How to Deal with China’s Acquisitions

China is on a quest to climb further up the value-added chain. To that end, it wants to acquire leading-edge technology firms.

That has made Germany – and especially its cutting-edge medium-sized, often family-owned firms — a favorite M&A target in the recent past years.

Targets pursued by the Chinese include the producers of high-end machinery (Krauss Maffei, Putzmeister), fork-lift trucks (Kion), LED chip plants (Aixtron), graphic electrodes (SGL Carbon) and now industrial roboters (Kuka).

The Chinese conglomerate ChemChina also recently offered to purchase the Swiss agribusiness Syngenta for $43 billion in early 2016, China’s biggest M&A deal so far.

Such Chinese acquisitions are opposed not only by politicians (EU competition tsar Oettinger, German Economic Minister Gabriel), but also by academics, such as former IFO president Hans-Werner Sinn and Merics (Mercator Institute for China Studies) director Sebastian Heilmann.

Before we get carried away with instant reactions, it is important to look at the longer time frame and perspectives.

China economic model

China’s old growth model relied on embracing trade integration with a fairly closed capital account (as summarised in Table 1, below). That strategy came to an end ten years ago. Nonetheless, China’s global inward FDI boomed up to 2010.

Since then, China’s attractiveness as a manufacturing location has stagnated. Rising wages in dollar terms have reduced its appeal for investment in the manufacturing sector.

Meanwhile, China’s outward FDI has been booming and increasingly targeted advanced countries, rather than resource-rich developing countries, which were the target of the initial investment wave.

Following what is now mainstream economic policy advice, China’s process to move toward capital-account liberalization has been gradual, but continuous.

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It is noteworthy that China has received far more inward FDI than it invested abroad, despite being a relatively closed economy (as measured by the OECD restrictiveness index). This index, running from 0 (very open) to 1 (closed) indicates a composite of

• equity restrictions (China allows joint ventures only);
• screening and approval requirements;
• restrictions on foreign key personnel; and
• operational restrictions such as on land acquisition and capital repatriation.

Despite all the recent noise from Western industry lobbies and politicians, China has managed to steadily liberalize its capital account, from an index score of 0.56 in 2005 to 0.38 in 2015. An important caveat, however, is that China still allows joint ventures only.

From a Western perspective, China’s state-guided outbound industrial and technology policies, aimed at technological leapfrogging through a proactive acquisitions strategy, challenge indeed both national investment regimes and competition policy.

China’s approach poses more industrial, competition and security concerns than acquisition transactions proposed and executed by sovereign wealth funds (SWFs). The latter merely seek higher risk-adjusted returns and diversification via passive investments.

Some of these policy concerns have been thoroughly discussed by Hanemann and Huotari (2015). The most relevant, in my mind, are:

1. Asymmetry in market access

Between Germany (as part of the EU) and China, there is no level playing field. Germany belongs to the most open economies (the OECD restrictiveness index score is 0.023 since 2010). In contrast, China imposes high (> 60%) local content requirements (“Made in China 2025”).

This is all the more troubling as this requirement affects companies in sectors where Germany is very competitive. They include power equipment, new energy, medical technology, industrial robots, large tractors and IT for connected cars.

2. Subsidies and non-market advantages

Many of China’s globally operating companies are receiving preferential treatment from local or central governments. These subsidies are a source of unfair competition. They lead, for example, to distorted bidding processes in global markets.

3. Technology transfer and industrial hollowing out

It is feared that Chinese state-controlled owners will end up absorbing key technologies and know-how, leading to a hollowing out of the industrial base of their Western competitors.

This is not to be taken lightly. The erosion of network externalities – strong in the case of Germany’s car upstream suppliers – can punch deep holes into the existing industrial fabric and ultimately even destroy an entire industry as well as industrial region.

4. National security threats

Concerns relate to the erosion of national defence industries, the creation of new channels for infiltration, surveillance and sabotage. In this regard, the German AWG (Aussenwirtschaftsgesetz, or Foreign Trade & Payments Law)) or the CFIUS, the Committee on Foreign Investment in the United States, in my view provide sufficient tools to restrict Chinese FDI.

In the absence of a multilateral agreement on foreign direct investment, these policy concerns, however valid, give easily rise to distortive and discriminatory policy response.

The effort to combat state-driven Chinese companies by building discriminating rules based on the nationality of acquirers are not the right avenue to pursue.

Here is why:

• From an economic (rather than from an industrial lobby) perspective, most of China’s FDI acquisitions provide no reason for policy intervention.
• An important yardstick to gauge the broad welfare effect of China high-tech acquisitions from a trade theory perspective is how it impacts on Germany’s terms of trade.
• Welfare gains from international trade are unaffected by China’s acquisitions as long as they don’t move Germany’s terms of trade, present and future.
• Inward FDI impacts Germany’s welfare only if the embedded technology transfer moves its terms of trade.
• China’s inward FDI and the ensuing technology transfer can even improve Germany’s welfare if it falls on industry branches with a competitive disadvantage (those that have a net import position): Germany’s terms of trade improve, as net imports become cheaper.
• The reverse holds if China acquires high-tech in areas where Germany is a net exporter as its competitive advantage will suffer from lower premium prices. In that case, China’s FDI has indeed worsened Germany’s terms of trade.
• In such cases, there is a definite need to undertake a careful examination of Chinese FDI in Germany.

Conclusion

What this approach suggests is to pursue a case-by-case and sector-by-sector approach, rather than arguing indiscriminately that any acquisition attempt originating from China is a devious attempt to steal the crown jewels of German industry that must be stopped at all costs.

If and when the latter is the case, then indeed great circumspection is warranted. In the other cases, we should act in a more self-confident and open-minded fashion.

Otherwise, we will only do the bidding of those in China who want to stop the gradual, but full-scale integration of the Chinese economy into the world economy.