Capital is flowing out of China at a record pace, sparking fears of financial instability and complicating the central bank’s efforts to support the slowing economy with lower interest rates. Capital is leaving China en masse, searching for superior returns elsewhere. It’s a complete reversal for an economy that was a magnet for foreign capital during the boom years of the past decade.
Regarding capital outflows, a fresh warning comes from the fact that China’s foreign exchange reserves have dropped for four straight quarters, representing the longest run of declines on record.
This is an historic reversal. From 2006 until last year, China’s foreign currency reserves quadrupled to almost $4 trillion. Some of the money came from trade surpluses and foreign investors spending dollars, yen, and euros on long-term investments in China, such as factories, hotels, and companies. Another chunk of the $4 trillion, however, was hot money from investors scouring the globe for the right bond rate or stocks promising the quickest returns. After hitting an all-time high of $3.99 trillion at the end of June 2014, reserve levels have started to fall.
Why is China facing worrisome capital outflows?
There are several reasons. Among the major causes is the ongoing property bust, the squeezed corporate profits, and the end of a multi-year currency upswing. These circumstances are giving investors fewer reasons to participate. The skyrocketing returns that investors had become used to are shrinking. All of this is happening as China implements initiatives making it easier to move money into and out of the country. China is pressing ahead with liberalizations as part of its goal to achieve International Monetary Fund (IMF) reserve-currency status.
Lombard Street Research’s Charles Dumas reported that capital outflows reached $800 billion over the past year, and asked when this movement will be called “capital flight” instead of capital outflows. According to JP Morgan chief China economist, Zhu Haibin, capital outflows—the net amount of assets leaving China—totaled $450 billion in the past four quarters after adjusting for changes in the valuation of foreign exchange reserves. It is undoubtedly a level “beyond anything seen historically”, in the words of Robin Brooks at Goldman Sachs.
Although data released on July 24th confirms high net capital outflow in the first six months of 2015, the State Administration of Foreign Exchange insisted that there has been no “large and continued capital flight so far.”
The investors moving money out include foreign hedge funds and Chinese individuals and companies, and the money leaves China in a variety of ways. Some escapes illegitimately, by skirting strict currency rules, and some of the transfers are approved by authorities, such as increased overseas lending by Chinese banks. Analysts differ on how much of the money leaving China is hot. Certainly, not all of the departing capital is speculative. Moreover, a considerable fraction is actually a sign of China’s increased economic development, such as outward investment as companies expand their global footprints. Economists say that some purely financial flows should be considered a healthy move by Chinese savers to diversify into foreign assets, rather than a sign of panic about China’s slowing economy. Capital outflows also reflect recent reforms to loosen capital controls and cautiously encourage financial fluxes through initiatives such as the Shanghai-Hong Kong Stock Connect, which allows Mainland Chinese to invest in foreign equities. Last but not least, “naked officials,” notwithstanding Xi Jingping’s clampdown on corruption, transfer a considerable amount of capital illegally.
Some interpret China’s economic slowdown as a signal of an impending financial crisis: capital outflows are a sign of waning confidence in China, and they warn that outflows will drain liquidity from the domestic economy, making it harder for companies and local governments to raise funds.
For more bullish analysts, moderate capital outflows are a sign that China is liberalizing capital controls and abandoning its mercantilist obsession with accumulating foreign reserves. They believe that domestic liquidity concerns are unwarranted, since the People’s Bank of China (PBoC) has plenty of new mechanisms to expand the money supply to replace the liquidity once created by foreign capital inflows.
From a global perspective, with the Federal Reserve preparing to raise interest rates and the Chinese stock market suffering big losses, capital flow trends have taken on even greater importance. Higher US rates are likely to draw capital out of China and other emerging markets, which could place even greater downward pressure on Chinese share prices. Another measure that could encourage capital flight is a rate cut, which means that money in China will yield less for investors, resulting in another reason to remove their money from the system. China has enacted four adjustments since last fall, and Wall Street fully expects another. In fact, rumors that a cut could be coming as early as this weekend helped fuel China’s stock market rally on Wednesday 19th.
If the exodus of funds continues, it will create a dilemma for the People’s Bank of China. China could retain some of this money by raising rates, but it’s leaning toward cutting them to stimulate growth. Thus, capital outflows are complicating the PBoC’s efforts to support the economy through monetary easing. For the past decade, the central bank’s acquisitions of foreign reserves were the main source of base money creation in China’s banking system. Now, with outflows threatening to shrink the money supply, the central bank is turning to new mechanisms to expand it. Among these, he most important is cutting banks’ required reserve ratio (RRR). The PBoC once used RRR rises to restrain excess money growth by forcing commercial banks to keep a chunk of newly created base money on reserve at the central bank, where it is unavailable for lending. Now the PBoC is doing the opposite: cutting the RRR to offset the loss of liquidity caused by capital outflows.
As a sign of such capital flight, short-term money-market interest rates have risen sharply since Beijing unexpectedly engineered what it labeled a “one-off adjustment” by devaluing the yuan against the dollar by 1.9% a week ago. As money leaves the country, the amount of cash in the financial system declines, pushing rates higher.
Kewei Yang, head of Asia-Pacific rates strategy at Morgan Stanley, expects that Chinese policymakers won’t allow their currency to fall too fast, writing that “unprepared weakness in the currency might potentially pose a more serious risk to financial stability in China (more serious than the equity market turmoil).”
A steep fall in the value of the yuan might boost the ongoing capital outflows, therefore the central bank is likely to spend more foreign reserves to prevent a currency free fall. Such supportive efforts—sales of other currencies for yuan—also tend to drain cash from the system.
Recently (August 17th), the PBoC poured the largest amount of cash into the financial system on a single day in almost 19 months, signaling Beijing’s growing concerns about capital flowing out of the country following the recent weakening of its currency. Analysts polled by Bloomberg think it will take an additional $40 billion a month to keep the yuan where the PBoC wants it through 2015.
Analysts have divergent opinions regarding China’s future. UBS’s Wang believes the Chinese government has tools at its disposal to prevent capital outflows from spiraling out of control and domestic liquidity from drying up. “If the Chinese government is concerned about sudden and destabilizing outflows, it could slow the pace of capital account opening and stabilize exchange rate expectation by anchoring the daily fixing rate and intervening in the FX market,” the economist writes. “We think China’s $3.7 trillion in foreign exchange reserves and existing capital controls can help provide sufficient cushion against large unwanted depreciation pressures in the coming year.” Charlene Chu of Autonomous Research, the most sought-after China analyst in the world, calculates that by 2018 all of China’s excess reserves (cash that on hand to use immediately) could be gone. The situation is likely more dramatic now since Chu’s note was written before the country devalued the yuan.
However, everyone agrees that capital outflows can become a big problem when they reduce domestic liquidity and, in the case capital flight, foster a sharp depreciation in the currency. If capital flight kicks up dramatically, China might have to enact some capital controls. But world markets wouldn’t appreciate a direct intervention in the market. It might result in a further departure from two crucial goals for China:
- Becoming part of SDR’s basket;
- Entering into the MSCI’s Emerging Market Index calculation;
Regarding the former goal, the IMF declared that China wouldn’t join the SDR till Sept 2016 at the earliest a few days ago. China is now facing an uphill struggle.