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Arnold: Go East, Young Man

China recently released figures on foreign direct investment (FDI) for January and February that showed a continued increase in the rate of foreign-owned capital flowing into the country. There was a year-over-year decrease from Europe of about 13%, but a whopping 43% increase from the U.S., even though there was a decrease in February from January.

Foreign investors in China, especially from the U.S., are expressing little concern for the potential impact of a Chinese debt crisis that could envelope their assets there, or for the ongoing geopolitical maneuvering between the U.S., Russia and China. There are similarities between what is happening economically and financially between the U.S. and China today and what occurred between the U.S. and Japan a generation ago. But there are also differences.

Putting aside for a moment the similarities and differences in debt levels and asset prices between what occurred in Japan a generation ago and China today, the most profound difference is in the treatment of foreign private capital by the Chinese government. The Chinese have adopted a government regulatory reform effort not only designed to attract foreign investment, but to increasingly attract the kind of investment necessary for the Chinese economy to grow. That is investment in high-level research facilities and technology. And, so far, they are very successful. (I previously addressed this in 2012.)

In the process, China is attracting capital away from other parts of the world, especially the U.S. and Europe, where high levels of government regulation burden companies and investors. I will deal with this more broadly over the Open House weekend, but in the meantime the Chinese government is adopting a framework consistent with what is known as the "efficiency thesis." The efficiency thesis stipulates that the best route to economic growth is by way of decreasing the state burden on private capital, through both taxes and regulation.

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In so doing, private capital will pull the rest of the economy up and forward, creating jobs and general economic opportunity in net. That growth in turn will afford for the eventual losses that the state and private sector will absorb when the public and domestic private debt bubble in China pops. The West, in contrast, both Europe and the U.S., have increasingly adopted the opposite approach: increasing regulatory burdens on private enterprise and capital. This is also helping to push capital and investment away from them and toward China.

The Chinese have chosen a kind of dual economic path of highly controlled state enterprise to ensure immediate economic activity, and a low-regulated private sector as it seeks to create long-term economic viability. Whether the path being taken by the Chinese will be successful in preventing the cascading economic and financial market crises that Japan suffered after 1990 and the bursting of their credit/debt/asset bubble from which they have not been able to recover is the $64,000 question.

The rise of the Japanese economy in the 1980s brought with it rising prices for both hard (real estate) and financial (stocks) assets and brought rising levels of debt. The same is happening in China today, with the exception of financial assets, specifically, stocks in Chinese companies.

In the past five years, even as the FDI flowing into China has steadily increased, the index value of stocks on the large exchanges there has steadily decreased, with all now trading at or below the levels of the 2008-09 financial crisis. A similar period of investment in Japan came between 1985 and 1990, during which the Nikkei 225 Index conversely quadrupled.

I'm not sure what to make of this dichotomy of increasing FDI flowing into China and rising real estate values and debt levels concurrent with steadily declining stock prices. Equity-market participants may be waiting for the debt bubble in China to pop and for further market liberalization to occur. The performance of the Chinese equity indices over the past five years is probably just as reflective of those issues as it is of the selling of stocks of companies in the older segments of manufacturing and real estate, but without the transfer of investor capital into the growing technology sector being large enough to offset that selling.

Among exchange-traded funds, the tech-heavy, U.S.-traded Global X Nasdaq China Technology ETF (QQQC) has doubled in the past year, while the real estate Guggenheim China Real Estate ETF (TAO) and the large-cap iShares China Large-Cap (FXI) are down about 12% and 10%, respectively, during the same period. I'm not advocating taking a position in Chinese equities yet, but investors should put together a list of issues to track and monitor the advancement in the opening of the markets, along with the nascent corporate debt defaults.

Editor's Note: This article was originally published at 6 p.m. EDT on Real Money on March 18.

At the time of publication, Arnold had no positions in the stocks mentioned.

Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.

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