Last month, Chinese police made the largest bust of illegal foreign-exchange transactions ever, cracking a ring of currency smugglers involving 370 people and RMB 410 billion ($64 billion). This was the latest and largest in a series of 170 such cases involving more than RMB 800 billion since April, and came in the wake of an August announcement that authorities were launching a three-month crackdown on illegal banking amid concerns of capital flight following the Aug. 11 devaluation. These fears appear well grounded, as a recent Bloomberg analysis estimated a record $194 billion left the country in September, marking the third consecutive record-setting month for Chinese capital outflows.
One major factor contributing to both this increase in capital outflows and the escalating enforcement of capital controls has been the massive growth of real estate purchases abroad over the past several years. While capital outflows have been extreme in recent months, it is important to note that this is also part of a much longer trend of China putting its growing wealth to use abroad, and not merely a reaction to recent economic conditions.
“Based on recent data, it appears that Chinese capital is finding more diversified markets in which to invest,” said Sean Wang, Vice President of Greater China for DTZ / Cushman & Wakefield. “Outbound Chinese investments in commercial real estate have seen a remarkable growth in the last few years,” with the US remaining “the most attractive single country destination.” Wang chalks this up to perceptions of the US as a “safe haven” for investment due to factors such as low interest rates and a stable currency. “Another attraction of the US market is its size,” Wang added. “In relative terms, the US market can withstand the inflow of Chinese investments better than other foreign locations without showing substantial price increases.” This surge has produced many challenges – especially in the case of China’s $50,000 per year limit on individuals moving money out of the country – and has acted as a major driver of illegal and underground banking, directly influencing the recent crackdown.
China’s foray into the global real estate market has been dramatic. On the commercial front, a CBRE report earlier this year found that Chinese outbound investment has produced a compound annual growth rate of approximately 72 percent over the past four years. In the US market, this growth has translated into commercial purchases of more than $16 billion in 2014, and is projected to surpass $20 billion this year – nearly four times the total in 2012. Meanwhile, Chinese buyers purchased a record $28.6 billion of homes in the US in the 12 months from March 2014 to March of this year. As a result, Chinese investors have become the leading foreign buyers of US real estate in terms of number of units purchased, total value and price paid.
Many international real estate companies have been rushing to serve these investors. In fact, whole companies have sprung up, as with Juwai, a leading property site for Chinese consumers. Four years in, Cofounder and CEO Simon Henry says the company has grown from four to 105 and the site now attracts 2.6 million users a month. Their busiest time? Chinese New Year, as traveling Chinese browse properties while on vacation. Henry says the market is still a “blue ocean space,” wide open for opportunity.
Restrictions and reactions
Commercial real estate transactions abroad can serve purposes such as increasing international competitiveness, strengthening country-to-country relationships and offering new avenues to put China’s industrial overcapacities to use, and as such are typically endorsed by the Chinese government through its “Going Out” policy. Individual home purchases, on the other hand, raise concerns over the exodus of wealthy Chinese and the potential for mass capital flight, which could result in strong deflationary pressures, and are thus much more restricted.
The $50,000 per year capital restriction for individuals has been causing complications not only in China, but abroad as well. Many countries are eager to sell to China’s growing number of wealthy investors, but encounter questionable money sources and fear violating Chinese laws in the process. In 2014, a financial advisor at the Canadian Imperial Bank of Commerce (CIBC) was fired for assisting a Chinese client to make several coordinated $50,000 dollar deposits from China to the Canadian bank on the same evening. This process – often referred to as “smurfing” – is a common workaround. If the purchaser needs a $500,000 down payment for property overseas, they enlist the help of friends and family, or even hire others to act as depositors, and make 10 different $50,000 transactions that all end up in one account in the desired destination.
This issue found its way to the Supreme Court of British Columbia, which ruled that no Canadian law had been broken, thus virtually endorsing this process of smurfing (though the case went on to be appealed, and remains unresolved). More recently, the Royal Bank of Canada removed its Canadian $1.25 million limit on mortgage loans to non-local clients – a move that will further help Chinese buyers skirt domestic restrictions rather than an effort to better enforce them.
As for the US, the main legal workaround comes in the form of the EB-5 visa, which allows wealthy investors to essentially purchase a green card. The minimum requirement to obtain an EB-5 visa is to invest at least $500,000 in the US in a manner that will create at least 10 domestic jobs. While the EB-5 program has been around since the early 1990s, in recent years Chinese investors have been flocking to it. Last year, the annual limit of 10,000 EB-5 visas was reached for the first time, with Chinese nationals comprising 85 percent of those issued, and this year the quota was reached three months early, again dominated by Chinese applicants.
The interim legal workarounds can, however, create unwanted gray areas for multinationals serving the real estate sector. What is illegal in one country might be more flexible in another, making cross-border transactions a minefield for companies hoping to be in compliance across the board.
“What’s right and wrong in one culture doesn’t necessary have the same value in another,” said Fleur Smeets-Tonies, Regional Director of Asia, Australia and New Zealand at Meritas Law Firms World Wide, a global alliance of independent full-service law firms. “That’s why creating a common set of rules and ethics, but even more important, creating a mutual understanding on legislation and compliance is inevitable and necessary. This is part of an evolutionary process that will continuously grow and change over time.”
Despite the challenges associated with Chinese individuals purchasing high-priced property abroad, it has nonetheless been occurring at an unprecedented pace. Chinese purchases of homes in the US have more than doubled in the past three years – from $12.8 billion in the 12 months ending March 2013, to the $28.6 billion seen in the 12 months ending in March of this year – and are growing so rapidly that they appear to be impacting the composition of the housing market. According to the 2015 Profile of Home Buying Activity of International Clients, a report released earlier this year by the National Association of Realtors, the number of homes sold to foreigners declined by 10 percent during the last 12-month period measured, but despite this decline the total dollar value of these sales saw a 13 percent increase. This was a direct result of Chinese homebuyers, whose average purchase was $831,800 – more than three times the price the average US buyer paid, and over $300,000 more than the average international buyer.
In addition to the home purchases associated with immigration, less permanent investments are becoming increasingly common as well. One key driver of this is Chinese investors sending their children to study abroad. “Twenty years ago, people would just send the child,” said Joe Yu, Associate Director for International Project Marketing at Knight Frank, a global real estate consulting company, “[But now] they also think the real estate property prices have gone up in the last 10 years, and they think, ‘Why am I not just buying it?’ When the child finishes, they sell the units and get the capital gain.”
Growth in the wake of collapse
While the reasons behind individual decisions to purchase real estate in the US vary widely, there have been a number of identifiable drivers over the past several years contributing to the drastic increase in outbound investment in real estate. According to Steven McCord, Head of Research for northwest China for Jones Lang LaSalle (JLL), the turning point came in 2009, at which time “everything about China changed.”
McCord points to China’s response to the global financial crisis as a key driver behind investors increasingly seeking real estate abroad. Prior to 2008, concerns regarding a possibly overheating economy had led the Chinese government to initiate several acts of monetary tightening, with some steps aimed specifically at the property sector and real estate speculation. These included measures such as raising the required down payment for purchasers of multiple properties and a series of five 2007 increases in benchmark interest rates. But as the global financial crisis grew in severity Beijing quickly reversed these policies, and by late 2008 announced its massive RMB 4 trillion stimulus package.
Although estimates vary regarding how much of the government’s stimulus package was actually implemented – the IMF puts the number closer to RMB 2 trillion – the spending that did occur was heavily focused on investment. Additionally, the stimulus was accompanied by the relaxation of lending conditions and other measures to stimulate investment, including the reduction of mortgage down payment requirements. The result was a massive increase of money flowing into the property market, which in turn drove real estate prices upward.
The end result of this, McCord points out, was a situation where investors wound up having to pay Western prices for property in China, thus negating one of the largest incentives for making such an investment. So when factoring in other concerns such as market stability, regulatory and legal systems, and issues such as pollution and other environmental concerns, the Chinese market began to look much less attractive and investors began looking to other parts of the world.
New troubles spur new outflows
Interestingly, just as an economic crisis rooted in Western economies led to a drastic increase in Chinese purchases of real estate abroad, recent domestic economic challenges have similarly triggered an increase in outward-looking investment. Stock market volatility over the past six months, combined with slowing economic growth and August’s currency devaluation, gave rise to many concerns over China’s overall economic condition. But despite the potential for these factors to produce a slowdown in outbound investment, it appears that the opposite is occurring.
“Has it (the stock market) affected outbound?” asks Darren Xia, who runs an outbound capital group at JLL. “It definitely has. In the short-term it actually helped outbound, because it has given investors alarms about ‘should I allocate all my money into the stock market?’ It has taught people to diversify their assets.”
Regarding the devaluation, Xia sees a similar outcome. “Devaluation means that in the short-term people are speeding up their investment because there’s expectation of further devaluation,” he said. “Investing today is better than investing tomorrow.”
Responding to concerns in China that this outward investment is growing to levels that could negatively impact its economy, the government has been attempting to stem this rapid outflow of money through its increasingly aggressive approach to enforcing capital controls.
Conflicted reform agenda
The Chinese government has floated many propositions for reforming capital controls, and earlier this year it appeared that the desire for increased RMB internationalization and the RMB’s inclusion in the International Monetary Fund’s Special Drawing Rights basket of currencies was providing significant motivation. But following the stock market complications this summer and the August devaluation, momentum on this front has been increasingly muted.
Earlier this year, the proposed Qualified Domestic Individual Investor program – a much-hyped addition to the existing institutional investor program, and one that would allow qualifying individuals to invest abroad in excess of the $50,000 limit – seemed poised to take effect by year’s end, at least in six pilot cities. But since the stock market turmoil over the summer, the plan appears to have faded into the background, with the State Council only stating in late October that it was considering launching the Qualified Domestic Individual Investor program in the Shanghai Free Trade Zone, but giving no timeline for its implementation. Meanwhile, the Chinese government has instead intensified some aspects of capital controls, and in September instituted a limit of RMB 50,000 on overseas ATM withdrawals for Union Pay users for the remainder of this year, with the limit set at RMB 100,000 annually beginning next year.
New signs of reform have recently emerged as well. There has been discussion of a 2020 deadline for the removal of currency controls, and the new China International Payment System was launched in October. This system provides a new means of cross-border interbank payment and seeks to increase the yuan’s usage internationally, which should simplify the process of yuan transactions abroad. These actions give the impression that China is conflicted over how to reconcile its opposing concerns over its currency – worried about capital flight on one hand, but seeking reform and increased globalization of the yuan on the other. (Editor's note: Learn more about the globalization of the yuan in next month's focus story.)
Boom continues in the face of adversity
As can be seen from the data over the past several years, China’s purchases of real estate abroad are in a period of extraordinary growth and show no signs of slowing. Toward this end, a report issued last year by Savills, a property consultancy, estimated this growth will continue at around 20 percent for several years, with real estate investment nearing $50 billion annually by 2020. This would put it on par with current US activity. With the recent complications of China’s economy appearing to increase this growth trend rather than slow it, such estimates seem plausible, at least in the short term. Yet this boom in overseas investment comes with many challenges, particularly those associated with capital restrictions and differing legal systems, and whether the Chinese government responds by continuing to reform and open its capital controls or by increasing such restrictions remains to be seen.