China capital flows: what we sort-of know

The world is now watching Chinese capital flows. What had been an odd hobbyhorse for some of us is now mainstream and noisy. China’s system still confuses in big ways: partial capital controls slowly being unwound but also a massive trade(able goods) sector where capital flows also hide. Up through early 2014, China’s problem had been hot money (ie speculative) inflows, not outflows. What’s been forgotten is that the shift from money inflows, which were a big part of China’s nearly $4 trillion reserve build-up, to outflow were the result of a deliberate policy choice to crack down on these speculators in February/March 2014 (as it is doing again now for different reasons) and then prompted a reversal of this relatively large FX carry trade that had even morphed into JPY-like structured products. There have been claims that China’s capital outflows have actually been going on for five years or so. That’s pretty much nonsense to anyone following this closely.

(On related notes, go read Karthik here and @stwill1 here and of course there’s my Tumblr chock full of China stuff and links. Also before I bore you the RBA had a nice, accessible summary last November and the BIS last September.)

So a few figures to start to put things in context:

1. Since the peak in July 2014, China’s reserves have dropped by $735 bln to $3.23 trln — obviously most of it recently, but an average decline of $38 bln per month
2. Our Reuters/Buzz rough (very rough but reflective of other estimates) “hot money” estimate of hot money flows, largely based on net bank/PBOC FX flows, total up to $1.3 trln and first turned negative in June 2014

Two things jump out. First, the drop in reserves is about half most estimates of hot money outflows. Second, the turn happened at the same time in mid-2014, a few months after the PBOC’s crackdown and unwillingness to tolerate more speculation leading to CNY strength. Wait, what did I just say? That’s right, back in 2014 the PBOC actively jacked up the USD/CNY fix to squeeze speculators (craziest being those buying TARNs/TARFs in HK, Taiwan and S.Korea that added to the volatility of USD/CNY’s reversal higher in 2014) betting on a STRONGER CNY.

Times have clearly changed. But we can see how the “hot money” proxies captured some but clearly not all of that change, or do so in an exaggerated fashion. At the same time, the decline in reserves is not purely about hot money. As seen in the BIS data, there are signs of Chinese banks and corporations cutting down their foreign debt exposure via debt/loans while also building up FX deposits (more below). Also remember that reserves are in USD and thus impacted by valuation changes, especially the roughly 25–30% EUR portion. Thus about $250 bln of the reserve decline since mid-2014 could be explained by EUR’s drop, which occurred about the same time. Thus the real reserve decline is closer to something like $500 bln, excluding any FX forward liabilities that aren’t feeding into reserve accounting just yet.

Which is why I have my issues with the use of China’s balance of payments errors & omissions (chart corrected below from original), a favorite among many bearish analysts, as a guide for hot money outflows. The trend there has been mostly negative since 2007/08. I haven’t heard anyone declare China having a capital outflow problem this whole time. While it makes sense that flows not tied to recorded capital/investment/FDI/trade would show up here, something is definitely weird. Just compare it to the chart above and look at how erratic it has been with amounts smaller relative to some implied capital flow estimates. The magical return to absolute zero in Q4 2015 (perhaps to be properly updated later) adds to the confusion of what this data is supposed to tell us.

Which brings me to the cleaner view provided by China’s net FX flows data as reported by SAFE each month. Clearly there are big currency conversions and outflows happening. The data reflect how China’s banks and central bank are buying/selling FX on a net basis each month. This is really important. Remember the PBOC plays a huge role here: it basically absorbs (trade surplus/hot money) or releases (hot money) the net demand for FX from its reserves each month due to the nature of its monetary system and the FX controls (let alone other factors). That’s why bank reserve requirements have long been the main monetary policy tool: FX is soaked up, banks get CNY in return and RRRs are used to sterilize the monetary impact. The chart below also gives a much cleaner view of this process: how incoming FX was purchased by banks the the PBOC. Those inflows start to moderate on a net basis in 2012, but it wasn’t until 2015 when things turned really ugly. Moving towards a more flexible FX regime should lead to more two-way capital flows, in theory a good thing. But in China’s case that very control over FX flows tied to reserves throws a spotlight on how messy the process can be. Impressively, this has not led to a tightening of domestic money market liquidity. The PBOC is leaning much more on medium-term liquidity injections (MLS facilities and others) that has taken care of that for now.

But on the FX debt part of the equation. The BIS data give some indication that China is cutting down its roughly $1 trln of FX debt, probably by pulling on FX reserves. So far this has mainly been via banks as in the charts below. Still, there does seem to be a concerted effort to take care of this. Thus some of the “outflows” are not purely capital fleeing, but banks/companies cutting the foreign debt exposure built up post-crisis. China’s biggest potential weakness is FX debt. The combination of falling claims on China (FX debt) and rising liabilities (likely China’s FX deposits) has totaled $665 bln since Q3 2014. So if those FX exposures are curtailed, China has many more options for dealing with its domestic debt problem and the reserve drain may not be a bad thing. Yes, China has a debt problem. But in a state-owned bank and mostly state-owned corporate system where the state-owned banks are as much fiscal agents as banks, this doesn’t lead directly to Minsky Moment-type situations. That’s for another blog.

Yet it’s also fairly clear that China’s trade channels remain a key source of money coming in and out of the country. China’s fake trade invoicing was a well-known way of concealing those hot money inflows described above, yet they have surged even in an environment where flows have turned the other way. China’s reported exports to Hong Kong in USD compared with Hong Kong’s reported “imports” from China in USD are a pretty good gauge. I am still waiting for some explanations for why this discrepancy is the same when net flows have turned both ways but haven’t heard any good reasons. Go read @stwill1 above for more details on what might be going on that contradict any suggestion this kind of invoicing is really responsible. But I think the onshore/offshore gateway via Hong Kong — long a plaything for companies doing arbitrage, especially now that Macau has been cracked down on as a locale for offshoring money — remains a huge part of the valve for shifting capital both ways that Beijing simply has a hard time keeping under control. Given the reports of the PBOC/SAFE clamping down on state-owned banks using onshore liquidity to lend to the CNH market as well as cutting off mainland companies from using CNH, at least until things settle down, it’s clear the onshore/offshore avenue remains an important one.

Thus, we can say: 1) outflows are sizable but exaggerated in reserves (Feb should be telling given EUR’s surge); 2) China paying down FX debt is part of the equation, so it’s not all hot capital flight; 3) China’s overall debt is a problem but mostly in its own currency, so it has more means of dealing with it than other EMs in the many well-known debt crises of the past 30–40 years. I’m still waiting for a good explanation of why China can’t monetize its local FX debt and not hobble households in the process. The implicit assumption is either inflation eroding real incomes or such depressed deposit returns that China’s consumers are in permanent hibernation. For which there is pretty much zero evidence. China’s debt problem was created by the misguided 2009 stimulus that I discussed in great detail over on Tumblr. Indeed, responding to its excesses is the very heart of the anti-corruption drive and much of what Xi has done in power! I’m not saying this will be an easy transition. I just don’t find the arguments of the traditional or new bears compelling. Again, for another blog.

Will the capital outflows undermine China’s strengths and its ability to achieve a more free-floating exchange rate? I don’t think so. It will be a very managed transition, even if it leads to a slightly weaker CNY (10–15%) and not the silly devaluation some high-profiled macrotourists are hoping for and even betting on USD/HKD of all things. Certainly the PBOC’s history of squeezing speculators suggest they will be the target first and foremost. A wider trading band for USD/CNY is very likely once the Shanghai Composite has stopped freaking out (see “cross-infection”) and the Shanghai Free Trade Zone is still being touted as a prime hub for cross-border investment flows, which many large foreign asset managers really shouldn’t ignore.

We have gone from a problem of too much CNY strength via hot money to one of the world freaking out about CNY weakness tied to capital outflows that seem fairly exaggerated. It’s time everyone take a deep breath and realize that if any command-ish economy can take care of itself, China’s in a pretty good position to manage this transition.