European investors in China face weak demand, increased competition and tighter regulations

Alicia García Herrero (Natixis) | China has long been a focal point for global companies, including European ones. However, there appears to be a shift in foreign direct investment (FDI) in China as it is now declining rather than increasing. In fact, China’s inward FDI has turned into negative growth for the first time in 25 years.

When examining this phenomenon, several questions seem to be relevant. First, the slowdown in FDI in 2022 can be explained by the stringent zero-Covid policy this year, but it is much more difficult to explain why the downward trend continues today, even after China reopens from Covid-related lockdowns. Secondly, the response of the Chinese authorities seems somewhat contradictory. On the one hand, China’s leaders do not miss the opportunity to announce further opening of the economy, and yet they constantly attack many sectors and introduce increasingly strict regulations for foreign companies. Examples of this include anti-foreign espionage laws and very strict regulations on data transfers outside China.

When it comes to European investors’ interest in China, views clearly differ. Large European companies that entered the Chinese market very early want to continue operating in China. This justifies the large investment pool they have accumulated in China, even if the business prospects are much less attractive. Businesses are therefore increasingly concerned about the EU’s risk reduction agenda as they may face retaliation. The second group of companies that are present in China, but for which China is not the most important market, diversify their exposure outside China, as part of the so-called China+1 strategy.

The third and final group of European companies that are losing interest in Chinese markets are small and medium-sized enterprises (SMEs). The reasons for this are mainly related to the increasing regulatory complexity in the Chinese market, which SMEs cannot cope with, or at least not in a cost-effective manner. Some of the regulatory changes result from China’s own decisions, especially in the field of digitization and data security. However, other causes of complexity are inextricably linked to great power competition between the United States and China and the measures both countries have put in place to protect their economies from each other. This is especially true for dual technology companies, both small and large.

A total of 75 percent of respondents to the recently published EU Business Confidence Survey for China 2024 report declining profitability, as many as 40 percent are losing market share and 50 percent are struggling with overcapacity.

A sharp slowdown in FDI to China seems a logical consequence. Chinese companies are also eager to adopt the China+1 strategy because it allows them to bypass tariffs on Chinese goods. This is especially true for consumer electronics, home appliances and home appliances, which were hit by Trump’s tariffs in 2018. However, Chinese green tech companies are now hit hard by the new US measures, such as tariffs and the lack of access to US subsidies under the Act on reducing inflation. The fear of limited market access in the EU, given several EU investigations into Chinese subsidies, is also pushing Chinese companies to move some of their production to Europe or areas that have signed free trade agreements with Europe.

China’s key comparative advantage, attracting and retaining the best companies, is changing due to the reluctance of foreign investors to operate in China (unless they are already too dependent on that market) and the fact that Chinese companies have also started moving abroad . Companies will not necessarily leave China because the market is still too big to ignore, but rather they will need to find alternative production and market access locations.

Strategic competition between the US and China is an important reason for this evolution, but it is not the only one. Even in sectors where this competition is not necessary, China is losing ground in attracting FDI. The reason is very simple: economic growth in China continues to slow, and with it business opportunities. Beyond growth, deflationary pressures don’t help maintain margins, so companies simply can’t imagine the same opportunities they would have had in the past. Finally, if we add China’s much stricter regulations on foreign companies, it becomes easier to understand what may seem like a mystery – the sharp decline in FDI inflows to China.