International Capital Flows: China's Tightrope Exercise

Since 2015, China has suffered persistent capital outflows. The risks associated with them should not be underestimated. For months, foreign exchange reserves accumulated massively by the People’s Bank of China, the country's central bank, have been declining. So much so that the Chinese authorities recently announced a strengthening of measures introduced to curb these flows. These measures are multidimensional: constraints on the profits that Chinese companies would be tempted to retain abroad; conditions imposed on repatriation of profits by foreign companies; macroprudential criteria on outflows of foreign direct investment; restrictions on bank loans to foreign banks, in foreign currency as well as in renminbi.

This active and multidimensional management of financial flows also pursues the objective of reducing financial under-reporting and curb unlawful financial activities. Nowadays, the balance of payments data suggest that there is a "hole" between trade flows and international capital flows traditionally thought as a mirror to the former. These past years, it has not been uncommon to register a quarterly "gap" of USD 80 billion to USD 100 billion between them!

But the government's efforts to curb capital flows respond to a more compelling reason: the erosion of the country's foreign exchange reserves. Certainly, China is known to have accumulated considerable foreign exchange reserves over the last decade, bringing the country into the lead among external creditors the United States. The stock of Chinese foreign exchange reserves even exceeded the threshold of USD 4000 billion. However, despite the interventionist stance adopted by authoirities in the foreign exchange market, the capital account registers a worrying erosion of reserves: between 2014 and 2015, not far from USD 1,000 billion of reserves have evaporated. While this pace has slowed, this slowdown will probably not be enough for the central bank to sleep on both ears.

Capital flight and reserve erosion are tough constraints for the Chinese authorities at a time of steep change in the US tax and international trade policies. If the US administration were to implement the announced extreme turnaround in many economic policies, the Dollar would appreciate while the Renminbi and many other emerging currencies would depreciate. The recent depreciation of the Mexican peso shows the way.

The economic policy equation is infinitely complex for China today. But this also gives China an important lever in geopolitics. So far, China has managed this unstable equilibrium by pulling on several strings - exchange rate fixing, capital controls, forex interventions. But would authorities be willing to go beyond if needs be? It is worth a thought.

For instance, China could raise its voice as a significant creditor of the United States. What would happen to the US "twin deficits" (fiscal and current account deficits) if China decided to reduce its dollar exposure, accentuating the currency effect of the dynamics of its foreign reserves? And what if the People's Bank of China twisted its portfolios away from dollar denominated assets? But we are not there (yet?). Professionals of debt restructuring would tell us that a large debtor has a lot of power over a large creditor.

From this to say that the United States would then threaten not to honor their external debt, there is a small step...but who would dare to imagine that the US sovereign could possibly fail on its debt? Are advanced countries not supposed to have "graduated" from sovereign debt crises? Everybody is well aware that the famous "Chapter 11" - the US bankruptcy procedure so admired worldwide for its effectiveness in solving insolvency problems in the private sector - is not a framework applicable to sovereigns. So let us forget this so, totally, unrealistic scenario!

Views expressed in this blog are the author’s own.

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