How bad are China’s capital outflows?

15 Feb 2017

Thinking is the hardest work there is, which is probably the reason why so few engage in it.  Henry Ford

 

Capital outflows from China have been rampant; but perhaps they are not as bad as market perceptions have it. There are signs that they may be slowing down.

Headline data shows that China’s FX reserves dropped by USD319.8 billion YoY in 2016 on the back of an estimated current account surplus of USD192.8 billion. This suggests that capital outflows amounted to USD512.6 bn, or more than 16% of FX reserves. Conventional wisdom has it that capital outflows have continued to soar, putting an undue pressure on renminbi depreciation and prompting the PBoC to tighten up on capital controls.

However, the estimated USD512.6 billion outflow in 2016 was 39% smaller than the USD 843.3 billion outflow in 2015. While outflow pressure is evident in the sharp growth in China’s FX deposits recently, the growth this time has been much slower than in the past two rounds when market sentiment turned against the renminbi (Chart 1). There has also been no loss of domestic renminbi deposits (Chart 2), suggesting no evidence of capital flight.

Statistically, capital outflows have been distorted by a valuation effect on China’s FX reserves. Since China reports its FX reserves in USD terms, a soaring dollar against other currencies would have trimmed the value of the reserve portfolio by eroding the dollar value of other currency assets even when there was no change in the asset positions. By our estimates, the valuation effect reduced China’s FX reserves by USD57.1 billion, or 11% of the estimated capital outflows. Adjusting for this, capital outflows were USD455.5 billion in 2016.

 

Capital outflows drivers

On the trade side, China’s widening service trade deficit1 is a source of capital outflows. This is less of a concern at this stage as it is not large enough to overwhelm China’s current account surplus (Chart 3), which is a source of capital inflows. China still enjoys a basic surplus (Chart 4), although it has declined recently due to capital outflows.

Overseas direct investment (ODI) has become a new source of outflows since Beijing pushes for renminbi internationalisation and a “going out” investment strategy in recent years. Annual ODI has risen exponentially (Chart 5), albeit from a very low base, and is also responsible for the decline in China’s basic surplus by eroding net FDI inflows. The rising trend of ODI will likely continue in the longer-term since China’s international investment position remains small relative to other major countries (Chart 6).

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