China’s falling FX reserves do not prove the case for capital flight
A record US$93.6 billion fall in China’s foreign exchange reserves to US$3.56 trillion in the same month that the yuan was devalued and another US$1 trillion was wiped off the face value of mainland stock prices has led many to the conclusion that capital is fleeing the country as fast as it can.
While money may well be flowing out of China, capital outflow and capital flight are two very different things.
Especially in the mainland context where capital controls remain very firmly in place, despite a series of incremental liberalisation measures and Beijing’s insistence that, to all intents and purposes, the yuan meets the broad definition of being freely tradeable.
Capital outflow and capital flight are two very different things
But it’s not – and even membership of the International Monetary Fund’s special drawing rights (SDR) basket will not make it so.
The notion of panicked investors picking up their cash by the boatload and taking it somewhere else without the authorities being aware, or able to do something about it, fails to recognise this fact.
Clearly there are ways to get capital out of the country by circumventing these controls. Surging imports is the tell-tale sign that Moody’s Analytics economist Alaistair Chan watches for.
A sudden jump in coming months could mean that firms are over-invoicing purchases to move funds offshore – which is why the government cracked down on it hard more than a year ago when over-invoicing of products via Hong Kong was generating about US$14 billion a month in outflows.
But if that is happening again, it isn’t showing up in the data. Quite the opposite, in fact – imports fell for the 10th straight month in August, sinking 13.8 per cent on a year ago – far faster than July’s 8.1 per cent decline and the 8.2 per cent fall economists had forecast.
So what else explains the outflow?
Bear in mind that every time the People’s Bank of China (PBOC) announces a cut in the ratio of required reserves (RRR) that domestic banks must hold with it on deposit, it has immediate implications for the central bank’s own balance sheet.
If liabilities (deposits) are falling, assets (US Treasuries, dollars etc.) must fall too.
Of course the PBOC could print yuan and maintain the level of liabilities, but that risks an inflation-inducing money supply problem that the central bank has been grappling with since it sprayed the financial system with cash to fight the 2008-09 global financial crisis.
The implication is that Beijing is using its huge hoard of foreign currency reserves to fund monetary easing via the PBOC’s open market operations (OMO), special liquidity operations (SLO) and medium-term lending facilities (MLF).
“We don’t think it’s an accident that the US$93.6 billion decline in China’s foreign reserves in August, the largest-ever, roughly matched the 590 billion yuan of liquidity injections via OMOs, SLOs and MLF in the two weeks following the devaluation,” is how ING’s head of Asia research Tim Condon puts it.
“OMOs and RRR changes sterilise the domestic liquidity implications of swings in foreign reserves. The latest 50 basis point RRR cut took effect yesterday (Monday) and injected a further 670 billion yuan (roughly US$105 billion),” Condon wrote in a note to clients.
And don’t forget that as nobody knows what makes up China’s foreign reserves – Beijing doesn’t disclose it – then applying the standard equation to assess capital flow (a change in reserves, adjusted for valuation gains and losses minus the current account balance) is guesswork.
Working on a set of conservative assumptions about reserve composition, analysts at JPMorgan estimate the valuation loss on China’s reserves to have been about US$229 billion between June 2014 and June 2015. Reserves reported by Beijing fell US$299 billion during that period. In other words, valuation effects probably accounted for the bulk of the change.
Meanwhile the capital for the US$40 billion Silk Road Fund, the US$30 billion pledged by China to the Asian Infrastructure Investment Bank, the US$10 billion for the BRICS Development Bank and the US$145 billion used to bolster the reserves of the China Development Bank and the Export Import Bank of China – a total of US$225 billion – is all likely to come from the foreign reserves stash.
Beijing’s decisive push for more outbound foreign direct investment has also turned the net FDI flow negative in recent quarters.
All of which add up to a plausible expectation that there will be continued capital outflows, of considerable size, for the foreseeable future.
But that’s not the same thing as a headlong rush for the exits.
