In February 2023, the world was abuzz with the now-infamous “Chinese spy balloon” incident, which quickly dominated the news cycle. At the time, I lightly remarked on one of my social platforms that this might be more spectacle than substance. I even half-jokingly came up with an economic model where one player had the option to “spy” or “not spy” and the other had the option to “shoot” or “not shoot”. Both the Nash equilibrium in the static game and the subgame perfect equilibrium in the sequential game pointed to the outcome “not spy, shoot”.
Fast forward seven months to a recent revelation by Gen. Mark Milley, the chairman of the Joint Chiefs of Staff. Speaking to CBS News, Milley explained that the balloon was unintentionally diverted from its original route by winds and ended up drifting over the continental United States. The device, it turns out, did not collect any intelligence or transmit any data to the PRC.
Regular readers of this blog are well aware of my views on China. While I’ve always maintained a nuanced perspective on the challenges posed by the PRC to the U.S. and the Western world at large, this balloon episode stands out as an interesting example of how narratives, once established, can overshadow reality. Ironically, the media’s uncritical role in the entire scenario bears a striking resemblance to China’s state-sanctioned propaganda within the Great Firewall.
The “Chinese spy balloon” downfall (pun intended) serves as a stark reminder of two things: the importance of evidence-based judgment and the need for cool heads to shape our perceptions. As people navigate this complex geopolitical landscape in this era of constant (mis)information, they should remain discerning and deliberate in their responses. When the stakes are so high, clear-headedness is not only a virtue, it’s a necessity.
This post is not intended to discuss the general topic of foreigners investing in China but rather to provide my thoughts on the recent news report that billionaire investor Mark Mobius was unable to take his money out of China. While the PRC has long restricted the free exchange of foreign currencies for its citizens, the repatriation of profits for foreign investors has typically not been a big issue when the Chinese economy is strong.
In light of this incident, I think it might be helpful to use a simple economic model to explore the factors that influence a foreign investor’s decision to invest in China, as well as how the PRC government would respond to such investment in different economic scenarios.
The Model
First, consider an outside rate of return, denoted as \(r_{0}>0\), such as that offered by Treasuries. Within the country, there are two rates of return: one under weak economic conditions, denoted as \(r_{1}>0\), and another under strong economic conditions, denoted as \(r_{2}>0\). The government levies taxes on the return earned by the investor at a rate of \(t\in(0,1)\). A one-shot strategic interaction between a foreign investor and the country’s government can be modeled using the simple Bayesian game below.
Nature moves first, with probability \(p\in(0,1)\) of a weak economy and probability \(1-p\) of a strong economy. The government is faced with two possible courses of action: “exploit” or “support.” “Exploit” involves taking over the entire investment and return of the foreign investor. This is relevant in the context mentioned above, as extreme measures to prevent foreign investors from withdrawing their money from the country can be seen as a form of nationalization. “Support,” on the other hand, involves allowing the foreign investor to retain full control over their investment and continue their business as usual. When the government observes a strong economy, it only opts for “support,” which can help establish a positive reputation and attract more foreign investment. However, when the government observes a weak economy, it may consider “exploit” instead of “support” for corporate control, revenue maintenance, and the control of capital outflows.
The foreign investor does not know the actual state of the economy—due, for example, to delayed reporting and/or the outright suppression and manipulation of data—or the government’s action beforehand. However, the investor has access to other information that is common knowledge, including the probability of a strong vs. weak economy, the returns under each scenario, the tax rate, and the potential payoffs. The investor moves simultaneously with the government and has two options: “in” or “out.” Choosing “in” signifies the foreign investor’s decision to invest in the country, while opting for “out” means staying out of the country and earning the external return \(r_{0}\).
Without loss of generality, suppose the foreign investor’s initial capital is one. The structure of the game and the payoffs are shown in the graph below.
Observations
Consider the foreign investor’s options and the government’s best responses. If they play “in,” then the government has a higher payoff by playing \(E^{W}S^{S}\) (“exploit” when the economy is weak; “support” when the economy is strong). If they play “out,” then the government is indifferent regarding its strategies. Hence, the strategy profile \((In, E^{W}S^{S})\) can be a unique pure-strategy Bayesian Nash equilibrium if and only if the investor’s expected payoff of playing “in” is larger than their expected payoff of playing “out”: \(-p+(1-p)(1-t)r_{2}>r_{0}\), which implies \(r_{2}>\frac{r_{0}+p}{(1-p)(1-t)}\). That the right-hand side is increasing in \(p\) suggests that as the risk of a weak economy increases, the investor demands a higher return when the economy is strong, or else they will walk away.
Perhaps the most interesting observation, given my simple model, is that playing “in” at the equilibrium point has nothing to do with the rate of return when the economy is weak. The foreign investor already takes into account the contingency that the government will “exploit” if the economy turns out to be weak. This may provide a partial explanation for why there are far fewer “bears” relative to “bulls” among Wall Street professionals who talk about projects in China (see, for example, here), as it is not \(r_{1}\), but \(r_{2}\) that really matters when it comes to making investment decisions. It remains to be seen how the absolute number of those “China bulls” will change as the longer-term growth outlook in the PRC turns dimmer and more uncertain (i.e., an adequate \(r_{2}\) becomes harder to find).
