China is deeply engaged with the global economy through trade links. While trade integration runs deep, China is minimally engaged on the broader globalization dimension of cross-border capital flows. It has been cautious in opening its financial account and concerned about domestic financial volatility and maintaining monetary policy autonomy. However, China has reached a development stage where financial account opening is critical for sustaining growth, increasing discipline and efficiency in financial intermediation, fostering transition to a new economic model, and ensuring the global competitiveness of Chinese companies. In its 2013 Third Plenum decisions, China pledged two-way opening of its capital markets and improved cross-border capital convertibility.
To gauge overall external financial liberalization progress, we sum the gross volumes of capital flows into and out of China on a quarterly basis and divide by gross domestic product (GDP) in the same quarter. This primary indicator of China’s degree of financial integration tells us how China’s opening to external capital flows is progressing compared to overall economic growth. We supplement this picture with other charts: the balance of cross-border capital flows by category plus net errors and omissions, the breakdown of inflows and outflows by type, the buying and selling of foreign exchange reserves by China’s central bank, the role of foreign buyers in total Chinese mergers and acquisitions, and the share of the Chinese currency in global payments.
Quarterly Assessment and Outlook
Our headline indicator makes clear that China’s financial globalization was on hold in 2Q2017. Faced with concerning levels of capital outflows, Beijing has tapped the brakes on more liberal policies for outbound investment. China’s new outward foreign direct investment (OFDI) regime is a clear step back in terms of external openness, and it shows that currently there is no confidence in letting companies and households act independently. At the same time, China has made efforts to encourage greater inflows of capital. The inward FDI regime was, at least on paper, overhauled significantly in the past 12 months, which could pave the way for a significant de facto change in foreign market access. China has also made incremental progress in opening financial markets to foreign investors, though the impact remains small. If these measures work as intended, our quantitative gauges will show it.
China’s decision to reimpose administrative controls on outbound investment raises concerns about China’s commitment to external financial liberalization. Advocates of sequencing domestic financial system reform before external opening appear in control for now. Backtracking on external opening entails long-term costs: capital controls and RMB convertibility restrictions damage renminbi internationalization goals, Chinese firms are disadvantaged in bidding for assets globally, Shanghai’s competitiveness as a financial center is hampered, important Chinese initiatives such as “Belt and Road” are undermined, and foreign appetite to put money into China is diminished.
Our primary indicator shows a significant first half 2017 drop in the ratio of cross-border capital flows to GDP.
Looking forward, we expect the current policy stance to persist. Recent stability can be attributed to capital controls plus temporarily favorable external factors, such as a weaker U.S. dollar. Conditions remain fragile and Beijing will be cautious on external reform. Once RMB or USD sentiment changes, or Chinese market participants find new channels for diversifying offshore, outflow pressures will increase again unless reform changes the fundamental outlook. We therefore expect formal and informal capital controls to remain in effect for the remainder of the year. As a result, the gross sum of cross-border capital flows will likely remain subdued, the financial account deficit for 2017 will likely come in lower than in previous years, and the composition of external capital flows will further shift to follow government preferences instead of market instincts.
This Quarter's Numbers
Our primary indicator shows a significant first half 2017 drop in the ratio of cross-border capital flows to GDP. Total cross-border capital flows reached USD296 billion in the fourth quarter of 2016, and the year to date (YTD) ratio of these flows to YTD GDP reached 9.1%, the highest since 1Q2015. In 1Q2017, combined external capital flows had dropped back to USD 146 billion, the lowest level in four years. In 2Q2017, combined cross-border flows nudged back up again to USD 192 billion, pushing up the degree of China’s external financial liberalization to around 6.1%.
As shown in Net Capital Flows the decline in aggregate capital flows was mainly driven by falling outflows. After a period of record capital outflows – driven by secular trends as well as exchange rate expectations and other short-term factors – outflows through all channels moderated markedly in 2Q2017. All three major types of capital flow were pretty much in balance, a stark contrast to 2015–16 patterns. The financial account deficit plus unexplained flows (net errors and omissions) narrowed from USD 161 billion in 4Q2016 to $21 billion in 1Q2017 and $19 billion in 2Q2017.
The biggest drop in outflows was recorded in the “other investment” account (see Breakdown of Cross-Border Financial Flows). This category captures lending, trade credit, and deposits and tends to move in tandem with exchange rate expectations. We attribute the sharp drop to reimposition of capital controls, as well as a weaker U.S. dollar that incentivized market participants to stop paying down U.S. dollar-denominated debt by switching their holdings from RMB to U.S. dollar assets. Outbound FDI dropped significantly in response to new policies by Beijing scrutinizing overseas investment, and regulatory action targeting large private outbound investors. Portfolio investment flows have also dropped, with outflows reaching the lowest level since 3Q2015 in 1Q2017 due mostly to reduced Chinese holding of foreign bonds but recovered again in 2Q2017.
Inward flows were stable or up compared to previous quarters. Inflows under the “other investment” and “portfolio” categories were driven by currency expectations, as well as some regulatory changes to attract foreign capital, such as the new Bond Connect schemes. Some increased inflows can also be explained by Beijing interventions. The strong uptick of FDI inflows in 4Q2016 was to a great extent attributable to year-end adjustments and altered regulation of foreign firm profit repatriation (non-repatriated earnings are counted as “inflows” under conventional balance-of-payments calculations). Since then, flows have dropped again to USD 33 billion in 1Q2017 and $22 billion in 2Q2017. The 2Q2017 figure represents the lowest quarterly level of inflows in seven years.
Thanks to a more balanced financial account, China was able to staunch the depletion of its foreign exchange reserves. Reserves held by China’s central bank fell from USD 4 trillion in June 2014 to less than $3 trillion in early 2017. Since February 2017, the drain slowed as the financial account turned positive. By the end of June, China’s official reserves had recovered to USD 3.1 trillion.
Policy Analysis: 2Q2017
In 2Q2017, China continued its policy-balancing act of limiting certain types of outflows while trying to stimulate inflows. On outflows, the most significant development was an intensified crackdown on OFDI. In June, the China Banking Regulatory Commission (CBRC) reportedly instructed banks to scrutinize OFDI loans made to several private investors, in an investigation of potential systemic risks. In August, the three main OFDI regulators, the National Development and Reform Commission (NDRC), the Ministry of Commerce (MOFCOM), and the People’s Bank of China’s State Administration of Foreign Exchange (SAFE) jointly announced a new regulatory regime for outward FDI, based on a system of encouraged, restricted, and prohibited sectors and codification of informal restrictions in place since 2016.
Regarding inflows, China has tried to keep up the momentum for further relaxing restrictions on inward FDI. In June, Beijing released a new Catalog on Foreign Investment (the national negative list) and a new Free Trade Zone (FTZ) negative list, which incrementally improved market access in several sectors. In July, President Xi Jinping called for further inward FDI opening, which was followed by a State Council announcement of relaxed restrictions in 12 additional sectors: special-use vehicles and new energy automobile manufacturing, ship design, regional and general aircraft repair and maintenance, international maritime transport, rail passenger transport, gas stations, Internet access service businesses, call centers, performance brokers, banking, securities, and insurance. However, the impact remains unclear as implementation details have yet to be released. In addition to FDI, Beijing also continues to promote additional foreign portfolio investment in debt and equity securities. In July, Beijing implemented a Bond Connect scheme to allow foreign purchases of Chinese bonds through Hong Kong (like the previous Stock Connect programs). In June, index-provider MSCI announced that it would gradually add Chinese stocks to its emerging market index, a move Beijing has encouraged.