There has been a new effort by Chinese monetary authorities to crack down on capital leaving the country in recent weeks. Quantitative and qualitative restrictions have been placed on Chinese firms trying to acquire foreign assets through the M&A process. Last week, there were reports that European firms were having trouble remitting dividends back to their headquarters as the State Administration for Foreign Exchange (SAFE)- the government department in charge of foreign exchange management- jealously guards their shrinking stock of foreign reserve assets.
Why is the Chinese government preventing firms and households from making international transaction that was permitted just days ago? Simplistically, the Chinese government wants to prevent households and firms from converting their RMB-based deposit into a USD-based (or other currencies) deposit; taking that money, and depositing it into a foreign banking system.
However, capital flows happen all the time to every country with China being no exception. Every time a Chinese national needs to make a payment to a foreigner, capital flows across borders to settle the transaction with banks on both sides to facilitate. Historically, and today, China has run a very large trade surplus vis-à-vis its trading partners. Through its trade surplus, Chinese firms and households have accumulated a large and growing claim against the rest of the world. Using official balance-of-payment terminology, China has a large current account surplus (the increase in claims each year or quarter) and net international investment position (the accumulation of all past claims) against the rest of the world. In this sense, China has and continues to see money (or foreign claims) built up and flow in from the rest of the world.
What about all the talk of money leaving the country then? China’s monetary problems are not about its trading relations with the rest of the world (or at least not yet, but under a Trump administration this may very well be the case). China’s current monetary issues resides in its financial account of the balance of payment and can be split into inflow issues and outflow issues.
For the past 30 years, the booming Chinese economy has been the economic story of the century. With average GDP growth above 10 per cent a year, foreigner firms were tripping over themselves to get established and have their claims on this booming economy. In the past, China has been a net recipient of capital from the rest of the world as international firms (mostly from developed economies) set up shop to construct factories and service centers to take advantage of the strong growth. By investing into China either by direct investment (commonly known as FDI) or portfolio investment, these foreign firms are increasing their claims on the Chinese economy. To conduct these investments, the foreigners are bringing foreign currency (usually in the form of USD) to some Chinese bank for the purpose of converting this foreign currency into the local currency: the RMB. Through this process China ran a financial account surplus (i.e. a net recipient of financial investments) with the rest of the world and was a contributor to its massive foreign asset reserve.
However, what was an economic miracle story has turned much gloomier. With daily headlines regarding slowing GDP growth, issues with China’s economic structure, unsustainable growth of debt and an increasingly unfriendly government attitude towards foreign investments, foreign firms are now much more hesitant to invest in China as compared to five years ago. Also, with the hamstrung measures to control last year’s stock market turmoil such as prohibiting the shorting of shares and freezing the sell order for most stocks, the Chinese monetary authorities severely damaged their reputation for respecting the choices of investors. These combined factors have turned what was once capital inflows to a mere trickle.
The weakening inflows is the more minor of the two issues. Increasingly, the Chinese monetary authorities’ problems are not with the foreigners, but with its own domestic investors. Because of perpetual fears of RMB devaluation, increasing financial risk, and slowing growth prospects: Chines investors want to put their money elsewhere – that is invest into foreign markets. Simply, the yield (i.e. return on investment) is higher abroad than locally so it makes more sense to invest abroad.
We see this trend with the strong increase in M&A activities by Chinese firms acquiring everything from Hollywood films producers in the US to chemical producers in Switzerland. There is no doubt that much of this M&A activity is to help Chinese firms update their technology and know-how, but a non-negligible portion may have been conducted as a channel to bypass SAFE’s rules regarding acquiring foreign assets for the purpose of currency speculation.
As the chart below makes clear, what was once strong sources of inflows has turned into outflows.
China’s monetary Achilles’ heel
Now let’s return to our earlier question: why is China so afraid of capital outflows? This question strikes at the core of China’s monetary system and the legacy of its development model. Firstly, we have to realize and accept that China currently runs an exchange rate policy that is not purely market-based and involves a heavy hand from the central authorities in managing its value. Many economists and commentators debate to the extent the currency is managed but there is near universal agreement that the exchange rate is not entirely determined by the market forces of supply-and-demand.
The moment that a monetary regime begins to dabble in managing its currency, it is confront with problems regarding the ‘impossible trinity’ . The basic framework says that a monetary regime can only choose two of following three choices: fixed exchange rates, open capital account and independent monetary policy. For the past thirty years of development, China clearly chose fixed exchange rates and an independent monetary policy (and hence a closed capital account).
As the Chinese economy deepens its interactions with the rest of the world through trade and financial channels (i.e. by joining the SDR basket), its capital account begins to open wider which impedes its ability to drastically control the exchange rate. With more foreigners and Chinese investing into and out of China, SAFE is increasingly have a hard time controlling the flows and hence the current problems we see with RMB depreciation.
It’s all about money, credit, and interest rates
But how does international capital flows affect the domestic Chinese economy? Ultimately, what the Chinese government cares about is stability of the local economy. To understand this relationship, we need to look at the People’s Bank of China’s (PBC, China’s central bank) balance sheet. We must first realize and accept that everything we call money or credit is the liability of some financial institution. In a fiat currency system, the ultimate form of money is currency and is the liability of the national central bank.
All liabilities are backed by some form of asset. In the US, the Fed’s assets swelled enormously after the financial crisis as the Fed went on a shopping spree for US government bonds and mortgage-back securities to depress interest rates and stimulus their economy. By buying financial assets, the Fed (or any other central bank) is creating more central bank liabilities (i.e. central bank reserves, which a form of currency) and hence the printing money phenomenon.
In China, because of its historical focus on controlling the exchange rate and its large current account and financial account surpluses, most of the assets backing Chinese money is foreign reserves assets in the form of short-term US government notes.
The basic monetary framework is outlined in the following stylized manner.
What is occurring with capital outflows (foreigners and Chinese residents wanting to convert RMB assets into USD assets) is that the balance sheet of the PBC is shrinking. When the balance sheet of a central bank shrinks, both its asset and liabilities decreases; and hence, the quantity of money in the local economy is being reduced. When the quantity of money in an economy is reduced, then interest rates will begin to climb. Rising interest rates will affect the investment and consumption choices of households and businesses and will ultimately impact of the overall rate of economic growth.
Given the Chinese government’s obsession and stakes their credibility on achieving an economic growth target (6.5 per cent until 2020), rising interest rates is an issue the authorities take seriously.
China’s large debt burden is a big source of vulnerability for the PBC and the exchange rate
By all measures, China’s current stock of outstanding debt to the non-financial sector is very large. In a financial system, one party’s debt is always another party’s asset. In China’s case, most of the debt is issued by corporations and is held as an asset of the banking system. Most of the Chinese banking system is funded by local deposits from households and firms. When analyzing China’s debt problems, we should also look at the very large stock of deposits used to finance that debt via the banking system.
Should the outlook for the Chinese economy continue to deteriorate, and households and corporations decides to transfer their domestic RMB deposits into foreign assets, this will very quickly run down the PBC’s stock of foreign reserve assets. Currently, there is only one yuan of foreign reserve assets to cover for every 6.5 yuan of broad deposit in the banking system (see chart below). Last year, when a minority of firms began to convert RMB deposits into USD for currency speculation, this caused a major panic in international financial markets. Many Western hedge funds began betting on the PBC being unable to maintain the current exchange rate regime and talks of the growing possibility of a financial crisis were frequently discussed among international policymakers.
Should a repeat of last year’s patterns among households and firms occur, the PBC will be placed under major stress to either:
1. Allow a large one-off depreciate but draw the ire of international partners (especially when President Trump is in the White House);
2. Allow interest rates to rise and cause an economic downturn right before the very politically sensitive 19th Party Congress;
3. Continue to defend an overvalued exchange rate and watch its reserves gradually disappear.
Either way, the PBC is trapped within the confides of the ‘impossible trinity’ with no appealing or easy options for a smooth exit.
David versus the Goliath
The one of the few tools the PBC has at its disposal to reduce capital flows is imposing administrative measures on capital account activities. Should the PBC be able to perfectly stop capital movement from occurring, then in theory, households and firms would have no way to convert their RMB deposits into USD and this situation can be sustainable. But given the degree of trade and financial integration China has with the rest of the world, how credible would these measures be?
In the long run, I take the view that money always go to where the returns are. Many countries have previously tried capital account controls, and under most of the circumstances, have ended in failure with the central bank eventually relenting and allowing for a large depreciation. Even with the stringent capital controls currently in place, Chinese households and firms are still finding innovating ways to sneak capital out of the mainland either by fake-invocing, purchasing foreign insurances, travel spending or conducting ‘fake’ M&A. This is a game of cat-and-mouse between the PBC and Chinese households and corporates in which, I believe, the PBC is gradually losing.
In the short-run, it is quite likely that the PBC can find way to bluntly curb capital flows. However, these measures will damage its reputation among international partners for greater global integration and prolong the economic and financial distortion in the Chinese economy.
In the long-run, it is unlikely that bureaucrats with limited knowledge of the rapidly evolving nature of the Chinese financial system can outsmart the collective wits of 1.4 billion Chinese citizens that are accustomed to circumventing official rules.
There is a Chinese expression that accurately describes this situation: 上有政策, 下有对策 (which roughly translates to: When policy is made upstairs, then there are ways to counter it downstairs). If I have to bet on who is going to win this game, my money would be on the collective wishes and choices of 1.4 billion self-interested citizens over the power of a few bureaucrats sitting in Beijing.