China's Buying Spree Ends Badly

China's overseas acquisition streak seems to be coming to an unhappy end. Outward direct investment fell by 46 percent in the first half of the year, due partly to tightened capital controls and partly to new restrictions on "irrational investments." But the authorities should be asking a more fundamental question: Why do China's companies struggle so much overseas?

Typically, companies that expand abroad -- through either trade or investment -- are the best and most productive in their industry at home. They offer better or cheaper products, make more money than their competitors, and have capital to spare expanding into new markets.

In China, this pattern doesn't hold. Productivity and profitability often matter less than politics. The government regularly publishes a list of industries it wants companies to invest in, and multiple regulators must approve every aspect of a proposed deal, from the purchase price to whether firms can obtain foreign currency. Reliably, companies planning to invest in preferred industries get the most approvals. And when state-owned banks determine which deals get financing, they tend to favor those that will advance government objectives.

This process creates a range of problems. One is that the overseas targets often don't make a lot of sense. In recent years, there has been a rush by Chinese firms to buy foreign football clubs -- not because they're particularly good investments, but because President Xi Jinping has expressed hopes that China would become a soccer powerhouse.

Another problem is that the acquiring companies tend to be uncompetitive. At home, they benefit from a wide range of goodies, such as preferential access to capital and near-impenetrable protectionism. Overseas, they often find that the competition is much tougher, and that business practices that are commonly accepted in China -- such as a relaxed approach to health and safety standards -- simply don't fly.

Similarly, companies that don't compete for capital on the merits see little reason to offer shareholders and debtholders a reasonable rate of return. One recent study of China's outbound mergers and acquisitions found that although state-owned companies enjoy higher financing capacity, their stocks significantly underperform those of privately owned competitors.

The most pernicious problem with this system is that it encourages companies to overextend themselves. Sometimes, this means simply paying too much for foreign assets, as when a troubled Chinese company recently bought an Australian port for more than twice what analysts said it was worth.

But a bigger concern is debt. China's companies have amassed a staggering $162 billion of total debt while expanding overseas, sometimes in seriously questionable deals. HNA Group Co., once a small airline, has turned itself into a giant global conglomerate by pledging shares to fund huge overseas purchases, including a $6.5 billion deal to buy a stake in Hilton Worldwide Holdings Inc. Regulators are growing increasingly nervous.

Or consider Dalian Wanda Group Co., which has also come under official scrutiny of late. It recently sold a $9 billion piece of its empire to Sunac China Holdings Ltd. to pay down debt after an ambitious acquisition spree. But the deal had an unusual twist: It was funded with a loan from Wanda-the-seller to Wanda-the-buyer. Wanda is actuallysecuring a loan to Sunac to buy the assets from Wanda.

This kind of thing doesn't usually end well, and China's regulators are rightly concerned. But the best way to discourage dubious deals and bad debt is to try to remove politics from the process of expanding overseas in the first place. As long as access to foreign investment is seen as a way of advancing political goals rather than financial ones, companies will keep incurring moral hazard -- and sometimes on a huge scale.

Simply reducing foreign investment, as regulators are now doing, will in all likelihood alleviate short-term pressure on China's currency and debt levels. But it won't address the more fundamental reasons that Chinese companies struggle overseas. Unfortunately, curtailing political influence is likely to prove a much taller order than minting billionaires.