolving commercial disputes in the courts (The World Bank, “Doing Business 2016”).
8. FOREIGN DIRECT INVESTMENT
As has been said above, the Chinese Government protects some economic sectors from full foreign participation and direct investment. These include monopolistic sectors where SOE successfully operate, resource-intensive and polluting industries, and sectors in decline. Thereby, we wouldn’t recommend a U.S. company a FDI in the form of an exclusively foreign-owned company. Although such an option exists, it is too complicated. Apart from a limited number of sectors where China allows forming foreign wholly owned subsidiaries, in this case, the enterprise should benefit the Chinese economy development and satisfy at least one of the following criteria: either export all or most of its products or adopt international advanced technology and facility (“FDI in China”).
Thus, we would advise establishing a joint venture with a Chinese partner. There are several advantages of this type of FDI. First of all, the local company is familiar with the customs, culture, and other peculiarities of doing business in China. Besides, a Chinese company may provide competent top and middle managers and may possess appropriate technology for the local environment. Moreover, local partner’s contacts and reputation increase chances to get access to Chinese capital markets. Finally, the public image of a partially locally owned enterprise may enhance sales opportunities in the Chinese market (Moffett, Stonehill, and Eiteman 408-409). However, the U.S. firm should choose the local partner very carefully and take into account the following deficiencies of this type of FDI: political risks, conflict of interests, control of financing, etc. (Moffett, Stonehill, and Eiteman 409).
9. RECOMMENDATION EFFICIENCY
As of May 18, 2016, the USD/CNY exchange rate is 6.53436, so the U.S. firm would need 10,000,000 / 6.53436 = 1,530,372 (dollars) to buy 10,000,000 CNY on this day (Exchange-Rates.org). On April 4, 2016, the exchange rate was 6.48017, and the U.S. firm could buy 10,000,000 local currency for 10,000,000 / 6.48017 = 1,543,169 (dollars). As we can see, the yuan appreciated against the dollar, so it was the right decision to buy the local currency later as the U.S. firm would buy it for a lower amount in dollars. We do not think that investing in Chinese futures and options would have been the best choice as Chinese derivative market has opened for foreigners recently and there are still many limitations for foreign companies (DeWaal; Jianxin and Sweeney).
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Appendix
4 China’s balance of payments statement is compiled in accordance with the principles of the fifth edition of the Balance of Payments Manual of the International Monetary Fund, recording all economic transactions between residents of the Chinese mainland (excluding residents of Hong Kong SAR, Macau SAR, and Taiwan province) and non-residents, based on the principles of a double-entry system.
Source: SAFE
