China's economic growth is decelerating. By our estimation, it has more than halved over the last five years. We believe that this is for the better, but many are fearful that we are on the verge of a crisis. They are pointing to recent capital flight as evidence – emerging market economic crises of the last 30 years were frequently accompanied by abrupt outflows of capital (although not necessarily caused by them).
However, data released over the last fortnight show financial outflows moderating and we believe that there is little evidence of the deleterious potential that many scaremongers have tried to claim over the last nine months. Money supply growth has stabilised around 13 per cent year-on-year, while core consumer price inflation has remained steady at around 1.5 per cent since October.
Large amounts of capital have certainly left China. But this is China and that means everything is dealt in large amounts. Many pundits have hit the panic button after looking solely at the large headline numbers, and have failed to dig into the balance of payments data and identify the various sources of capital outflow. Not all are pernicious – far from it in some cases. Below I’ve broken down the various components of the financial account and flagged what I believe has the potential to do persistent damage, quarter-after-quarter, and what represents an outflow over which investors shouldn’t fret.
Far from the insidious developments that many investors believe them to be, this decomposition reveals that many of the outflows are actually positive developments for economic stability. Others are flows that have a limited amount to run, or that the government could easily stop. The data cover the second, third and fourth quarters of 2015, i.e. since the People’s Bank of China liberalised its currency fix against the dollar, the renminbi changed direction and sentiment soured. Detailed first quarter 2016 data are unavailable for another three months, but looking at the numbers currently available, the release is almost certain to show further deceleration in the pace of outflows.
There are two worrying problem areas. First, Chinese firms and households choosing to hold non-RMB deposits. Second, the large outflow caught in the “net errors & omissions” line item, which is likely to capture illegitimate outflows of Chinese wealth. Indeed, these flows are likely beyond the legitimate outflow of capital that one would expect, as capital controls are liberalised and Chinese firms and households diversify their assets.
Still, importantly, they account for just 27 per cent of the capital outflows of the last three quarters, and even if they persist at the current rate, they are not large enough to bring official reserves to their knees. Furthermore, RMB deposits by firms and households at Chinese banks have continued to grow at high single-digits throughout the period, casting serious doubt on the scaremongers’ assertions that we are staring down the barrel of a broad loss of confidence in the monetary system.
The decrease in foreigners’ deposits in China (i.e. repatriation) is a little concerning, but thanks to historically tight capital controls, the total pot isn’t enormous. Already in the last two quarters, 55 per cent of net inflows since 2010 have flowed out and much of the remaining corporate cash balances are needed for operational reasons. The rise in Chinese firms/households’ investments in overseas equity and bonds is a natural consequence of diversification opportunities, but may be a little worrying in so far as it’s indicative of a desire to move money abroad. However, the conduits for these portfolio outflows are tightly controlled and policymakers could quite easily tighten the faucet here. These two items account for a further 19 per cent of outflows in the second and third quarters.
The single largest sources of outflows are an increase in Chinese foreign direct investment (FDI) abroad (there’s been a lot of cross-border M&A) and a rise in Chinese banks extending loans overseas – 31 per cent of outflows combined. FDI is clearly benign and could be reined in if it really came to that. In third place we have the repayment of external debt – clearly no bad thing and sensible when your central bank has declared that currency appreciation is over.
Changes to trade credit transactions account for another 14 per cent of total outflows. These represent rational one-off moves on behalf of Chinese firms: now that RMB appreciation has come to an end, they prefer to receive trade credit but make payments of their own immediately in cash.
So digging deeper into the data reveals a picture far less ominous than many are making out. That’s not to say that we shouldn’t continue to keep a close eye on the balance of payments data. Substantial deposit withdrawals for no reason other than concern about the banking system’s stability can in themselves damage banks and strain the entire domestic financial system. But at the moment these flows are not large enough to justify market panic.