Capital flight a risk that must be monitored
Conventional wisdom has it that the yuan has come under severe depreciation pressure due to capital flight which will have damaging consequences for the mainland’s financial system.
Some market players have estimated that non-FDI (foreign direct investment) capital outflows amounted to US$160 billion (HK$1.2 trillion) in the fourth quarter of last year and to more than US$320 billion for the full year. They included capital flight, hot money (portfolio investment) outflows, net trade credit flows and net foreign borrowing by mainland companies. Yet there is no solid data to confirm this.
Meanwhile, data from the People’s Bank of China shows that net foreign exchange purchases by onshore banks fell on a month-on-month basis in both December and January, despite a record trade surplus of US$109.6 billion in the same period. The decline, totalling US$36.5 billion for the two months, was the largest cumulative two-month drop on record, implying net capital outflows.
The drop in foreign exchange purchases might though reflect the hoarding of foreign currency, mainly by onshore companies, to protect against yuan depreciation. Indeed, foreign-currency deposits jumped by more than US$82.2 billion in January from a cumulative decline of US$50.6 billion in the fourth quarter of last year.
Fuelling the worry about capital flight, the director of international payments at the State Administration of Foreign Exchange, Guan Tao, was recently quoted as saying that capital outflows were akin to the situation before the 1997 Asian crisis, when capital flight accelerated.
Other observers have cited the US$150 billion decline in mainland foreign exchange reserves in the second half of last year as evidence of capital flight.
Large capital outflows are one of the three factors that can help to detect a change in the underlying trend of the yuan, the other two being a persistent deterioration in external balances and a change in the central bank’s currency policy stance.
While the risk of capital flight is real, it is a long-term structural issue. The evidence of capital outflows so far remains both preliminary and sketchy.
The mainland’s relatively closed capital account makes capital flight manageable. It also buys time for structural reforms to fix the problems that underlie capital flight.
Observers have cited the evidence of capital flight in isolation, which tends to skew any analysis of the mainland’s financial and currency risks. These analyses have exclusively focused on the near-term decline in foreign reserves and foreign currency purchases by onshore banks. They have failed to discuss the most important aspect – that mainland foreign reserves recorded a net increase of US$22 billion last year.
Granted, this was the smallest increase in reserves in the past 14 years, but it is also an undeniable fact that there were net capital inflows to the mainland last year, despite some outflows in the final quarter. These inflows would have pushed up the yuan against the US dollar in 2014 if the People’s Bank of China had not intervened early in the year to squash the one-way bet on yuan appreciation.
The mainland’s current account surplus is turning around, with the rising trend likely to continue. Steady net inbound foreign direct investment will boost the economy’s basic balance (current account plus net long-term capital inflows), which amounted to more than 4 per cent of gross domestic product last year, and support the yuan’s external value.
What about the mainland’s overseas direct investment (ODI), which has increasingly become a crucial source of capital outflow?
While ODI has been national policy since 2000 and has risen 13-fold since 2003, it remains too small to have any material impact on the overall net capital flow trend. It amounted to an estimated 0.13 per cent of GDP in 2014, up from 0.01 per cent in 2004. But given the risk of capital flight, Beijing is unlikely to boost ODI significantly in the medium-term. Net FDI inflows will continue to augment the basic surplus.
The mainland’s capital flight is not yet a major problem, but it is a risk that must be monitored closely. If it were to increase and overwhelm capital inflows, it would destabilise the financial system and put significant downward pressure on the yuan. To prevent this, Beijing is unlikely to open the capital account anytime soon.
Chi Lo is a senior economist at BNP Paribas Investment Partners (Asia) and author of The Renminbi Rises: Myths, Hypes and Realities of RMB Internationalisation and Reforms in the Post-Crisis World