Venture Capital

How Silicon Valley may get hit by China's 'virtual reality' economy

The San Francisco Bay Area attracts some of the nation's top technology talent.
Adam Jeffery | CNBC

Picture the scene: Asia's largest economy, a counterweight to U.S. global hegemony and flush with cash from a near-miraculous expansion that's lasted decades, is on a shopping spree for American assets.

The country amasses more worldwide influence, and its companies both compete against and provide a financial lifeline to key U.S. companies.

To the casual observer, the scenario sounds a lot like modern day China. In fact, it fits the description of pre-1990 Japan—a parallel that hasn't escaped some observers.

Just as Japan's forgone economic clout—and the alacrity with which it lavished money on U.S. assets—was once a source of domestic alarm, the $18.4 billion the Chinese have sunk into U.S. investments this year is stoking new concerns. The country's struggles have sent investors running for the exits, with most of that flood of cash has found a welcome home in Silicon Valley, where startups are beginning to encounter some culture shock with their Chinese paymasters.

Meanwhile, warning signs about China's economy are emerging everywhere. On Friday, the International Monetary Fund said that China's corporate debt was "manageable but…high by any measure" at 145 percent of its growth. It all has one investor believing China in 2016 could be a source of longer-term worry, and a potential replay of Japan before its economic bubble was pierced in spectacular fashion.

"Japan 25 years ago and China now were both debt [and] currency fueled flood of cash into U.S. assets inflating both valuations and fears," Josh Wolfe, co-founder and managing partner of Lux Capital, a $700 million venture capital firm, told CNBC via email this week.

Wolfe tweet

Like other skeptical investors, Wolfe believes there are "really two Chinas: A high growth tech and biotech driven economy conflated with a levered old asset state owned influenced burden of very bad decision making and governance."

As the China bubble pops, it has been commodities and commodity exporting countries in the first wave, then banks and non-performing loans, then it will be the assets they financed or were secured by.
Josh Wolfe
co-founder, Lux Capital
Getty Images

China's high debt, slowing growth and appetite for U.S. assets—the country already owns trillions in U.S. Treasuries and dollars—raises the stakes for tech companies if the country's fortunes should suddenly reverse.

Of the nearly $60 billion that the National Venture Capital Association says was invested in U.S. startups last year, about a quarter of those flows came from one destination: China. Along with art and high end real estate, tech ventures have been the primary recipient of China's largesse. Meanwhile, 2016 has already exceeded last year's record flow of Chinese capital, according to recent figures from The Rhodium Group.

Wolfe told CNBC that Chinese investors "are fleeing a virtual reality economy in China and funding virtual reality startups in the U.S. They seem to be choosing illiquidity and uncertainty, denominated in dollars over liquidity and certainty of devaluation denominated in yuan."

China's slowing economy has reverberated across the globe, sending commodities reeling and giving investors fright. That pain is far from over: The IMF warned on Friday that China's real gross domestic product could sink below 6 percent in 2020.

If Chinese interest rates rise or liquidity tightens, the flood of money threatens to do "what all excesses do: reverse or stop," said Lux Capital's Wolfe. "As the China bubble pops, it has been commodities and commodity exporting countries in the first wave, then banks and non-performing loans, then it will be the assets they financed or were secured by."

The muddled outlook for China means Silicon Valley could find itself on the business end of a deep retrenchment in the Chinese economy—much like Japan's burst bubble eventually forced American multinational firms to downsize and restructure.

At least for now, higher rates don't appear to be an immediate concern. China's central bank has kept its currency weak and kept monetary conditions easy. Bank of America-Merrill Lynch analysts noted this week that the People's Bank of China "is adding to domestic liquidity by expanding its net domestic assets on its balance sheet."

Yet the bank warned that the PBoC's policy response has been "muddled" and insufficient. "The danger comes when heightened risk aversion causes this liquidity and domestic capital to flee offshore, exacerbating [yuan] weakness and feeding into greater concerns about…devaluation."