China’s balance of payments deficit in the second quarter was its first such deficit since 1998, and it attracted a lot of attention. Together with other bits of data about currency flows, it heightened fears about whether there was some kind of capital flight out of the country, and what it would mean for domestic monetary policy just as the economy became slightly stretched — but still somewhat inflationary.
But it’s not so bad, Societe Generale’s Wei Yao says. Yao looked through the details of the State Administration of Foreign Exchange data from Q2 and reckons most of it can be explained by fairly normal changes associated with the authorities’ tentative steps towards renminbi internationalisation: namely, an increase in private foreign currency deposits (as opposed to the official reserves), and credits to foreigners on domestic banks’ balance sheets.
(Though, it’s worth pointing out that the problem with the internationalisation explanation is that it’s hard to know which came first. Attempts to internationalise the yuan or the outflows and yuan weakness itself? And how sincere are the internationalisation efforts anyway?)
Yao concedes the outflows pose challenges to domestic liquidity management — but the scale of the change is small and most of it can be explained by motives other than panicked capital flight. She writes that of the seven items in the BoP accounts that recorded outflows of more than $10bn, most don’t appear to signal “panic outflows”:
Under the current account (CA), the service trade deficit widened to USD22bn – the largest quarterly deficit ever, and income turned to a loss of USD15.6bn, probably due to the poor investment performance of global financial markets in Q2.
Under the financial account (FA), outward direct investment was USD13.3bn in Q2, down marginally from USD14.8bn in Q1. Bigger outflows occurred in the three items under the subcategory “Other Investment Assets” –trade credit (USD33.6bn), loans (USD25.1bn) as well as currency and deposits (USD63.9bn). The four outflow items added up to USD136bn, negating the USD94bn inflows under other FA accounts and resulting in the USD42bn FA deficit.
Outflows recorded in the “trade credit” and “loans” subcategories are probably okay, because:
Any negative reading of asset items indicates an increase in China’s external assets. Hence, the negative reading of trade credit claims/assets occurs as the direct extension of credit by Chinese suppliers for international transactions in goods and services is rising. Similarly, the negative reading of loan assets means that net lending to non-residents by Chinese financial institutions is increasing.
And as for the other financial account item, “currency and deposits”, which recorded a $63.9bn outflow? Wao says that is because the People’s Bank of China has been encouraging the private sector to accumulate and manage their own FX reserves for some time — and now it looks like they are. Here are a couple of possible scenarios:
First, if a Chinese corporate purchases some US dollars with yuan from the central bank (through a domestic commercial bank) and deposits the dollars in China’s banking system, this transaction does not affect the BoP.
Second, a Chinese exporter earns some US dollars by selling goods to foreigners and then deposits the proceeds with a Chinese bank, instead of converting to yuan as before. The bank either lends the money overseas or utilised it in some other ways, and so it becomes FA outflows in the form of an increase in other investment assets.
In fact, she writes, the large increase in “currency and deposits” outflow was roughly matched by a similar increase in Chinese banks’ foreign currency assets — an expansion which exceeded the banks’ domestic and foreign FX lending.
Another point Yao makes is that portfolio liabilities rose ($8.7bn in Q2, up from $5.9bn in Q1 and compared to the total of $13.4bn for 2011), which she says suggests foreigners are still investing in China’s financial markets.
But how long will this last?
From Reuters’ report today on how regulators in China have ramped up approvals for foreign investors of late:
“The worry is that foreign investors — many of them concerned over health of China’s economy — are not actively applying for quota to invest in the Chinese market,” said an official familiar with the issue, who declined to give his name because he is not authorized to speak to the media.
In an unusual move by the Chinese government, officials from the Shanghai and Shenzhen stock exchanges, accompanied by domestic fund managers, custodian banks and brokerages, embarked on a global tour earlier this month aimed at winning overseas investors for Chinese assets, according to three sources familiar with the plan.
Portfolio flows are just one part of the BoP picture. Yet, while it’s interesting, we’re not sure Yao’s dive into the BoP details negates concerns about what the BoP change might signify. For example, another BoP item she notes is that “net errors and omissions”, which she describes as usually representing “a most opaque account under which skilful hot money sneaks in and out of China” . This item showed historically large outflows over the first half of this year, equivalent to 0.8 per cent of GDP; the second-highest since 2000 (the highest being H1 of 2009, which was equivalent to 2 per cent of GDP).
Hence, it was slightly alarming, but, certainly, far from disastrous, given China’s USD3.3tn official FX reserves.
That’s a problem, though — one can’t assume that the official FX reserves are a tool entirely at the PBoC’s disposal for increasing domestic liquidity because it can’t just go and sell off big chunks of its enormous holdings without risking market upheaval that would threaten its own balance sheet.
As Yao demonstrated in an earlier note, from May, the PBoC still appears to have a lot of leeway; because at that point it was sterilising such a large volume of capital inflows:
Which of course corresponds to the still-very-high required reserve ratio, or RRR, which has tended to be the PBoC’s first port of call for producing or reducing liquidity — and it doubles as a tool for sterilising the foreign currency inflows.
None of this changes the view we’ve had around here for a while: this is not a big problem right now, but it signals what might be the start of a problem. If the renminbi’s popularity continues to decline to the point that outflows grow, and while domestic inflationary pressures remain a challenge, the PBoC’s options will inevitably become more constrained. Sure, it is branching out into more traditional monetary mechanisms such as reverse repos, but without the option to sterilise foreign inflows, the central bank could eventually come up against some difficult choices.
At the end of the day, inflows are the core element around which Chinese central bank strategy and policy has been structured. If they stop, PBoC market operations have to be re-engineered on a more permanent basis.
China’s two-way liquidity risk: Capital outflows – FT AV
China investment quota granted to foreigners exceeds $30bn – Reuters
China’s ’1 per cent’ risk - FT Alphaville