Foreign investment in China: risks and rewards

As one of the biggest and fastest growing economies in the world,

China offers unique opportunities for foreign investors. As appealing

as this idea may be, you may find yourself wondering about the

difficulties of understanding a business culture with its own set of

rules and the risks of investing in a highly regulated market.

Historically, China favored a more protectionist philosophy and did not have a very friendly attitude towards foreign investors.  However, during the last decade and to stimulate an aggressive economic growth, the Chinese government implemented a series of legislative changes that have allowed international investors to access local markets more easily.

Thanks to the massive size of its consumer market, China represents an investment opportunity hard to ignore.

The Covid-19 pandemic slowed down China’s economy, but it did not stop it. While the United States is braced for a historic 6% contraction in gross domestic product, China’s rapid rebound means possibly another year of growth and a speedier catch-up in the race to overtake the U.S. as the world’s biggest economy.

In China, the combination of a high savings rate and tight controls on moving capital out of the country means that a lack of funding is unlikely to be a problem. Its banks can count on a steady inflow of domestic savings to provide a stable, long-term basis to fund operations.

Investing in a foreign country, out of your comfort zone, can be daunting. Language barriers, cultural idiosyncrasies, and geographical distance are some of the main concerns faced by international investors interested in having a presence in China.

However, growing economies in foreign countries can offer interesting business prospects. If you are only investing in the United States, you are eliminating three-fourths of the investment opportunities out there. Overall, the benefits outnumber the risks.

As a general rule, 20 percent of your assets should consist of international stocks. If you feel this could expose you to too much risk, ask your financial advisor to evaluate which funds would be less risky to invest overseas, and in China, in particular.

You can assess how risky, or not, an international investment is by taking a look at the growth of the country’s economy. China’s GDP per capita is just a third of the level in the U.S., which means that there is ample room for continued growth. As China focuses its attention on the technologies of the future—from electric vehicles to industrial robots and artificial intelligence—the annual pace of growth could stay close to 5% through 2025.

Other countries may have investment benefits that are not available in the U.S. or Europe. Emerging markets in many Asian countries, which have implemented free-market economic policies, are expected to have high growth rates. Since corporate revenues can potentially grow faster when economic growth is on the rise, countries like China become good places to invest.

 

When you have the ability to generate cash flow in other currencies, you will be exposed to less risk in your international investments. If anything goes down with your primary currency, not everything in your portfolio will be negatively impacted.

If you are investing in countries where the currency is stronger than it is at home, you have the potential to benefit from higher growth. This point plays into the point above, as well. If your own currency is falling in value, you will rest assured that your international investments are solid.

While the United States is known for having the biggest stock market, and for being particularly strong in investment growth, it does not capture all that there is to be offered in the global market. Other countries are growing fast, and over half of the world’s stock market value sits outside of the United States.

After the massive lockdown caused by the COVID-19 pandemic, the People’s Bank of China injected 1.7 trillion yuan into the economy—a record amount of money. Interest rates were cut, and short sellers faced new regulatory constraints. Cash-rich insurance funds were stimulated to buy stocks.

When the coronavirus hit China, a drop in stocks was inevitable, but with the assurance of strong support from Beijing the market quickly regained lost ground. The yuan, a crucial gauge of investor confidence, moved back to the strong side of 7 to the dollar. China’s seven-day repo rate, the beating heart of the financial system, stayed low and stable, showing banks had no shortage of funds.

With the financial system steady, Chinese policy makers focused on preventing the lockdowns necessary to control the pandemic from triggering a downward spiral of bankruptcies and unemployment. Banks were told to go easy on borrowers. Nationwide, small enterprises and companies got a break on loan repayments, and fiscal policy shifted to reduce the burden on business, freeing up cash flow.

The aggressive measures taken by the Chinese government allowed the country to survive the health crisis, unlike many other nations around the world that are still struggling. According to Bloomberg Economics’ forecast, China’s GDP will expand 2.1% in 2020.

If you are new to the foreign investment arena, the foreign exchange market, Forex, where currencies are traded, and multinational companies do business with different countries, is a good place to watch and learn how international markets move.

The Forex provides opportunities to take advantage of exchange rates and it will allow you to invest overseas in different currencies, which is a good idea for diversifying your portfolio.

Like any other investment, putting your money overseas is not risk-free. International assets may help diversify your portfolio, but there are a few areas you should consider before evaluating the potential risks and rewards of going global.

The investor who buys stock in foreign companies must also be aware of political, economic, and social factors that may affect the value of the investment. Changes in political leadership, civil unrest or restrictive trade agreements are examples of events that can affect market returns.

There are challenges that come with investing in markets that operate differently. One important factor to keep in mind is that each country has its own financial reporting requirements, some of which vary from those in the U.S. and Europe.

Likewise, differences in accounting practices may make it more difficult to compare foreign and domestic investments. Since transaction fees for investing abroad are often higher, you may need to spend more money than you would to buy stocks on a U.S exchange.

The additional transaction cost is one of the biggest barriers to investing in international markets. Transaction costs vary greatly depending on which foreign market you are investing in. Brokerage commissions in international markets are almost always higher than U.S. rates.

On top of the higher brokerage commissions, there can be additional charges specific to the local market. These can include stamp duties, levies, taxes, clearing fees, and exchange fees. Currency volatility is an additional layer of risk in making foreign transactions, while liquidity could be a problem, especially when investing in emerging economies.

If you decide to invest through a fund or professional manager, the fee structure will be higher. For the manager, the process of recommending international investments involves considerable amounts of time and money spent on research and analysis. They may include hiring analysts and researchers familiar with the market, and other professionals with expertise in foreign financial statements, data collection, and other services.

Another option to minimize transaction costs is to invest in American Depositary Receipts (ADRs). Depositary receipts, like stocks, are negotiable financial instruments but they are issued by U.S. banks. They represent a foreign company's stock but trade as a U.S. stock, eliminating the foreign exchange fees.

ADRs are sold in U.S. dollars. However, this exposes the investors to vulnerable currency price fluctuations. That is, if you buy an ADR in a German company, and the U.S. dollar falls in value against the euro, the value of the ADR will drop correspondingly.

When investing directly in a foreign market, you first have to exchange your U.S. dollars into a foreign currency at the current exchange rate. At the time to sell it, you will have to convert the foreign currency back into USD. That could help or hurt your return, depending on which way the dollar is moving. This risk worries a lot of investors.

The solution to this problem would be to hedge your currency exposure. Available tools include currency futures, options, and forwards. These are strategies most individual investors are not familiar with. A more user-friendly version of those tools is the currency exchange-traded fund (ETF). Like any ETF, these have good liquidity and accessibility.

Liquidity risk is characteristic in foreign markets, especially in emerging economies. This means you may not be able to sell an investment quickly without risking substantial losses due to a political or economic crisis. There is no easy way for the average investor to protect against liquidity risk in other countries.

Despite the challenges of foreign markets, CPAs generally agree that investing abroad can be a good way to grow your portfolio. China’s massive market size and its resilience to come back, even after a global pandemic, are reasons enough to consider the potential rewards that investing in this country would have in your overall investment strategy.


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DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.

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