Cutting U.S. Capital Flows to China? A Small, Bad Idea

(Bloomberg Opinion) -- The Trump administration last month circulated a memo saying it was considering restricting U.S. capital flows into China, delisting Chinse companies from American stock exchanges and barring government pension funds from investing in Chinese companies. The administration has since seemed to back away from such a plan. But what would such limits entail? Bloomberg Opinion columnists Nir Kaissar and Noah Smith met online to debate.

Noah Smith: It seems to me that something along these lines will eventually be politically necessary if the trade war is to continue. Stock index providers like MSCI have been increasing the weighting of Chinese assets in their indexes, meaning that anyone who owns an index fund or invests passively is likely to own some Chinese assets. Because tariffs and trade restrictions threaten the value of those assets, portfolio investment creates a broad class of Americans with a financial interest in stopping the trade war. Thus, restricting portfolio flows to China is an obvious step for Trump.

Whether the restriction is a good idea is more questionable. On one hand, it will deprive U.S. investors of the outsized returns they could see in fast-developing China, and cause the dollar to appreciate against the yuan. But there’s also the possibility that it might save American investors from accidentally bailing out Chinese companies that might be sitting on a lot more bad debt than they admit.

Nir Kaissar: I tend to think investors are too easily freaked out, but this idea of curtailing U.S. investment in China is truly worrisome.

It’s not that U.S. portfolios are too exposed to Chinese assets. Most U.S. investors harbor a home bias and therefore have little invested overseas. Even those who own a market cap-weighted global stock fund, which isn’t many, only have a 3.6% allocation to China, and that’s likely further diluted by other investments in their portfolios, such as bonds and cash. If anything, U.S. investors have too little exposure to China.

It’s also not clear that Chinese stocks are more vulnerable in a prolonged trade dispute than U.S. ones. Yes, China’s stocks have fared worse so far, but it’s early days. They’re also a lot cheaper than U.S. stocks, so they’re less vulnerable to the occasional negative surprises that inevitably accompany a protracted dispute.

On the other side, China’s companies have a world of investors available to them, so they don’t need U.S. money. Their ability to attract capital ultimately depends on their ability to grow. Failing that, a modest amount of American investment would be little help.

China undoubtedly knows all this, which is why it’s likely to view any move to curtail U.S. investment as a ploy to gain leverage in trade negotiations. And therein lies the danger. If governments begin using markets as weapons in disputes, everyone will be worse off for it.

NS: If we’re worried about China reducing its investment into the U.S., it’s too late. In 2018, Chinese investment into the U.S. fell a staggering 83% from 2017. Part of that might be due to new U.S. investment restrictions, part might be trade war retaliation, and part might be due to other factors like tightening capital controls.

You’re right that U.S. investment restrictions probably won’t stop Chinese banks and companies from offloading their bad assets onto unsuspecting foreigners -- the world is full of suckers. But it could stop Americans from falling into the trap. As you mention, that would only save U.S. investors a little money, since their overall exposure to China is so low. But it could prevent any systematically important financial institutions from becoming overexposed to China, as some U.K. banks might be.

And you’re right that Chinese stocks are cheaper than U.S. stocks, but that could just be because China's financial system isn’t as developed. It certainly doesn’t protect them from steep declines; witness the spectacular crash in 2015.

NK: Hang on. While the quality of U.S. stocks is higher right now based on commonly cited measures, Chinese companies are no slouches. Return on equity for the MSCI China Index was a healthy 13.1% last year, and analysts expect only a slightly lower ROE of 12% this year.

Quality attributes are also highly cyclical and turns are difficult to predict. The Standard & Poor's 500 Index posted a higher ROE than the China index from 1995 to 2000, the earliest year for which numbers are available. China then took the lead during 13 of the 15 years from 2001 to 2015. Since then, U.S. stocks have regained the advantage, but they could lose that edge any time. And when that happens, Chinese stocks will probably fetch higher prices than those in the U.S.   

Even so, U.S. investors are much more likely to get into trouble here at home. They’ve been on a junk binge since the 2008 financial crisis, chasing low-quality U.S. corporate bonds and shares of the most expensive and least profitable U.S. companies. And because U.S. assets account for most of their portfolio, we should be more concerned about their domestic choices than their piddling investments in China.

I’m not worried about China’s investment in the U.S. Like China, the U.S. has a world of investors available to it. But I am worried about the impact of a financial trade war on markets and investors. Markets work best when they’re open and fair. Putting up gates could reduce the number of participants, leaving markets less liquid and efficient. It would also hinder investors’ ability to diversify their portfolios, the only free lunch in investing.

NS: It’s interesting to hear you warn about the low quality of U.S. corporate bonds, when in our debate about corporate debt a year ago you weren’t very concerned! But that aside, I agree that because of the low exposure of U.S. investors to Chinese assets, the average U.S. investor won’t be much affected by the new restrictions one way or another. It’s a little bit of diversification and upside, balanced against a little bit of risk if China is opening up its markets just in time for a crash; either way, the stakes aren’t large.

My worry is that some important U.S. financial institution could decide that piling whole hog into Chinese assets is the edge it needs in this era of low returns and constraining regulations. And if China crashed and that hypothetical bank failed as a result, it could result in increased contagion.

But sure, even this is probably not too big of a worry in the grand scheme of things. Ultimately the portfolio investment restrictions, if they ever materialize, will be a mainly political move.

NK: I wasn’t concerned that U.S. companies are taking on too much debt, but I was and remain concerned that investors are paying too much for U.S. corporate bonds, particularly junk bonds.

Still, I wouldn’t favor curbing investment in junk bonds or low-quality stocks to save investors from themselves. The price of open markets is that everyone is free to make bad choices, but the alternative – namely arbitrary limits on investments by policy makers – would be worse.

I agree that banks require special consideration because, as we learned during the financial crisis, their bad choices could bring down the entire economy. But financial regulations enacted since the crisis have substantially – and some would argue excessively – curbed risk-taking by banks. Financial regulators also have lots of additional tools to rein them in.

So in essence, it seems to me that the White House is feigning concern about investors in order to threaten China with financial combat. It may not be a big deal in isolation, but woe to markets if it becomes the norm.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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