China capital outflows: as US battles inflation, Beijing goes on alert for ‘spillover effects’ from rate hikes
- Foreign investors have dumped Chinese equities and bonds at a rapid pace over the past two months, while the yuan has come under strong depreciation pressure
- The last time China experienced such severe capital flight came between 2015-17 and it was only halted by heavy capital controls and the release of forex reserves
As the US shifts to more aggressive rate tightening, concern is mounting in Beijing about capital outflows and growing depreciation pressure on the yuan. The question on many people’s lips: how prepared is China to deal with it?
Investors have withdrawn money from China at a rapid pace over the past two months, triggered by market expectations of further interest rate hikes by the US Federal Reserve, the Omicron outbreak and the Russia-Ukraine war.
The current US monetary policy adjustment is undoubtedly unprecedented in terms of scale and pace
The last time China experienced such severe capital exodus came between 2015-17, and it was only halted by heavy capital controls and the burning of a quarter of the national foreign exchange reserves.
Now, more cautious observers are warning that any misstep during the US Federal Reserve’s current rate cycle could come at a heavy cost to the Chinese economy.
“The current US monetary policy adjustment is undoubtedly unprecedented in terms of scale and pace,” former vice-finance minister Zhu Guangyao told the China Wealth Management 50 Forum on Sunday.
US Federal Reserve chair Jerome Powell said last week that a 50 basis point increase would be “on the table” in May.
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Market expectations are for rate increases at each of the six US Federal Reserve meetings over the remainder of this year to curb inflation, which has hit its highest level in decades. Interest rates are forecast to spike above 2 per cent from the current level of 0.25-0.5 per cent.
In addition to hiking rates, the Fed has a plan to downsize its record high US$9 trillion balance sheet – and could start shedding assets as early as May.
“This is the biggest pressure we are now facing,” Zhu said, referring to the Fed’s plan to tighten monetary policy.
Over the past week, the yuan has weakened by nearly 2 per cent against the US dollar in the onshore market and surpassed 6.6 per dollar in offshore trading on Monday before an intervention by the central bank.
The fall of the yuan last week “points to the beginning of a new depreciation cycle that will not quickly reverse”, Wei He of Gavekal Dragonomics said on Monday, noting export momentum was softening and monetary policy was diverging between China and the US.
Chinese authorities have taken a variety of precautionary measures to guard against capital flight, as well as corporate loss on stock exchanges and market panic.
The State Administration of Foreign Exchange (SAFE) cracked down on foreign exchange market manipulation a year ago. Since then, it has worked to persuade exporters to stay neutral to exchange rate risks, asking them to better manage their foreign exchange exposure and use hedging tools.
The battle lines have also been extended to overseas casinos, underground banking and bitcoin transactions.
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Wang Chunying, deputy head of SAFE, said last week China was capable of adapting to changes in US monetary policy.
China’s trade surplus, foreign direct investment into the country, net overseas assets worth US$2 trillion, and a record US$700 billion foreign exchange deposits left it well placed to offset capital flight, she said.
China would also “closely monitor the process of Fed policy adjustment and its spillover effects”.
“Cross-border capital flows will be reasonably balanced,” Wang said.
Concern over capital outflows and the yuan-US dollar exchange rate – a gauge for external shocks – comes against a backdrop of dramatic changes in the Chinese economy over the past six months.
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At December’s annual economic conference, the country’s top leaders acknowledged threefold pressures, including a contraction of demand, supply shocks and weaker expectations.
International investment banks such as UBS and Nomura have slashed their economic growth forecasts for China.
The International Monetary Fund also cut its 2022 estimate for the country from 4.8 per cent to 4.4 per cent, well below Beijing’s annual target of “around 5.5 per cent”.
Amid dimming economic growth prospects, many foreign investors are fleeing the Chinese market.
Last month, net outflows from the Mainland Stock Connect, where foreigners can trade equities listed on mainland exchanges, totalled 45 billion yuan (US$6.9 billion). Overseas investors also slashed their holdings of Chinese bonds by 112.5 billion yuan in March, after selling 80.3 billion yuan a month earlier.
More outflows could be in the pipeline as the US dollar index jumped to a five-year high of 101.6 on Monday in anticipation of US rate increases.
Guan Tao, former director of SAFE’s balance of payments department, said two drivers of the 2015 capital exodus – including one-way bets on yuan appreciation and high debt in the private sector – have been addressed.
“The surprising yuan devaluation [in 2015] forced many [private companies] to repay their liabilities in advance, causing massive outflows,” he said. “Now outstanding foreign liabilities in the private sector are much lower.”
China’s outstanding foreign debt reached a new high of US$2.75 trillion by the end of last year, an increase of 14.4 per cent from a year earlier, SAFE data showed.
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Still, China’s debt-to-GDP ratio of 15.5 per cent was lower than in 2020, at 16.3 per cent, and 17 per cent in 2014, government data showed.
The structure of China’s debt has also been optimised. Short-term liabilities grew 9.9 per cent year on year to US$144.6 billion by end-2021, accounting for 52.7 per cent of the total. The proportion was the lowest since 2004 and significantly lower than 78.4 per cent in 2013 and 72.9 per cent in 2014.
Foreign debt sensitive to markets, including bank loans and trade finance, was 31 per cent of the total in 2021, compared to 75 per cent in 2014 and 43 per cent in 2016.
Debt concerning their holdings of Chinese bonds doubled to 32 per cent in the 2016-21 period.
Zhang Monan, chief researcher for the US and Europe at the China Centre for International Economic Exchanges in Beijing, said Federal Reserve tightening will accelerate capital return to the US from the rest of the world, but China’s capital controls and only partially opened financial account will restrain large-scale flows.
Compared to the 2015-17 period, the environment is different
“Some capital could flow out to other markets if downward pressure is deepened or market expectations worsen, but it would be a gradual process,” she said.
The size of current outflows remains quite small compared to 2015, which the Institute of International Finance estimated to be more than US$500 billion.
Yuan assets may become more attractive for hedging purposes, Zhang said.
“Compared to the 2015-17 period, the environment is different. The yuan has become a safe haven against the backdrop of the Russia-Ukraine conflict,” she said.
On the other hand, the value of the US dollar tends to fall in the medium-to-long term amid fiscal deficit monetisation and high inflation, meaning it is no longer safe when used as a tool for sanctions, the government researcher said.
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Some government advisers are still calling for more action to boost the economy and market confidence.
“Overseas interest rate hikes will certainly impact the Chinese economy, but it’s not the most important factor,” Wu Xiaoqiu, a senior professor of finance at Renmin University, said at the Boao Forum for Asia last week.
“Chinese growth was mainly decided by domestic capital. We must anchor their expectations.”
Huang Yiping, a former central bank adviser, said US monetary tightening could affect China, but the actual impact will depend on the country’s financial health and economic stability.
Although China has a current account surplus and huge foreign exchange reserves, “special attention” should be paid to efforts to stabilise our economy, he said.
Additional reporting by Ji Siqi and Luna Sun
