Schroders’ Keith Wade ponders whether Chinese capital outflows are a sign of stress or structural change
Keith Wade, chief cconomist at Schroders, has said that while expectations are for capital outflows to reverse as Chinese data improve towards the end of 2012, the question remains whether the flows overall signal stress or structural change.
Some investors have become concerned about the implied portfolio outflows in China. This has been exacerbated by accounting identities and a structural shift in the economy, though fears over the Chinese economy have certainly led international investors to withdraw their capital. We expect these outflows to reverse as Chinese data improves towards year-end.
Chinese capital outflows: signs of stress, or a structural shift?
Since announcing that the second quarter delivered only the third capital account deficit since the end of 2008, investors’ minds have started to turn to the impact of capital outflows from China. In the past, even with a large current account surplus (predominantly net income from international trade), China has run a capital account surplus through its accumulation of foreign exchange reserve assets, such as US Treasury bonds (rather than the private sector using the money earned to purchase overseas assets). Does this reversal to a capital account deficit and fall in foreign exchange reserves reflect fears over the prospects for the Chinese economy, with both domestic residents and overseas investors reluctant to keep capital in China? What does this imply for the Renminbi? Or are other factors at play?
Foreign exchange reserves have fallen, but this is partially caused by the weakening euro
One measure of capital deployment by investors into China is the level of implied portfolio inflows, which has fallen sharply since the middle of last year. This is the difference between the change in foreign exchange reserves and the Chinese trade surplus, plus the net inflow of foreign direct investment (FDI), all measured in dollars. By definition, the strengthening of the dollar will reduce the value of foreign exchange reserves ceteris paribus (since the dollar value of dollar reserves is unchanged, but the dollar value of all other foreign currency reserves falls). Since a sizable portion of these foreign exchange reserves are likely to have been held in euros, which has declined sharply versus the dollar in the past twelve months, international exchange rates are at least partly to blame, with research by JP Morgan suggesting this could be worth at least $200 billion. Thus, some of these implied portfolio outflows are merely the result of an accounting identity, as opposed to any real effect caused by international capital withdrawal.
The Chinese private sector is choosing to hold more assets in foreign currency
Furthermore, the rate at which trade surpluses are converted into official foreign exchange reserves is decreasing as part of a structural shift in the economy. Generally, Chinese corporates and households receive the surplus from their international trading activities in a foreign currency (primarily dollars), which they then convert into Renminbi through the People’s Bank of China, who retain the foreign reserves. But as more households and corporates seek to hold some of their assets in foreign currency (either as a means of exchange or for investment purposes) the rate at which trade surpluses develop into accumulated reserves by the authorities will be reduced. This will be deemed a portfolio outflow by this metric, since official foreign exchange reserves are reduced, but reflects more the accounting measure of these flows than any real effect caused by international investors.
Though the reduced desire by the private sector to convert foreign currency from trade into Renminbi may reflect fears over the Chinese economy, it is reasonable to assume that a significant part of it simply reflects the changing preferences of a more outward-looking society; that desires, and can afford, to explore more of the world (i.e. holding foreign currency as a means of exchange). Indeed, this is part of the explanation given by the Chinese State Administration of Foreign Exchange (SAFE), though it is unlikely that such a dramatic reversal in flows could be solely caused by a medium-term secular shift.
Overseas investment in the property sector has been declining, but we expect this to reverse
Therefore, it is true that at least some of these outflows are due to fears over a Chinese hard landing and the repatriation of capital by overseas investors. We can see that some of the reversal in flows has come about as a result of reduced investment in the property sector from overseas. We have seen improvement in the property sector data recently (albeit the latest print was slightly disappointing), with both prices stabilising and sales volumes improving. Given that the latter tends to lead housing starts, the improvement in sales volumes suggests that the fall in investment in real estate development, including from overseas, may be about to reverse.
Although a slowdown is inevitable, a hard landing in China is an unlikely outcome
Our belief has long been that although a slowdown was inevitable, a hard landing in China was an unlikely outcome, with monetary easing measures being implemented and further policy armoury available if needed. Recent data, which generally suggested an improving picture in September, seemed to justify this position. Though Wednesday’s flash PMI remained below the 50 mark separating expansion and contraction, it continued to improve (49.1 from 47.9). Moreover, the subcomponents with the greatest leading tendencies are all suggesting stronger activity in October, with new orders and new export orders rising and inventories falling sharply, and we expect this strengthening to continue throughout the fourth quarter.
This recent improvement in Chinese data and global sentiment, as well as a halt to the euro’s slide, is likely to be the reason that the portfolio outflows tentatively appear to have stabilised. We expect the reduced fear of a hard landing to drive investors into the Chinese market in search of more attractive growth prospects, reversing the capital outflows we have seen. Furthermore, we believe the more encouraging price and sales volume data coming out of the Chinese property sector recently will lead to further foreign investment flows into this sector, reversing the declines we have seen for much of 2012.
Over a longer-term horizon, the structural decline in the conversion rate of trade surpluses into official foreign exchange reserves is a welcome development for the global economy, as private Chinese capital is deployed more productively across the globe. The US Treasury market, however, may not be so thankful.