Massive capital outflows from China over the past four quarters have been viewed as a symptom of the moderation in growth prospects for the world’s second-largest economy and a possible cause of further weakness.
According to JPMorgan 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.
“The magnitude and the duration of capital outflows are unseen in China,” the economist writes.
The simple inference that can be made from these headline figures is that assets are leaving China en masse, in search of superior returns elsewhere; the money that flowed in during boom times has reversed course.
Capital outflows can become a big problem when they reduce domestic liquidity and, in the case of full-fledged capital flight, foster a sharp depreciation in the currency.
But in analyzing and decomposing the nature of these capital outflows, economists have concluded the picture is considerably more nuanced—that the reasons these assets moved out of the country are not cause for alarm.
Much of the capital outflows can be attributed to seemingly prudent management of corporate-sector balance sheets.
Due to a growing realization that the yuan would not be a one-way trade grinding higher against the U.S. dollar, Chinese corporations sought to pay down foreign exchange liabilities.
Kewei Yang, head of Asia-Pacific rates strategy at Morgan Stanley, explains:
[T]he private sector is being more active in the optimization of asset-liability management (ALM). During periods of macro weakness and rising expectations of RMB weakness, the private sector becomes more active in reducing USD liabilities and increasing USD assets.
UBS chief China economist Wang Tao agrees:
We think that the unwinding of earlier foreign exchange liabilities and “arbitrage inflows” by domestic entities have contributed significantly to the recent large outflows. In the few years before Q2 2014, especially during much of 2013 and early 2014, as the expectation of RMB appreciation had been strong and the onshore-offshore interest rate gap had been large. As a result, domestic entities accumulated foreign exchange liabilities rapidly, including through offshore borrowing. China’s short-term foreign debt rose significantly and foreign banks’ international claims to Chinese entities expanded by $440 billion between end 2012 and Q1 2014, according to data from the Bank for International Settlements (BIS).
Since Q2 2014, following the PBC’s move to guide a modest weakening of the RMB, the market has expected a depreciation of the RMB instead. The weakening of Chinese economy and cuts in interest rates, and the strengthening of the USD along with QE tapering, have solidified expectations of further RMB depreciation. Such changes have prompted Chinese entities to reduce FX liabilities and accumulate FX assets.
Yang expects Chinese policymakers won’t allow their currency to fall too fast, so as not to greatly exacerbate worries about paying back dollar-denominated liabilities, 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).”
UBS and JPMorgan’s economists also make the point that in terms of net foreign investment, the amount coming in hasn’t changed—outward direct investment has just picked up steam.
The Chinese government wants corporations to keep revenue generated abroad in those locales and has encouraged domestic banks to lend overseas as part of a “going out” strategy, Wang observes. Therefore, these kinds of capital outflows could be viewed as “mission accomplished” for Chinese policymakers.
And these outward flows are further skewed by the government, which has doled out at least $168 billion to recapitalize policy banks and fund international lending institutions since the second half of 2014, she adds.
Finally, JPMorgan’s Zhu says the increased internationalization of the currency—chiefly, settling more international trade in yuan—“has significantly reshaped the capital flow dynamics,” with more imports settled in yuan than exports. According to his calculations, cross-border settlements are responsible for roughly one-quarter of capital outflows since the second half of 2014.
Once you account for corporate balance adjustment, the increased internalization of the yuan, and the change in net foreign direct investment, the unexplained portion, or so-called hot money outflows, accounts for less than 30 percent of total outflows over the past four quarters, Zhu estimates.
The economist contends that China is experiencing a regime change in its balance of payments composition, one that appears to be largely intentional and policy-driven. While the country once enjoyed sizable current- and capital-account surpluses, the shift to a deficit in the latter is likely to continue—and that’s nothing to get too worked up about.
“Such a regime-shifting was driven by the exchange rate reform (reduced intervention by the central bank in the FX market), the change in CNY outlook, the impact of RMB internationalization, the changing role of China from a capital recipient to a capital exporter (e.g. One-Belt-One-Road), and other global and domestic market factors,” writes Zhu. “Again, capital outflow is not equivalent to capital flight.”
Meanwhile, 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 FX reserves and existing capital controls can help provide sufficient cushion against large unwanted depreciation pressures in the coming year.”
Further reductions to the reserve-requirement ratio would also help spur base money growth and offset the negative impact capital outflows can have on domestic liquidity conditions, she adds.