“China’s currency outflows may be bigger than they look,” warned a report in the South China Morning Post earlier this month. The article played into the narrative that has prevailed in financial markets since August last year, when the authorities in Beijing sprung a surprise 2 per cent devaluation of the yuan against the US dollar. According to this narrative, a crisis of confidence in China’s future growth and stability has triggered mass capital flight – capital flight that left unchecked will threaten to precipitate the very Chinese meltdown that financial markets so dread.
It’s a scenario sufficiently compelling that a number of prominent international investors have staked large bets on a deep depreciation of the yuan and on big falls in the prices of Chinese assets. There is, however, another less apocalyptic interpretation of what is going on.
At first glance, the pessimistic view looks reasonable enough. According to this narrative, by mid-2015 Beijing’s longstanding policy of keeping the yuan stable against the US currency had begun to carry a heavy cost. As the US dollar appreciated by some 20 per cent against other developed world currencies over the second half of 2014 and the early months of 2015, so the yuan strengthened too.
This gain made Chinese goods more expensive in world markets, eroding the competitiveness of China’s exporters. The result was a year-on-year decline in Chinese exports that threatened to exacerbate the ongoing slowdown in domestic investment, jeopardising the economy’s overall growth rate.
According to the accepted story, Beijing responded with a poorly thought-out and ill-communicated devaluation, which badly dented confidence in the competence of Chinese policy-making. Expecting further depreciation of the yuan, Chinese individuals and companies began shipping their savings offshore, whether through legal or illicit channels, in order to preserve the value of their capital. To the bears, the evidence of this capital flight is all too clear: a massive US$820 billion slump in China’s official foreign exchange reserves, from US$3.99 trillion in mid-2014 to US$3.17 trillion in September this year.
But while the drawdown in China’s foreign reserves is undeniable, it is not necessarily a symptom of panicked capital flight. Two other things have been going on. First, before last August’s devaluation, companies generally expected the yuan to continue appreciating. As a result, it made sense for Chinese importers to delay settling their bills to make the most of the anticipated favourable foreign exchange movement.
Watch: Currency war fears over yuan devaluation
Conversely, foreign buyers of Chinese goods tended to pay up as soon as possible. Given the sheer size of China’s foreign trade, this mismatch – known by the French term termaillage – artificially inflated China’s foreign exchange reserves, possibly by as much as several hundred billion US dollars. When sentiment swung towards expectations of yuan depreciation, this mismatch corrected and even reversed, leading to a sizable decline in the headline number for China’s foreign reserves.
Second – in a related phenomenon – when everyone expected the yuan to be stable or to appreciate against the US dollar, it made sense for Chinese companies to take advantage of low US interest rates to borrow in US dollars rather than in yuan. With that certainty removed by last year’s devaluation, Chinese companies moved to control their foreign exchange risk by paying down their US dollar debts.
The amounts involved are considerable. According to the Bank for International Settlements, the money owed by Chinese concerns to international banks has fallen from almost US$900 billion in mid-2014 to a little more than US$500 billion in the first quarter of this year, with much of the fall accounted for by the repayment of short-term US dollar debt to Hong Kong-based banks.
These outflows are not mass capital flight, which would mean domestic savers abandoning the Chinese financial system following a catastrophic loss of confidence. Rather they are a rational adjustment of positions in response to a change in expectations.
What’s more, there are signs this adjustment has largely run its course. The Chinese central bank reports that foreign currency debt is beginning to inch higher, while after a long period of decline, loans from Hong Kong banks to mainland entities are increasing once again. As a result, the drop in China’s foreign exchange reserves has slowed, from US$80-90 billion a month in the fourth quarter of 2015 to a relatively modest US$19 billion in September this year, with much of that decline accounted for by officially sanctioned outward direct investment.
This doesn’t mean there is no capital flight out of China at all. The “errors and omissions” item of China’s balance of payments showed a deficit of US$50 billion in the second quarter of this year, much of which was no doubt illicit capital outflows. However, the amounts are small relative to the vast sums expected by the China bears and – for an economy running large trade surpluses and still sitting on more than US$3 trillion in foreign reserves – easily manageable.
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years