When a Chinese delegation from Jiangsu province’s Department of Commerce came to Cayman last month to explore investment opportunities, the visit highlighted a role for which Cayman is less well known: channeling outward investments from China into, among others, previously protected markets in the U.S.
The eight-member group from Jiangsu, a province on the eastern seaboard of China with a population of 79 million and an economy that is half the size of India’s, said they had come to the Cayman Islands to find out why so many companies registered in Cayman are investing in businesses in their region.
For many years, Cayman companies have been used, often in combination with BVI firms, to invest in China. Critics have at times associated these fund flows solely with the practice of round-tripping, a process whereby capital is sent from China to offshore vehicles and then brought back under the guise of a foreign investment to take advantage of government benefits and lower taxes.
However, rather than being part of round-tripping uniquely for tax-avoidance purposes, a large share of the fund flows offshore from China are in fact “capital augmenting,” Dylan Sutherland from the University of Nottingham wrote in a 2009 paper that analyzed why Chinese outward investments use Caribbean financial centers.
A number of large Chinese firms, for instance, established companies in the Cayman Islands and successfully raised capital. Household names in China like Baidu, Geeley and Alibaba were able to use their Cayman-based companies to attract funding. These examples were followed by smaller Chinese companies that chose the offshore route for foreign financing.
Since 2005, Chinese residents and nationals have been expressly permitted to set up special purpose vehicles offshore to finance Chinese businesses and benefit from tax and foreign exchange preferences available only to foreign investors.
However, these transactions, like any transfer of assets from China abroad for foreign investment, require the approval of various state and local regulators in China, both to curb potential tax evasion and to maintain foreign exchange controls.
Outward foreign direct investment
While China has until recently been mainly an importer of capital, a growing number of Chinese companies are looking to make acquisitions overseas. This was confirmed by the delegation that visited Cayman.
“More and more companies from Jiangsu province have the interest and desire to invest outside of China for the purpose of acquiring new techniques and to open up new markets,” explained Zhao Yuhong, deputy consultant-director at the Department of Commerce’s Division of Outward Investment and Economic Cooperation.
Overall Chinese outbound foreign direct investment continues to grow. In December 2012, Chinese OFDI reached its highest level, and for the first time Chinese outbound investments, US$77.2 billion in 2012, exceeded inbound foreign direct investments, according to the Chinese Ministry of Commerce.
The Caribbean has become one of several regions worldwide targeted by Chinese firms. One of the major projects in the region is the 3,000-room Baha Mar resort in the Bahamas. It is being built by China’s largest construction company, the China State Construction and Engineering Corp, in a deal worth $1.9 billion.
Much has been made of the political influence that China is allegedly exerting through investments in Caribbean countries, for example by trying to reward those countries that do not diplomatically recognize Taiwan. Another often cited motivation is China’s desire to simply gain political influence in America’s backyard.
But investment decisions are often more complex and also depend on who is making the investment. There are three categories of Chinese foreign investment. The People’s Bank of China uses foreign reserves to invest in government securities, mainly U.S. Treasuries. Chinese sovereign wealth funds, such as the China Investment Corporation or HuaAn Fund Management Corporation, use foreign reserves to invest in equities, and Chinese enterprises and state-owned companies invest directly abroad through infrastructure projects and mergers and acquisition.
While the first two categories are completely government controlled, the third category is a hybrid that is mostly driven by corporate decision making rather than political strategy.
Geography and market access
In fact, the geographical location of the Caribbean is less important for political reasons than it is for market access. China is encouraging its enterprises to invest in the Caribbean because it sees the region as a gateway to the United States.
“Manufacturing is a promising investment prospect in the Caribbean region because if Chinese companies transfer their production base to the region, they will be closer to major target markets, including the United States,” according to Wang Haifeng, a researcher at the Institute for International Economic Research under the National Development and Reform Commission.
“More private companies should be encouraged to invest there in such sectors as textiles, light manufacturing and household appliances,” Wang told China Daily.
He argues that even though the more dynamic industries in the region are mainly in the resort and tourism sectors, Chinese companies should first invest in manufacturing when they enter the market and develop from there to the service industry.
China’s relations with former low-cost competitors in Central America like Mexico or Costa Rica have thawed for the same reason. As wages in China have increased and higher energy prices have raised transport costs for shipping goods, Central American and Caribbean manufacturing bases become more attractive. If free-trade agreements with the United States are in place, as is the case with Mexico and Costa Rica, this proposition becomes even more enticing.
The members of Jiangsu province’s Department of Commerce agreed that import restrictions also play a part in their outward investment strategy, since producing and manufacturing locally can effectively circumvent tariffs and other restrictions.
“If we invest directly in the countries, we can avoid these direct export obstacles,” said Zhao.
Securing natural resources
In South America, Africa and Asia, Chinese companies have used foreign investment to gain access to much-needed natural resources, including oil, iron, copper and other raw materials.
Cayman companies are often used to facilitate these transactions and outbound Chinese investments.
The purpose of Cayman companies in this context includes holding overseas assets owned by a Chinese company as a vehicle for co-investment by multiple Chinese entities, as a joint venture vehicle and as a financing vehicle for the acquisition of natural resources for the Chinese market.
Typical examples for Cayman transactions involving Chinese outbound investments are the acquisition of petrochemical, gas and energy companies in the region and worldwide.
Now Chinese firms are also interested in determining how Cayman vehicles can be used for investments in the U.S. market.
Zhao explained that Jiangsu province is known for natural resources. “Now that the U.S. is opening up some markets to Chinese investments, certain companies in Jiangsu have an interest in investing through the Cayman Islands in the U.S. mineral industry,” she said.
“We are in the process of learning the rules of how to invest through Cayman in other countries.”
Decreasing profit margins for smaller Chinese companies mean that many are looking at outward investments and there is broader political support for Chinese firms venturing out to acquire technology and talent or to enter new markets.
This is reflected in new sets of regulations making it easier for Chinese private companies to make investments abroad. Small and medium-sized investment projects now only need the approval of more receptive local officials instead of central government authorities.
And private firms can more easily keep foreign exchange from exports in offshore accounts, giving them more flexibility to finance overseas deals. This already had an impact on the level of private companies’ investments from China. While state-owned enterprises made up 70 percent of Chinese outbound direct investments in 2010, Chinese private companies reversed the trend in the first nine months of 2012 and accounted for 62 percent of overseas investment transactions, as well as the majority of deals, according to a research note by Rhodium Group.