China’s forex erosion points to high outflows amid capital control loopholes
Capital controls and tight onshore liquidity are priorities for policy makers, analysts say
China’s foreign exchange reserves unexpectedly fell below US$3 trillion in January for the first time in six years.
The breach of the psychologically important level raises the question of whether they are still sufficiently large to guarantee Beijing’s ability to continue supporting the yuan. The consensus among observers seems to be yes.
But the rapid fall in reserves serves as a warning sign that individuals and companies are still managing to get around regulations designed to prevent capital flight, analysts caution.
The value of China’s foreign exchange (forex) reserves slipped to US$2.998 trillion at the end of January, down US$12 billion from a month earlier, official data indicated. It was the seventh consecutive monthly drop and the first time the reserves have breached the US$3 trillion mark since February 2011.
Excluding currency valuation effects, forex reserves may have fallen by US$37 billion in January, after declining US$35 billion in December, according to a Goldman Sachs’ estimate.
China’s forex reserves are “a telling indicator of the PBOC’s [The People’s Bank of China] eagerness to stem the yuan decline,” said Jingyi Pan, a strategist for IG Group.
“The breach of the psychological level raises concerns, though the authorities had done their part downplaying these concerns by stating that fluctuations in foreign exchange reserves is normal,” she added.
Much of the concern is focused on whether the central bank is still able to maintain its control of the stability of the exchange rate.
“Our view is that the PBOC can afford to keep selling FX at the current pace for a long time,” said Julian Evans-Pritchard, a China economist for London-based research firm Capital Economics.
International Monetary Fund (IMF) guidelines suggest that, given the scale of China’s export income, money supply, foreign liabilities and capital controls, its forex reserves could fall to as low as US$1.8 trillion and still offer adequate protection against balance of payment strains.
However, although the breach of US$3 trillion itself may not be hugely significant, the rapid decline in reserves is a red flag indicating that policies aimed at preventing money from escaping the mainland are flawed, according to some analysts.
“If there is anything that the PBOC policy makers can take away from this reserve erosion, it is the fact the current financial market model they rely on is stale and in need of an overhaul,” said Stephen Innes, a senior trader at Oanda Asia Pacific.
“Despite their [the authority’s] heavy-handed interventions, the reserve data clearly signals greater than anticipated capital flight and highlights the ineffectiveness of current policies.”
Tim Condon, an analyst for ING Asia, said the current level of reserves, according to the IMF standard, still remains adequate. But he expects the situation to become more urgent if Chinese residents continue transferring their money overseas.
“Capital controls could be tightened but that wouldn’t dampen the sentiment,” he said.
He believes the PBOC may guide the yuan higher to fight the trend and ensure stability.
“The most direct path would be for the PBOC to appreciate the CNY fixing,” he said.
Standard Chartered analysts also forecast that the erosion of reserves will prompt a more heavy-handed approach by the Chinese authorities to support the yuan and restrict residents from pulling money out of the country.
“If anything, the fall in China FX reserves to USD 2.998tn is not only confirmation that renminbi depreciation and capital outflow pressures remained evident as of end-January, but also that persistent reserves depletion should make the authorities rely on more capital controls and higher onshore rates to achieve stability,” said Kelvin Lau, Eddie Cheung, and Chidu Narayanan in a recent research report.
More liquidity tightening measures may be on the horizon, with the PBOC likely to raise domestic interest rates further.
“We believe maintaining the interest rate differential with the US was one of the considerations behind the PBOC’s recent 10 bps [basis points] hikes across its reverse repo [repurchase agreements], medium-term lending facility and standing lending facility rates,” Lau and Cheung said.
“This, together with rising inflation and the need for deleveraging, means there could be another 20bps of such hikes in the pipeline before year-end.”
They said if capital controls are strictly enforced, China’s outflows are likely to moderate to around US$400 billion in 2017 from above US$ 700 billion last year.