Beijing tightens capital controls to manage stability risk
The surging US dollar has presented Chinese officials with difficult policy choices
Almost a month after the US presidential election, expectations of Trump policies have continued to rattle the global financial markets. In particular, they have caused wide-spread jitters across emerging markets (EM) via a stronger dollar and higher US interest rates. While Latin America has been hit the hardest, Asia also suffered from capital outflows and currency depreciation, with countries of weak external matrix (e.g. Malaysia and Indonesia) bearing the brunt of the shock.
The yuan has not been spared from this mini-rout. The onshore yuan rate shed 1.7 per cent in November, easing to 6.92 against versus the US dollar, a level that represents an eight-year low against the greenback. The offshore yuan rate went even further, easing to 6.95 per dollar before retracing to 6.89 per dollar recently.
The currency depreciation has mirrored an acceleration of capital outflows from China, with measures, using foreign exchange purchases by financial institutions, pointing to a monthly outflow of over US$60 billion between September and October. While they are still below the alarming levels seen at the start of the year, the pace of the capital exit has clearly stepped up a notch in recent months.
These outflows, however, have not caused any visible adverse impacts on the domestic market so far. First, the money market has remained broadly stable, thanks to the skillful operation of the PBOC to keep the system liquid. While short-term interest rates, such as the 7-day repo rate, have ticked up slightly, we know that it was partly driven by the authorities clamping down on shadow banking activity and reducing leverage in the bond market.
Second, large capital outflows are usually associated with declines in domestic asset prices, as foreigners repatriate capital and locals diversify investment overseas. Such is not evident in China either. Onshore equities, take the CSI 300 for example, have outperformed most other markets, gaining 8.5 per cent over the past two months. Property prices have also been resilient, despite the tightening measures instigated recently by local authorities. While the bond market has seen a sell-off of late, the rise in yields has been much more timid compared to that of the US Treasuries.
Third, large capital flight and currency depreciation are usually a precursor of financial crisis in emerging markets for countries that rely on external financing. This was true for the Latin American financial crisis in 1980s, and in Asia during the late 90’s crisis. However, China does not hold much external debt, which is less than 8 per cent of GDP. And for those do have it, many borrowers have been actively paying down their US dollar debt over the past 18 months following the yuan depreciation, and as onshore financing became cheaper and more accessible. With most of its debt denominated in yuan and held internally, China does not face a great risk of a classic emerging market debt crisis.
Fourth, the economy has not exhibited any signs of a liquidity constraint. In fact, credit growth has remained robust, and if anything, the PBOC has been trying to control liquidity to slow the buildup of financial risks. In addition, recent economic data, such as last week’s PMIs, suggests that the economy has maintained solid momentum so far in the fourth quarter. Contrast this with the capital flight seen at the start of the year, when the market was worried about the Chinese economy falling off a cliff, the short-term macro condition is clearly much stronger now.
Finally, it is worth highlighting that the key difference between the current episode of external weakness and the one at the start of the year lies in the drivers. In the previous episode, the shock originated from within China, as the market fretted about an imminent collapse of the Chinese economy and that the government would deliberately devalue the currency to save it. Now, the driver has shifted to the US, as optimism about Trump’s policies has boosted the dollar and expectations of a faster policy normalisation by the Fed. If one compares the moves between the yuan and the US dollar trade-weighted index since October, the former has depreciated by 3.2 per cent, while the latter has rallied by almost 6 per cent. This means that the yuan has outperformed most other non-dollar currencies, with the CFETS RMB Index appreciating, not depreciating, by close to 1 per cent.
Overall, conditions in China’s domestic system appear to be resilient enough to cope with the current level of capital outflows. However, allowing these trends to continue unchecked could be dangerous, as depreciation expectations may become deeply entrenched, causing sustained capital outflows to the extent that they become unmanageable.
Fortunately, the government has taken the appropriate action to ease pressure. On the one hand, foreign exchange reserves have been deployed to slow the pace of yuan depreciation. At the same time, the authorities have tightened capital controls and closed some loopholes of outflow channels, such as restricting the size of outward direct investment, limiting cross-border lending by banks and corporates, and banning mainland citizens from buying investment-related insurance products in Hong Kong.
These measures have gained some traction lately, as the yuan eased off recent highs and the spread between onshore and offshore exchange rates narrowed. However, relying too much on these administrative controls for a prolonged period could create distortions and expose the government to the criticism of backtracking on financial reforms. Hence, striking a right balance between preserving near-term stability and liberalising the capital account will be important. It is just that balancing these objectives against the backdrop of a rising dollar has become a lot more difficult.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers