Some market participants anticipate that the Chinese authorities soon will devalue the renminbi by a large amount or that market forces eventually will force a similarly large depreciation. This narrative is based on several factors. First, China’s growth is slowing, perhaps by more than is revealed in the official headline numbers. Second, export growth turned negative in 2015 and continued to shrink on a year-over-year basis in the first two months of 2016. A large decline in the value of the renminbi, the argument goes, would give exports a shot in the arm and help offset domestic economic weakness. Third, China’s currency has appreciated by 55 percent in real terms against a weighted average of its trading partners’ currencies since mid-2005, when China first introduced flexibility in its exchange rate. The China bears argue that China’s currency is now overvalued and a correction is overdue. Fourth, China’s official foreign exchange reserves are both vastly overstated and falling rapidly because of capital flight that the authorities seem unable to stem. Thus, even if the authorities do not want to devalue, the market will force a capitulation.
This narrative has several fundamental flaws. Start with the exchange rate. Yes, the renminbi has appreciated significantly over the last decade, but that does not support the view that the currency is now overvalued and thus due for a sharp correction. China’s currency was massively undervalued in the mid-2000s and the cumulative real appreciation since then led the International Monetary Fund (IMF) to judge in 2015 that the exchange rate is at a level “that is no longer undervalued.” My colleague William Cline, in an earlier post in this series, reaches the same conclusion.
Moreover, there is not much evidence that renminbi appreciation has undermined China’s global competitive position. Yes, China has lost market share in recent years in some of the most labor-intensive commodities, such as footwear and garments, but it has successfully moved up the value chain into higher value-added products and, as a result, according to the World Trade Organization (WTO), its share of global exports measured in constant prices continued to expand through early 2015. In value terms in 2015 China’s share of global exports was 15 percent, up from 6 percent in 2004 (before the currency began to appreciate), and up from 4 percent in 2001, when it joined the WTO. Yet another indicator pointing in the same direction is that China’s current account surplus in 2015 was almost $300 billion, the largest of any nation (though not the largest as a share of GDP).
Another flaw in the “depreciation is inevitable” is that China is running out of foreign exchange reserves. According to Kyle Bass, a prominent hedge fund manager, China’s official reserves at the end of January this year were only $2.1 trillion to $2.2 trillion, not the advertised $3.2 trillion. Most of Bass’s downward adjustment to the value of China’s reported foreign exchange holdings is based on the assumption that a large part of these reserves has been allocated to China’s sovereign wealth fund, the China Investment Corporation (CIC), and to the recapitalization of the government’s three policy banks. This assumption is simply incorrect. Detailed analysis by UBS, conducted a half year before Bass’s claim, showed that the government’s use of foreign exchange reserves to fund CIC, to recapitalize policy banks, and other official initiatives was reflected in a reduction in headline foreign exchange reserves.
Even if the official reserve numbers are not overstated, aren’t the amounts falling rapidly and doesn’t this reflect “panicked mainlanders desperately seeking ways to get money out of the country”? The first thing to note is that a chunk of the decline in official foreign exchange reserves reflects valuation changes. China’s official foreign currency reserves include financial assets in a variety of currencies, but their value is reported in US dollars. Since the US dollar began to appreciate against these currencies (think euro, yen, sterling, etc.) starting in late 2011 and continuing until very recently, the value of these nondollar assets measured in dollars has been going down. In 2015 the headline decline in official foreign exchange reserves was $513 billion. But UBS estimates that $130 billion of this decline, or fully one-quarter, reflects this valuation effect rather than an actual outflow of reserves.
Second, a large part of the reduction of reserves reflects Chinese corporates repaying foreign currency debts and foreigners reversing carry trades—both primarily as a result of a change in exchange rate and interest rate expectations. Because interest rates were lower offshore, because of monetary policies of central banks in advanced economies, and because the renminbi had appreciated steadily against the US dollar from 2005 through 2013, a growing number of Chinese corporates borrowed money offshore and then converted the funds to renminbi needed in their onshore businesses. They saved on interest expenses and figured on additional gains when they converted renminbi to dollars at a more favorable rate in the future when the loans came due. As a result, the Bank for International Settlements reports that cross-border claims by foreign banks on Chinese counterparties resident in China reached a peak of $1.1 trillion at the end of the third quarter of 2014, roughly double the amount at the end of 2012. But once the expectation of these corporates that the renminbi would continue to appreciate eroded, and the possibility that the end of quantitative easing by the US Federal Reserve would be followed by rising interest rates offshore, Chinese corporates began to repay this debt. By the end of the third quarter of 2015 (the most recent data available), cross-border claims had fallen by $235 billion to $875 billion. This reduction is recorded as a capital outflow, but it should not be regarded as capital flight. Most importantly, repayment of this foreign debt leaves China’s net international financial position completely unchanged. The foreign currency assets of the central bank, which supplies the foreign exchange to the corporates in exchange for domestic currency, fall. But the foreign currency liabilities of the corporate sector are reduced by an identical amount. Attention in most press treatment of this topic is exclusively on the fall in the foreign exchange assets of the official sector; a completely offsetting decline in the foreign currency liabilities of Chinese corporates is not mentioned.
The same analysis applies to the so-called carry trades of foreign investors. They brought foreign currency into China and converted it to renminbi, in the process swelling China’s official foreign exchange reserves. They deposit the renminbi in bank accounts in China or buy renminbi-denominated bonds, which pay higher interest than bank deposits or bonds available offshore, and hope to benefit from the renminbi appreciation as well. As the expectations of these foreign investors began to change, with respect to both the continued appreciation of the renminbi and the favorable interest rate differential, they began to repatriate these funds. Again while this is recorded as a capital outflow, it should not be regarded as capital flight and has no effect on China’s net international investment position. The foreign currency assets of the central bank are reduced, as it supplies foreign currency to the investors in exchange for their renminbi, but the foreign liabilities of domestic banks are reduced by an identical amount.
How large a contribution to the reduction of China’s official reserves have these two types of transactions made? According to an estimate of Oxford Economics, repayment of foreign currency loans by Chinese corporates and the repatriation of foreign inflows in the third quarter of 2015 accounted for 53 percent of China’s net financial outflows, which were $228 billion after adjusting for valuation change.3 These flows are likely to diminish going forward because a growing portion of cross-border claims by foreign banks on Chinese counterparties has already been repaid and the stock of foreign financial capital in China available to repatriate is relatively small.
Another large chunk of outflows, about 31 percent of net financial outflows in 2015Q3, reflected higher foreign currency loans to foreign entities. These loans are extended primarily by China Development Bank, China’s main policy bank, or other state-owned banks, which acquire the foreign currency in the foreign exchange market with the funds coming from the central bank. These transactions too have no effect on China’s net international investment position. The central bank’s foreign exchange assets fall, but the foreign currency assets of domestic banks rise by a similar amount. A substantial share of these loans appears to be extended to advance China’s foreign policy objectives. The authorities can easily dial back the volume of these foreign currency loans should it be necessary.
The remaining source of outflows is primarily the increase in foreign deposits and foreign currency acquired by Chinese citizens and corporates and the overinvoicing of exports, which is usually reflected in errors and omissions in the balance of payments. These are more difficult to control, but if necessary the Chinese authorities could reduce or even suspend the right of every citizen to acquire $50,000 worth of foreign currency annually in exchange for renminbi.
In short, capital outflows are not as large as the headline numbers suggest, and a large share of these outflows reflects changes in exchange rate and interest rate expectations of Chinese corporates or foreign investors or the foreign policy objectives of the Chinese government, rather than a rush for the exits for fear of a hard landing. Reserves are large and highly liquid and continually replenished by large current account surpluses. And the authorities have ample tools to limit the sources of outflows that are not already largely self-limiting. Thus the likelihood that the Chinese authorities will devalue the renminbi or that market forces will force a large depreciation seems small.