Revamping the Landscape of Forex Flow

Capital flows out of China may be accelerating, a phenomenon commonly associated with waning confidence in a nation’s economy. But the foreign exchange regulator says the change is a step in the right direction.

In the first six months of the year, China’s capital account saw a deficit of US$20.3 billion, and its accumulated forex reserves grew to US$3.24 trillion, up only US$63.6 billion—77 percent less than the amount added in the first half 2011, data from the State Administration of Foreign Exchange (SAFE) shows.

This does not indicate capital flight, the regulator said, but primarily reflects shifting foreign exchange activity from the central bank to domestic institutions and individuals.

From January to June, China received US$79.1 billion more than it paid out in cross-border transactions, yet the value of foreign currencies converted into yuan at Chinese banks exceeded that of yuan converted into foreign currencies by only US$29.5 billion. In principle, Chinese enterprises and individuals held the difference in their forex accounts.

This is in sharp contrast to between 2003 and late 2011, when most enterprises and individuals wanted to convert their forex holding into yuan assets because the yuan was expected to appreciate, said Zhang Bin, a research fellow at the Chinese Academy of Social Sciences. Now that the yuan’s exchange rate has started fluctuating both ways, the incentive to hold yuan instead of foreign currency has weakened. Therefore, companies started adjusting their assets to hold more foreign currencies, Zhang said.

Capital outflows resulted from this adjustment are incremental, he said, as opposed to typical capital flight during which investors lose confidence in a nation’s economic fundamentals and move investments elsewhere for fear conditions may deteriorate.

An increasing willingness to keep U.S. dollars rather than yuan also explains why this year’s forex reserves grew considerably slower than in previous years, said Wang Qinwei, an economist with the London research firm Capital Economics. There was no need to be concerned about capital flight, he said, because a large amount of forex was still held by Chinese enterprises and residents.

Indeed, the amount of foreign currency deposited in Chinese banks shot up this year, reaching US$137.3 billion in the first seven months, SAFE data shows. This represents an increase of 47.5 percent over the amount for 2011, and is 66.5 percent higher than during the same period last year.

Growing foreign exchange deposits enabled Chinese enterprises to strengthen investments overseas. Meanwhile, the momentum of foreign direct investments into China has decelerated since last November.

As a result, the gap between inbound and outbound foreign direct investments has narrowed, resulting in fewer contributions to the nation’s forex reserves.

From January to July, the amount of non-financial direct foreign investment from mainland Chinese investors hit US$42.2 billion, up nearly 53 percent from the same period a year earlier, the Ministry of Commerce says.

In comparison, the amount of inbound foreign direct investments fell 3.6 percent year-on-year, slipping to US$66.7 billion.

Manufacturing Blues

The decline is, of course, partly due to turmoil in economies overseas which weigh down foreign companies’ ability to invest in places like China. Yet domestic factors played a significant role as well.

Rising labor costs, for instance, were often cited by experts as the primary reason why China has been losing its manufacturing attractiveness, even though it remains the world’s manufacturing base. As average Chinese worker wages increased, many multinational companies, such as footwear giant Nike, found production costs surging and decided to move to countries such as Vietnam and Thailand.

In addition, regulatory restrictions on property development dampened foreign direct investment in the services sector. In the first half of the year, the amount of foreign direct investment to the real estate sector fell by 12.4 percent year-on-year.

Yuan settlements in cross-border investment are also behind the slowing growth of forex reserves. In the first half of this year, the amount of yuan settlements in cross-border direct investments was 110.6 billion yuan, of which 91.8 billion yuan was from foreign investors to China and the rest was from Chinese investors.

The difference between inbound and outbound yuan direct investment was therefore 73.1 billion yuan. Based on the current exchange rate, this reduced the inflow of foreign exchanges by around US$11 billion.

Changes in cross-border capital flows inevitably affect China’s monetary policies. Funds outstanding for foreign exchange, that is, the amount of yuan Chinese banks put into the domestic market when they acquire foreign currencies from individuals or companies, traditionally make up most of the domestic money supply.

However, with the inflow of foreign capital slowing and the funds outstanding for foreign exchange declining as a result, concerns are rising that there might be a liquidity shortage in the domestic market.

Yet Zhang views these changes positively, arguing that it reduces the need for the central bank to interfere with the foreign exchange market. Besides, he said, there are many alternative instruments, such as open market operations, that the central bank can employ to adjust money supplies.

Reducing the reserve-requirement ratio for banks is another effective method to bump up liquidity, Wang said. Based on his calculation, lowering the RRR to the level of a decade ago, 6 percent, could offset the impact of 1.9 trillion yuan flowing out of China.

“It’s almost impossible for such massive capital flight to occur unless there is an economic or political crisis that completely shatters the confidence of the middle class,” he added.

Yu Hairong is a Caixin staff reporter. Staff reporters Huo Kan and Wang Changyong also contributed to this article.