photo: David Dennis
China’s capital outflow last year is estimated to have totaled $1 trillion. Money has been channeled out of China in various ways, including individuals carrying cash, the purchase of foreign assets, the alteration of trade invoices and other more indirect ways. The monetary exodus has pushed the exchange rate down despite a trade surplus, and raised questions about public confidence in the government’s ability to manage the economy. Moreover, the changes in the composition of China’s external assets and liabilities in recent years will further weaken its economy.
Before the global financial crisis, China had an external balance sheet that, like many other emerging market economies, consisted largely of assets held in the form of foreign debt—including U.S. Treasury bonds—and liabilities issued in the form of equity, primarily foreign direct investment, and denominated in the domestic currency. This composition, known as “long debt, short equity,” was costly, as the payout on the equity liabilities exceeded the return on the foreign debt. But there was an offsetting factor: in the event of an external crisis, the decline in the market value of the equity liabilities strengthened the balance sheet. Moreover, if there were an accompanying depreciation of the domestic currency, then the rise in the value of the foreign assets would further increase the value of the external balance sheet. and help stabilize the economy.
After the crisis, however, there was a change in the nature of China’s assets and liabilities. Chinese firms acquired stakes in foreign firms, while also investing in natural resources. The former were often in upper-income countries, and were undertaken to establish a position in those markets as much as earn profits. Many of these acquisitions now look much less attractive as the world economy shows little sign of a robust recovery, particularly in Europe.
Moreover, many of these acquisitions were financed with debt, including funds from foreign lenders denominated in dollars. Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated that Chinese borrowing in dollars, mostly in the form of bank loans, reached $1.1 trillion by 2014. The fall in the value of the renminbi raises the cost of this borrowing. Menzie Chinn points out that if the corporate sector’s foreign exchange assets are taken into account, then the net foreign exchange debt is a more manageable $793 billion. But not all the firms with dollar-denominated debt possess sufficient foreign assets to offset their liabilities.
Declines in the values of the foreign assets purchased through Chinese outward FDI combined with an increase in the currency value of foreign-held debt pushes down the value of the Chinese external balance sheet. This comes at a time when the Chinese central bank is using its foreign exchange assets to slow the decline of the renminbi. The fall in reserves last year has been estimated to have reached $500 billion. Moreover, foreign firms and investors are cutting back on their acquisition of Chinese assets while repatriating money from their existing investments. China’s external position, therefore, is deteriorating, albeit from a strong base position.
Policymakers have a limited range of responses. They are tightening controls on the ability of households and companies to send money abroad, as the head of the central bank of Japan has urged. But controls on capital outflows are often seen as a sign of weakness, and do not inspire confidence. Raising interest rates to deter capital outflows would only further weaken the domestic economy, and may not work. Such moves would be particularly awkward to defend in the wake of the IMF’s inclusion of the Chinese currency in the basket of currencies that the IMF’s Special Drawing Rights are based on.
China’s remaining foreign exchange reserves and trade surplus allow policymakers some breathing room, as Menzie Chinn points out. The Chinese authorities retain a great deal of administrative control over financial transactions. As policy officials are shuffled around, those still in office seek to reassure investors that the economy remains in good shape. But injecting more credit into the economy does not alleviate concerns about mounting debt. The economic measures promised by the leadership are being judged in the financial markets, and the verdict to date seems to be one of little or no confidence.