This is the second article in a three-part series looking at China’s US dollar shortage risks in the trade war, as it aims to open up its markets. While China’s capital controls have limited how much access its citizens have to foreign currencies at home, banks and companies are finding it harder to obtain US dollars as the trade war not only hinders the nation’s ability to earn dollar revenue from exports, but also foreign lenders’ willingness to supply the US dollar to a slowing economy. China’s central bank has been picking up its rhetoric to assure the public that economic fundamentals and policymakers’ competence would ensure that both the safety of the nation’s financial system and the yuan’s exchange rate are well under control. But Beijing’s decision to step up capital controls, a growing number of analysts have said, underscores the perilous state of the economy, which was also reflected by the recent reluctance of foreign financial institutions to lend to Chinese banks and the nervous behaviour of Chinese citizens. Recent cases of individuals refused permission to buy US dollars at Chinese banks have started to accumulate, including one which involved a former central bank adviser, Yu Yongding. “People are thinking if China’s future is so strong and stable, why aren’t we allowed to buy dollars?” said Michael Every, Asia-Pacific senior strategist at Rabobank. “The harder it is to get around the capital controls, the more people want to obtain dollars.” The nation’s foreign exchange regulator, the State Administration of Foreign Exchanges (SAFE), allows every Chinese citizen to exchange and withdraw up to US$50,000 a year in foreign currency, either in a lump sum or in instalments. The harder it is to get around the capital controls, the more people want to obtain dollar Michael Every But Chinese individuals and companies still face major hurdles within that quota in the examination of their applications and declarations that indicate how and when the foreign exchange purchases are to be spent. Additionally, banks are carefully scrutinising foreign currency withdrawals of US$3,000 or more in any single transaction, down from US$5,000 previously. China had also set rules to ban some banks from allowing customers’ overseas currency transfers to be used for “speculation” buying of overseas insurance policies, foreign stocks or luxurious flats in cities such as Vancouver and San Francisco. Companies also require government approval to purchase property abroad, and these approvals are hard to come by unless property acquisitions are their primary business. Currency transfers abroad are meant to be restricted to “normal and legitimate business activities” such as tourism, schooling, business travel and medical care. But Beijing on Tuesday issued a travel advisory for Chinese citizens planning to go to the US – the latest salvo in the trade battle – citing shootings, robbery and harassment as reasons for the alert. Last month, in a routine disclosure of its foreign exchange disciplinary cases, SAFE named and shamed 17 banks, companies and individuals for trying to illegal transfer money out of China. In one case, a man identified only by his surname, Hong, was fined 24.97 million yuan (US$3.6 million) for purchasing 312 million yuan (US$45.2 million) worth of foreign exchanges to buy homes abroad between February 2011 and October 2015. Beijing is clamping down on outflows because it needs to head off the possibility of a significant economic and financial upheaval, especially if it fails to reach an agreement with the United States at the G20 meeting this month, leading US President Donald Trump to proceed in July with a tariff of up to 25 per cent on the remaining US$300 billion of Chinese imports that are not now subject to sanctions, analysts said. “[China] is letting very little money to go out. Every time when they try to let [money] go out, the markets get too volatile for [China] to stand and they need to stop it immediately,” said Kevin Lai, chief economist for Asia, excluding Japan, at Daiwa Capital Markets. The domestic demand for dollars, coupled with the growing wariness in the global capital markets to provide US dollar funding to Chinese banks, seen as increasingly risky, are raising the possibly of a systemic “ dollar shortage”. One of Washington’s main demands in talks to end the trade war is for a smaller state role in China’s economy and financial system. Analyst John-Paul Smith, in a research note published on the fintech research network Smartkarma, said that for Beijing to do that would almost certainly trigger a systemic event, as many inefficient Chinese firms would fail without government intervention. The reason for any reluctance to lend US dollars to local Chinese banks freely [especially through Japanese banks] has to do with risk perceptions Jeffrey Snider Last month, China’s bank regulator bailed out city commercial bank Baoshang Bank, which was collapsing under extensive and hidden credit risks after a massive expansion over the past few years. While the People’s Bank of China (PBOC), the nation’s central bank, gave its assurance that the bailout was a one-off case, the incident has reinforced concerns about financial risks in China. “Right now, China is viewed as a tremendous and growing risk in terms of economic downside and financial risks,” said Jeffrey Snider, head of research at Alhambra Investments. “The reason for any reluctance to lend US dollars to local Chinese banks freely [especially through Japanese banks] has to do with risk perceptions.” Foreign buying of yuan assets, including bonds and equities, has also declined recently, reflecting worries over yuan depreciation and the difficulty for foreigners to justify putting more money into China’s markets and committing to the country, Smith said. The trade war makes matters exponentially worse if China can’t earn US dollars from exports to the US, said analysts, which would rapidly push the current account into deficit. Domestic demand for US dollars is rising sharply because of exporters’ reluctance to repatriate dollars earned abroad amid fears over yuan depreciation and escalating trade tensions. For years, US dollars have been entering China as payment for cheap Chinese exports and through foreign investments. At the same time, Chinese firms relied on the US dollars they earned to pay for needed raw materials and technology for making their manufactured goods, as well as to make overseas investments. But the hot money inflows that stocked the yuan’s rapid appreciation also became China’s headache that was hurting the competitiveness of its exporters in the years leading up to 2014. The PBOC had to regularly buy up excess US dollars flowing into Chinese banks in exchange for yuan to curb the strength of its exchange rate. As a result, a significant quantity of these dollars ended up in the nation’s foreign exchange reserves, which, at their peak, exceeded US$4 trillion. The yuan’s appreciating trajectory started to reverse in 2015 as the economy slowed. The PBOC was forced to burn through US$1 trillion (US$144 billion) of its reserve to defend its currency and safeguard its financial system after it devalued the yuan by nearly 3 per cent against the US dollar over two days triggered investor panic across global financial markets. The PBOC’s foreign exchange reserves have stabilised at around US$3.1 trillion in recent years but only because authorities have stepped up with the country’s capital controls and clamped down on outbound remittances. Rabobank’s Every said that while China was trying to hold onto its US dollars by stopping people from taking money abroad through capital controls that will be effective in the short term, it could also be cutting itself off from the rest of the world, rather than integrating with it. The third instalment will look the dollar shortage problem related to the financing requirements of China’s Belt and Road Initiative.