Everyone loves a horror story, and there are a number of real chillers doing the rounds just now about China, the yuan, and the looming risk of a financial collapse. These stories differ in detail, but generally they share a similar plot. It goes something like this: rich Chinese are losing faith in their economy and the yuan. As growth slows and debt mounts, Chinese fearful of an impending crisis are shifting their wealth offshore and into foreign currencies. These outflows are putting pressure on the yuan, which is weakening in response. In turn this weakness is prompting more and more mainland Chinese to try to preserve their capital by seeking safety in foreign currencies. The result is a self-reinforcing feedback loop that threatens to precipitate the very crisis those fleeing the yuan hope to escape.
It’s a gripping tale. Happily, like all good horror stories, it springs more from imagination than from fact.
That’s not to say it has no basis at all in reality. Clearly China’s growth is slowing, debt does continue to rise relative to gross domestic product, the yuan’s exchange rate against the US dollar did weaken last year, and the domestic economy has seen net capital outflows.
But none of this portends the imminent financial death spiral the more blood-curdling China-sceptics describe.
Yes, China’s growth has slowed as the easy gains from playing catch-up with more developed economies have been exhausted. Yes, total debt has ballooned to somewhere around 250 per cent of GDP, up from 150 per cent following the financial crisis, with much of the capital misallocated to unneeded steel mills, uninhabited ghost cities, and unwanted white elephant infrastructure projects.
And yes, as a result, the returns earned by real economy investments have deteriorated.
It is also true that the yuan has weakened against the US dollar. Between the beginning of 2014 and the end of 2016, the Chinese currency declined 13 per cent. And it is true that wealthy Chinese have sought to ship money offshore. Even though Beijing still maintains controls on cross-border capital flows, the inventive have found numerous ways around the restrictions. These have ranged from buying a gold Rolex in Macau on a UnionPay debit card and immediately pawning it, to – at the other end of the scale – buying trophy assets like New York hotels or English Premier League football clubs under the guise of outward direct investment.
But both the extent of the yuan’s decline and the scale of capital flight have been exaggerated.
Over the last three years, while the yuan has fallen 13 per cent against the US dollar, the Canadian dollar has fallen 20 per cent, the British pound has dropped 21 per cent, and the euro has slumped 24 per cent. In other words what we have seen is not broad-based yuan weakness, but US dollar strength. In fact, over the last six months, the yuan has remained stable against the People’s Bank of China’s (PBOC) reference basket of currencies.
Similarly, the drawdown in China’s foreign reserves from almost US$4 trillion in mid-2014 to roughly US$3 trillion today has been overstated. If we assume that China held half its foreign reserves in non-US dollar currencies, then the 28 per cent appreciation of the US dollar against a basket of major currencies implies that the US dollar value of the non-US portion of China’s reserves would have fallen by US$438 billion even without any drain on the reserve pot.
As a result, net outflows have been much smaller than the fall in headline reserves. In November, for example, the net outflow was closer to US$40 billion than the US$69 billion that the slump in the US dollar value of China’s reserves suggested.
Still, US$40 billion is a lot of money to watch going out the window in a single month. Despite that, there is little evidence that capital flight is gaining pace. The recent increase in net outflows is not the result of a pickup in flight capital. Instead it has largely been caused by a slowdown of inflows into the yuan as Chinese exporters have retained their revenues offshore to take advantage of the US dollar’s strength.
Of course, if there were to be a marked acceleration in outflows from here and a steep fall in the yuan, the combination could badly dent confidence in Beijing’s ability to maintain financial stability.
However, the authorities have plenty of tools available to forestall any such run on the yuan. In recent weeks they have tightened their scrutiny both of individual foreign exchange purchases and of outward investments by Chinese companies. There is talk that the government is twisting the arms of state-owned companies to repatriate foreign currency earnings held offshore. And on Thursday the PBOC engineered a liquidity squeeze in the Hong Kong market that saw the overnight interest rate on offshore yuan hit 80 per cent – more than enough to deter any foreign players planning to borrow the currency in order to sell it short.
In a nutshell, the scare stories about the devastating consequences of a weakening yuan and gathering capital flight are just that: stories.
The spectre of a financial crisis in China – at least this year – is illusory, nothing more than a figment of the storytellers’ overactive imaginations. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years