China had another month of declining foreign exchange reserves in January. Reserves fell $99.5 billion USD to $3.23 trillion in the first month of 2016. The numbers show that China’s outflow problem persists, and while the yuan has stabilized, downward pressures continue to require the PBOC to burn through its reserve hoard. Mathematically, if outflows continue at the rate seen over the last two months, Beijing has reserves to last until early 2019. But, it is unlikely that the PBOC will simply let the money run dry. Continued outflows and expectations by the markets of a lower yuan put the PBOC in a tough position. The PBOC needs to either use reserves to hold its ground and wait for sentiment and expectations to change, or they may find themselves in a vicious circle of outflows and expectations that will make the situation far worse.
How much capital has left the economy?
There have been a number of estimates for 2015 capital outflows recently, some over $1 billion USD. Estimating capital outflows flows is complicated, but if we use the balance of payments as a guide, we can use the following equation to get a rough estimate:
Capital flows = current account surplus + decline in foreign exchange reserves
Estimated Capital Outflows ($ billion USD)
Using this method, we get a rough estimate of: $293 + $513 = $806 billion USD (see the chart on the right for past outflow numbers). Even if we make adjustments to the number, the point is that outflows in 2015 reached a staggering sum.
$216 billion in 2015 capital outflows was recorded in the official numbers under “errors and omissions”, and widely considered as capital flight that has made it through China’s strict capital controls. But, “errors and omissions” is a “plug” number used to bring the overall number into balance. It is an oversimplification to view all of that as capital flight that has circumvented Beijing’s capital controls. Price declines in forex reserve assets and Chinese firms delaying conversion back to RMB require a significant “plug” figure to get the official numbers balanced. Many wealthy Chinese looking to send money overseas beyond current quotas, or officials looking to hide ill-gotten gains certainly are getting capital out of the country through unofficial channels, but the number is probably much lower than the $216 billion often cited.
Where are the outflows coming from?
The vast majority of capital flight is coming through official channels from a few main sources.
- FDI inflows have slowed, declining 4.7% on the year in Q3 ’15, after averaging 18% annual gains since 2007.
- Fears and expectations of a lower currency by investors has created a self-fulfilling scenario, accelerating investor-driven outflows and leading to a weaker yuan. Portfolio and "other" investments have seen meaningful outflows. Portfolio investment and “other” investment outflows totaled $370 billion USD for the year by Q3 2015. Investors, foreign and domestic, have moved massive sums out of the country. Stock market turmoil, weaker growth than many have expected, and the monetary policy mismatch between the PBOC and the Fed have sent sentiment to an all-time low. Chinese outbound investors have been felt around the world and have re-shaped a number of global markets. Chinese investors are now the largest foreign buyers of property in the US, Canada, and Australia.
- Chinese firms have recently become significant FDI investors. Outlbound FDI rose 53% on the year as of Q3 2015. That trend has accelerated in 2016, with Chinese companies announcing plans in January alone to purchase 66 foreign firms worth roughly $68 billion, according to CNN/Money.
- Chinese firms with USD debt have been paying down obligations for a number of reasons, effectively deleveraging China's external debt. This is not an insignificant development. The Institute of International Finance (IIF) estimates that half of the recent outflows have been repayments of dollar liabilities by Chinese companies, estimating that towards the end of 2014 total dollar debt was around $1.5 trillion. According to the World Bank, private external debt by the end of 2014 was only $800 billion. Firms are paying down USD bonds and loans as worries over currency volatility, expectations of rising US rates, and low Chinese domestic interest rates make holding USD debt look much less attractive. That would paint a less pessimistic picture of outflows, as sentiment-driven investor outflows are less than the headline numbers imply. There is a finite limit to these deleveraging outflows, and we will most likely hit the limit in 2016 if the current pace is maintained.
- Lastly, some amount of money has fled the economy through unofficial channels.
The PBOC has some difficult decisions.
China's Annual Trade Balance $ billion USD
China's Exports as a Percent of Total Global Exports
The outflows leave the PBOC with a difficult problem. First, aside from sentiment and outflows, there are few reasons for downward pressure on the yuan. A lower yuan will not make exports more competitive. China already has the most competitive exports in the world. The trade balance last year was $600 billion USD, larger that the Swedish economy. And China is now 13% of all global exports, larger than its share of global GDP. China does not need to make its exports more competitive via the currency. Beijing policymakers do not want a falling currency for both reform and political reasons. Engineering a currency devalue would force consumers to subsidize industrial exporters, exactly what current reform efforts are trying to reverse. Beijing does not want to be seen as starting a currency war with the G20 set to meet in China later this year.
If Beijing does not want or need a weak currency, the PBOC has been left with a difficult decision: burn through reserves in a game of chicken waiting for outflows to slow or end, or let some pressure out by allowing for some controlled currency devaluation. The first choice threatens to empty China’s foreign reserve hoard, removing Beijing’s safety net for global financial turmoil. The second choice creates the risk of a vicious circle. When the PBOC is seen giving the green light to currency weakness, the market panics, and outflows accelerate. Just about any size move lower in the yuan seems to generate fears of a loss of Beijing's control. Accelerating outflows require more currency declines to relieve pressure, causing more panic and worry. The PBOC can either wait out currency market sentiment as long as it has ample reserves, or potentially ignite worse sentiment and make matters worse.
Going forward,
It is uncertain where outflows go from here. Looking at the outflow sources described above can give us a little bit of insight.
- Given China's slowing growth, inbound FDI will probably not see a significant rebound anytime soon. Outbound FDI will continue to grow, as Chinese mainland firms see less rapid growth at home, and firms looking to acquire technology and know-how to compete globally. The FDI situation will not be supportive of stopping outflows.
- USD liability pay downs by Chinese firms will eventuality slow, certainly before the PBOC runs out of reserves. If the IIF is correct, at the current pace, companies will have reduced external liabilities to half of the 2014 peak by mid-year this year. Outflows due to liability pay downs, possibly half of all outflows, will subside this year.
- The real wildcard in the outflow problem is investor-driven flows. It is impossible to know just how long it will take for investment outflows to slow. Missteps and poor communication from Beijing have exacerbated negative sentiment and pushed it to new highs. Beijing has recently signaled willingness to avert more yuan weakness, which could be a possible step in shoring up confidence in the PBOC's ability to get ahold of the capital outflows and yuan declines. After declining 1.5% in the first week of the year, Beijing has chosen to hold the yuan steady for the last month, and has been willing to burn through reserves to do it. Beijing seems to be signaling the willingness to stem a downward vicious cycle of expectations and more outflows.
So what amount of reserves might Beijing target, and how many months of $100 billion outflows until they reach that amount? There are a few commonly used rules of thumb for reserve adequacy: 3 months of imports, short-term external debt, and 20% of broad money supply.
- If we take IIF's estimate of all external liabilities, not just short-term, then conservatively the PBOC can get by with at least $1.5 trillion to cover external obligations. It would take 17 months of outflows at the current rate to get there with $100 billion USD a month in outflows.
- If we assume the PBOC wants enough reserves to cover a full year of imports, not just three months given the heavy reliance on imports of raw materials, then it will take potentially 15 months to get there with $100 billion USD a month in outflows.
- 20% of M2 money supply means reserves of $4.2 trillion USD is need, and reserves are $1 trillion USD too low. Given China's closed/controlled capital account, they probably don't need to cover so much of the broad money supply.
If investor sentiment and yuan expectations can ease within those time frames, then the PBOC has time to wait out the market. If not, the PBOC will enter into extremely uncertain times. Perhaps the Spring Festival holiday this month will give markets time to calm their worries a bit.