Analysis: Spectre of capital flight slows China FX reform drive


Long-time China watchers probably felt a sense of deja vu when HSBC's chief China economist, Qu Hongbin, predicted last month that the yuan would be convertible within five years.

China has been thwarting such predictions since 1993, when it first formally adopted capital account convertibility as a long-term goal.

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Consummate China insider Fred Hu, who stepped down as Goldman Sachs' Greater China chairman in 2010 to launch a private equity fund, made a similar prediction in 2002, just before China's last political leadership transition.

Market watchers remain bullish on capital account loosening - pointing to positive signals from the central bank - but the importance the political leadership places on the country's foreign exchange reserves as a guarantor of economic stability remains a major obstacle.

Indeed, signs that outflows are accelerating have already provoked concern from policymakers.

"We shouldn't interpret capital account convertibility as a free currency, with cross-border asset transfers without control," People's Bank of China's (PBOC) Governor Zhou Xiaochuan told a forum in Hainan province on Monday.

"We will reserve the right to monitor and restrict capital flows in some sensitive areas," Zhou said.


Analysts say the central bank is the center of pro-reform sentiment in the government. But other policymakers still equate foreign reserves with national strength and may oppose any reform that would put the $3.3 trillion stockpile at risk.

To them, the FX reserves underpin confidence in the financial system, serving as a security blanket for both the government and financial markets.

Few believe China's banks are as healthy as they claim, while many local governments and state-owned enterprises are awash in debt.

But as long as investors and depositors believe Beijing could tap its foreign exchange reserves to fund a bailout, a run on banks or a credit crunch for local governments and state-owned enterprises is unlikely.

"Chinese households hold a huge amount of deposits," said Yu Yongding, a former member of the central bank's monetary policy committee. China has 84 trillion yuan ($13.45 trillion) in corporate and household bank deposits.

"If households want to diversify their holdings into foreign assets, say just 10 percent of their assets, capital outflow will become huge, which will lead to a fall of the (yuan) and then there will be panic and more outflows -- a herd effect," said Yu, who is now director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences (CASS).


There are signs that some money is already leaving China.

China's trade and foreign direct investment (FDI) surpluses totaled $181 billion in the six months ending October, official data shows.

But Chinese banks, including the central banks, purchased only about $32 billion in this period, while firms kept another $53 billion onshore without converting it to local currency.

With capital controls in place, the surpluses should have been roughly equal to the FX purchases and unconverted FX receipts.

Instead, this analysis, commonly used by analysts as a rough estimate of hot money flows, indicates approximately $95 billion that was meant to be in China moved overseas in the six-month period.

The outflows are striking given the yuan appreciated sharply from late July and the U.S. Federal Reserve launched a new round of quantitative easing in September. Both factors would normally draw hot money into China.

"Middle-income Chinese individuals are opening offshore bank accounts -- among 40 to 50 year olds there is a real undercurrent of fear," Jonathan Clifton, managing director of Offshore Incorporations Group, a consultancy that helps clients facilitate offshore investment, told a conference in London last month organized by the newsletter OffshoreAlert.


Even as China's economy boomed last decade, there were a gross $3.8 trillion of illicit outflows from 2000 to 2011, according to a study released in October by Global Financial Integrity, a Washington, D.C.-based research and advocacy group.

Yet such outflows went largely unnoticed because they were overwhelmed by the massive trade and foreign direct investment surpluses.

Those "twin surpluses" were the main factors that swelled China's FX reserves by an average $25 billion per month in the decade from 2002 to 2011.

But now those surpluses are shrinking, in what some analysts expect to be a long-term trend.

"In the context of narrowing surpluses on the current account and capital and financial accounts, we must shift from guarding against the risk of capital inflow to guarding against capital outflow," two officials from the PBOC wrote this week in China Finance, a magazine backed by the central bank.

Over the first nine months of 2012, reserves rose an average of $11.5 billion -- much of which would due to be interest on reserves already held rather than new inflows.

"By the middle of next year, China will tighten the capital account considerably," said Andy Xie, the former Morgan Stanley chief Asia-Pacific economist and well-known China analyst.

He added that lower trade surpluses in 2013 would spark concern among political leaders about capital outflows.


Still, optimism of an opening up persists.

"There are clear signs that China's new leaders, who will take power in early 2013, will make speeding up reform top of their policy agenda in the coming years," HSBC's Qu wrote.

There have been a steady drumbeat of statements this year from the central bank, including a widely noted report in February titled "Conditions are basically mature for China to speed up capital account opening".

Even former central bank governor Dai Xianglong, who spent much of the 1990s refusing to offer a timeline for capital account convertibility, said this year that significant progress could now be made within five years.

In March regulators increased the foreign debt quota for foreign banks, allowing them to bring in more capital. In April, authorities expanded the Qualified Foreign Institutional Investor (QFII), granting foreigners greater access to China's capital markets.

But far from a shift towards allowing households more freedom to invest overseas, these policies appear to be a continuation of China's long-standing approach to foreign capital flows, which some compare to the popular "roach motel" insect traps: money can check in, but it can't check out.

(Additional reporting by Sara Ledwith in LONDON; Editing by John Mair)