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Capital is flowing out of China at a record pace, sparking fears over financial stability and complicating efforts by the central bank to support a slowing economy with lower interest rates.
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China ran a balance of payments deficit of $80bn in the first three months of the year, the largest quarterly net outflow on record, according to official data.
The outflows are all the more striking because China’s trade surplus remained strong over the period. As falling commodity prices slashed the country’s import bill, it recorded a $79bn current-account surplus — the largest in nearly five years.
But this was overwhelmed by outflows on the capital and financial accounts worth a record $159bn. The lure of China's surging stock market also failed to counter the outflow trend.
Although the outflows signal investor concern about China's economy, which grew at its slowest pace in six years in the first quarter, a rising US dollar and declining Chinese interest rates also helped draw funds out of the country.
"All things considered, [Beijing] would rather not have confidence-sensitive capital going out," said Tim Condon, head of Asia research for ING Financial Markets in Singapore.
By some measures, outflows have been continuing for more than a year. The central bank’s holdings of foreign assets have dropped for seven consecutive quarters — the longest run of declines on record.
But economists say that as yet, capital outflows have not accelerated to a level that would threaten the stability of the financial system. That such relatively small outflows even set a record largely reflects the tight control Beijing has long maintained over cross-border capital flows.
And even if the $80bn quarterly outflow were maintained for the entire year — an unlikely scenario — it would still represent only 3 per cent of 2014 gross domestic product and 9 per cent of foreign exchange reserves.
All this explains why Chinese officials do not appear overly concerned. “Recent capital outflows represent an adjustment that is within expectations. One can’t equate them with illegal and secret capital flight,” Guan Tao, head of the balance of payments department at the State Administration of Foreign Exchange, said last month.
According to analysts, it is also important to distinguish between outflows of so-called “hot money” — purely financial investments — and foreign direct investment flows linked to real economic activity, which the government is actively encouraging.
“China has a huge manufacturing sector and it’s looking for places to do business cheaper. That’s cold money — there are goods and services associated with it,” said Mr Condon.
Economists say even some purely financial flows should be considered a healthy move by Chinese savers to diversify into foreign assets, rather than a sign of panic about China's slowing economy.
They also reflect recent reforms to loosen capital controls and cautiously encourage financial outflows through initiatives such as the Shanghai-Hong Kong Stock Connect, which allows mainland Chinese to invest in foreign equities.
Nevertheless, capital outflows are complicating efforts by the People’s Bank of China to support the economy through monetary easing. For the past decade, central bank purchases of foreign exchange inflows were the main source of base money creation in China's banking system. Now, with outflows threatening to shrink the money supply, the central bank is turning to new mechanisms to expand it.
The most important of these is cuts to banks’ required reserve ratio. The PBoC once used RRR rises to restrain excess money growth by forcing commercial banks to keep a chunk of newly created base money on reserve at the central bank, where it is unavailable for lending. Now the PBoC is doing the opposite: cutting the RRR to offset the loss of liquidity caused by capital outflows.
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Yet even after RRR cuts totalling 1.5 percentage points this year, the ratio for big banks, at 18.5 per cent, remains far higher than in any other large economy. Most economists believe that for the PBoC to meet its broad M2 money growth target of 12 per cent, further RRR cuts will be necessary.
“From the start of this year, capital inflows have been negative. We believe the key factor now restricting effective monetary easing is that the required reserve ratio remains at a high level,” said Liu Liu, macroeconomic analyst at China International Capital Corp.
In addition to RRR cuts, the central bank has slashed benchmark rates three times since November. But lower rates could exacerbate capital flight by making Chinese assets less attractive, especially in comparison to the US, where the Federal Reserve is expected to raise interest rates this year.
Forex traders say the PBoC has drawn down its foreign exchange reserves to head off depreciation of the renminbi. That explains why the exchange rate has been flat this year despite the record-setting outflows.
“As long as the renminbi remains broadly steady, domestic capital outflows are likely to be modest,” Standard Chartered analysts led by Beckly Liu wrote last week.
The PBoC’s signal to the market that it intends to hold the renminbi stable has helped prevent the trickle of outflows from becoming a flood.
Twitter: @gabewildau
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