While flows of foreign investment to China have slowed sharply, a cyclical downturn of the U.S. economy and falling U.S. interest rates should help support a rebound in 2024. According to China's central bank, foreign capital inflows turned mildly negative last year, while foreign direct investment inflows stood at $180 billion. Inflows have since slowed further over the past year, and foreign direct investment inflows turned negative to the tune of $11.8 billion in the third quarter of 2023, marking the first time the measure has entered negative territory since it began being recorded in 1998. FDI inflows into China have fallen sharply over the past year against the backdrop of elevated geopolitical risk, supply chain reengineering and the country's weaker-than-expected growth outlook. But it has thus far fallen less sharply than non-FDI inflows. FDI is typically characterized by longer leads and lags, which translates to lower sensitivity to short-term interest rate movement compared with liquid cross-border portfolio investments. This may account for a lagged decline, suggesting FDI inflows may continue to weaken in the near term. 

• According to official data provided by the State Asset and Foreign Exchange, which is an agency within the Chinese central bank, capital inflows have slowed in the past few quarters. Foreign investment inflows into China turned negative in the third quarter of 2022 for the first time since China's mini balance-of-payments crisis in 2015-16, to the tune of minus $70 billion. On a four-quarter trailing basis, those inflows turned negative for the first time in the fourth quarter of 2022, reaching a negative $30 billion. At the end of the second quarter of 2023, capital inflows into China stood at minus $70 billion.
• Chinese initial public offerings in the United States raised only $0.5 billion in 2022, compared with $13 billion in 2021.

The relative attractiveness of Chinese financial assets has declined due to both cyclical and structural factors. Cyclically, higher U.S. interest rates, along with relatively strong U.S. economic growth compared with China's weaker-than-expected growth, have made U.S. financial assets relatively more attractive than China's. Structurally, perceptions of increased geopolitical risk in China, China's grimmer economic growth prospects, and its uncertain domestic business environment amid Beijing's selective regulatory crackdown have also deterred foreign investment. Moreover, investors expect lower post-rebalancing economic growth, as Beijing struggles to adjust its economic growth strategy. Geopolitically, Russia's ongoing war in Ukraine has further incentivized foreign companies to diversify their supply chains away from China, by jolting them to take the risk of a Taiwan conflict and concomitant supply chain disruptions more seriously. Finally, the United States and China's tit-for-tat economic conflict and the threat of increasing U.S. restrictions around both trade and investment in China have led many international and especially U.S. investors to take a more cautious approach toward investing in China, especially in the sectors targeted by U.S. measures, like technology.

• The International Monetary Fund projects that China's real gross domestic product growth will fall to 4% in the next few years, compared with 7.7% in the decade preceding the COVID-19 pandemic in 2020. More importantly, China's post-COVID-19 growth has disappointed investors' expectations of a quick economic rebound.
• U.S. interest rates increased significantly in the past 20 months, from virtually zero in early 2022 to 5.25%-5.5% in 2023. Longer-term U.S. bond yields have also increased sharply, reaching two-decade highs. By comparison, China's seven-day reverse repo loan-prime rate has been relatively steady around 3.45% and is now lower than the U.S. Federal Reserve's funds rate.
• The administration of U.S. President Joe Biden issued an executive decree in August establishing a screening of U.S. outbound investment. Additionally, U.S. banks have been dragged before congressional committees and criticized for doing business with China. China has retaliated against unfriendly U.S. economic measures through 'exit bans' and regulatory tightening. Foreign direct investment will continue to be relatively more sensitive to Chinese and U.S. tit-for-tat economic conflict than non-FDI investment.

The risk of geopolitical conflict will continue to weigh on investment flows to China, but weakening U.S. economic conditions and lower U.S. interest rates will help support a rebound in portfolio and other investment flows to China in 2024. Geopolitical risk and the concomitant risk to foreign investors in China are not going away in the foreseeable future. Similarly, Beijing is unlikely to reverse its national security-related regulatory tightening. However, U.S. interest rates have likely peaked at 5.25%-5.0%, paving the way for potentially significant monetary easing in 2024 against the backdrop of a further softening of U.S. economic growth or even an outright recession. Whether or not China manages to reassure international investors about the medium-term outlook for economic growth, Chinese assets, especially portfolio and other investments, will become relatively more attractive, and non-FDI will rebound. To what extent non-FDI inflows rebound will significantly depend on the size of the U.S.-China interest rate differentials, which will be a function of the two countries' economic growth dynamics. FDI investment will likely recover more slowly, especially in tech-related areas due to U.S. measures targeting outbound investment, as neither geopolitical risk nor U.S. pressure will decline significantly. 

• The market is pricing in an easing of U.S. interest rates by the middle of 2024, and a faster-slowing economy may lead to even greater expectations of interest rate cuts next year. If Chinese economic activity continues to disappoint, Chinese interest rates may also decline, even if more modestly, in 2024.
• Once continued uncertainty about China's economic growth outlook diminishes, foreign investors will move into undervalued Chinese assets, particularly portfolio debt and other investments, like loans and deposits.

The ongoing slowdown in investment flows will only have a limited impact on China's economic growth outlook and even less so on its international financial position, because future economic growth will be largely a function of domestic macro-rebalancing and structural reform, not the level of financial inflows. While lower inflows will make it moderately more difficult for China to maintain high levels of medium-term productivity growth, its impact on China's balance of payments and international financial position will be negligible. Reduced FDI inflows, especially in technology-related sectors, will weigh on productivity growth at the margin, but it will not matter in terms of the availability of financing, given China's solid external financial position in terms of both solvency and liquidity. Moreover, FDI inflows are very small compared with domestic capital formation: FDI inflows averaged less than $120 billion during 2010-19, while gross capital formation averaged $4,700 billion. Increasing U.S. and allied export controls and investment restrictions will also continue to weigh on FDI inflows, while China is not going to open its strategic sectors to FDI or substantially improve the domestic business environment for foreign direct investors. China remains the world's third-largest international creditor in dollar terms, and continues to register substantial trade and current account surpluses. Finally, capital account restrictions sharply limit the risk of a capital account crisis.

• China continues to run sizable current accounts and trade surpluses. Combined with restrictions on current account convertibility, the risk of diminished foreign capital inflows will be more than manageable. The central bank sits on more than $3 trillion of foreign exchange reserves, and the authorities have the ability to slow resident financial outflows to ease pressure on China's balance of payments.
• China is the world's second-largest international creditor after Japan and Germany, and its net foreign creditor position is roughly comparable to Hong Kong. China's net international investment position amounts to $2.6 trillion. The composition of foreign assets is strongly skewed in favor of liquid government-controlled assets, readily available for intervention. Moreover, around 50% of Chinese foreign liabilities consist of relatively illiquid foreign direct investment liabilities.
• Diminished investment flows into advanced technology sectors will negatively impact medium-term economic and productivity growth, all other things being equal. Those lower investment flows are due largely to geopolitical risk, other countries' restrictions and a geopolitical risk premium, meaning there is little China can do about this. However, such reduced tech investments will have little if any impact on China's international financial position. Successful macro adjustment and structural reform would help offset the marginal decline in productivity growth due to lower levels of especially tech-related capital inflows.