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Why Is There So Much Talk of China’s Bleeding Money?

A ChinaFile Conversation

China has seen its foreign reserves depleted for months, but economists don’t agree about why: Is it because Chinese people are buying offshore assets, such as real estate? Because Chinese companies are paying down their foreign debt? Or both? Or is it because of something more to do with complex bets on foreign exchange movements? What explains why China’s foreign exchange reserves fell this spring to their lowest level since December 2011? And what long-term effects might this have on the U.S.-China relationship and China’s trade with the world? —The Editors

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China is not bleeding money. Foreign exchange reserves fell sharply in 2015 and early 2016 as Chinese corporations began to bet that the renminbi would fall against the dollar, and started moving money into dollars. Global financial markets took note—and panicked—in August 2015 when the People’s Bank of China (PBOC) devalued the currency by 2 percent as part of technical shift in the way it manages the exchange rate. Bets against the renminbi intensified in January when China’s stock market opened the year with sharp losses, causing some to worry that China’s economy was on the brink of a sharp slowdown.

Since March, however, China’s foreign exchange reserves have remained stable at around $3.2 trillion—by far the world’s largest stash. Reserves actually rose slightly in June. This stability of reserves has been maintained even though the renminbi has depreciated by about 2 percent against the dollar since April, and by about 5 percent this year against a trade-weighted basket. Rather than spreading scare stories about supposed “capital flight,” we should observe that, after a bumpy start last summer, the PBOC has now learned how to manage a steady depreciation in the currency without triggering hysteria in Chinese or international financial markets.

This depreciation was warranted. The renminbi rose by around 20 percent in trade-weighted terms between the beginning of 2014 and mid-2015, not because of conditions in China but because the currency was tightly tied to a dollar that was rocketing upward. Since last August, when the tie to the dollar was loosened, it has retraced about half of that unwelcome gain. This is a perfectly legitimate adjustment to ensure that Chinese exporters stay competitive, and the domestic economy does not get pummeled by the deflation that comes with an overvalued currency.

Even when China was losing reserves, stories about “capital flight” were grossly exaggerated. When a country experiences true capital flight—as Cyprus and Greece have in recent years—it shows up as a decline in bank deposits, as households pull their money out of domestic banks and send it abroad. In China, household bank deposits today are a healthy RMB 21.5 trillion, up 16 percent from a year ago. The vast majority of reserve losses reflected Chinese companies paying down foreign-currency debts, making real-economy investments abroad, or simply shifting cash into dollar accounts inside Chinese banks.

The one truly important international impact of the weaker renminbi is that Chinese private companies have accelerated the pace of their investments abroad: outbound direct investment by Chinese firms in the first half of 2016 already exceeds the total for all of 2015. But even here the currency plays only a supporting role. The most important factor is that many Chinese companies are now mature enough to want to expand internationally—just as Japanese firms did starting in the 1970s. Second, China’s economy is slowing, so that investments in untapped markets abroad seem more attractive. And finally, companies have an incentive to move fast, because the longer they wait, the greater the risk that the renminbi will have fallen a bit more, making their investments more expensive. This is not capital flight, this is the Chinese economy growing up. And on balance, that’s a good thing for the world.

Arthur’s initial assessment is, of course, correct: the significant capital outflows recorded in China’s Balance of Payments (BOP) since 2015 were mostly a result of companies adjusting their currency exposure in response to a combination of fundamentals pointing to a weaker renminbi. These outflows have slowed down significantly since February, as a more dovish policy stance by the U.S. Federal Reserve has weakened expectations of U.S. dollar strength. This has decreased pressure on the Chinese currency and, in turn, slowed the depletion of China’s foreign exchange reserves.

At the same time, we are witnessing a more fundamental shift in China’s financial account dynamics. While the scale of net capital outflows has decreased since February, the breadth of outflows has further widened in the first six months of this year and China is now running a deficit in all three components of the financial account: in addition to lower but still significant net outflows under the “other investment” channel (a BOP category that mostly captures lending and trade finance), China also ran a deficit under the portfolio investment channel (as Chinese investors want to diversify but foreigners remain disinterested to invest in Mainland securities) and the foreign direct investment (FDI) account. The change in the FDI balance is particularly notable, swinging from an average quarterly surplus of $40 billion in recent years to a deficit of -$16 billion in Q2 2016.

This financial account deficit marks a significant departure from the structural surplus recorded throughout the past decade, and it will likely persist: The slowdown in economic growth, increasing political uncertainty and the end of the one-way renminbi appreciation bet means that foreigners are more reluctant to channel money into China. On the other side, Chinese households and companies are eager to overcome the “home bias” in their current asset position and increase their exposure to foreign currency, equities, bonds, real estate, and real economy assets.

As Arthur rightly points out, this situation is far from what economists commonly characterize as “capital flight”. A financial account deficit is in line with China’s development stage and what we should expect from a country running a large current account surplus. In fact, Beijing intentionally liberalized capital controls to give the private sector a greater role in investing surplus foreign exchange instead of further adding to the central bank’s reserves. At the same time, the pace and scale of capital outflows in the second half of 2015 and early 2016 have clearly made Beijing nervous. While China’s leaders continue to stress their commitment to external financial liberalization, but they felt compelled to launch a slew of informal measures in the first half of 2016 to slow down the pace of foreign exchange outflows.

Going forward, the scale and nature of capital outflows will critically depend on Beijing’s ability to re-instill confidence in China’s long-term growth trajectory. If the leadership manages to accelerate the pace of reforms that address structural problems and improve market access for foreign investors, then they can be confident about allowing greater freedom for overseas investment, as outflows will be balanced out by the inflow of foreign capital seeking new opportunities in China. But if Beijing continues to postpone necessary reforms, sentiment will continue to sour, aggravating the financial account imbalance and fueling outflows that would best be described as capital flight. This in turn would make it necessary to impose additional capital controls, which could severely disrupt not just household diversification but also the global ambitions of Chinese companies.