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 deeply cautious in opening its financial accounts 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 the 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 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
China’s 2013 Third Plenum reform agenda recognized the importance of freer portfolio and direct investment flows in allocating resources efficiently and fostering new comparative advantages. The government specifically pledged to “promote the opening of the capital market in both directions” and to “raise the convertibility of cross-border capital.” To gauge Beijing’s progress, our primary indicator tracks the sum of China’s cross-border investment flows as a share of GDP. The indicator shows that investment openness is trending in the opposite direction: the ratio of cross-border capital flows to GDP was flat in the fourth quarter from the third and fell for the 2017 calendar year to 6.2%, down from 9.5% in 2016. This reflects Beijing’s prioritization of currency stability over liberalizing two-way investment flows and fulfilling its reform commitments. Despite a period of calm and a favorable global macroeconomic environment, tighter controls on cross-border capital flows remain in place as Beijing is concerned that it has not yet addressed the domestic problems that led to large-scale capital outflows in 2015 and 2016 or established a sustainable regime for managing China’s exchange rate. On the upside, China is promoting greater two-way portfolio investment flows but only through programs it can monitor and control.
Our policy outlook is mixed. There is a good chance that Beijing will make progress in liberalizing inbound investment channels in coming quarters. However, a return to more liberal outbound investment policies remains unlikely in the near term. On the inflow side, in the past six months Beijing set new expectations that it will implement far-reaching foreign direct investment (FDI) reforms, including the abolition of equity restrictions in the financial services sector – a promise that the People’s Bank of China (PBoC), China’s central bank, said this April would be achieved within three years. On the outflow side, China has gradually relaxed certain outflow restrictions imposed over the past 24 months (e.g., the relaxation of informal restrictions on outbound FDI resulted in a partial recovery of flows in that channel), but stability continues to be the top priority and the goals of promoting external financial liberalization and currency internationalization are on pause.
In the run-up to the inclusion for Chinese A-shares in the MSCI Emerging Markets equities index this June, China will have to convince foreign portfolio investors that it is committed to properly regulating capital markets and allowing the unrestricted repatriation of capital. This could be a catalyst for getting China back on track toward the more meaningful liberalizations promised in the 2013 Third Plenum Decisions. The bigger potential pickup in foreign inflows would result from China’s inclusion into global bond indices, a process which is just starting with the admission of Chinese government bonds into the Bloomberg Barclays Global Aggregate Index scheduled for April 2019. However, the persistence of these flows will require additional confidence in the stability of China’s balance of payments and reduced foreign investor apprehension about the potential for a re-imposition of capital controls.
Beijing set new expectations that it will implement far-reaching foreign direct investment reforms, including the abolition of equity restrictions in the financial services sector.
This Quarter's Numbers
To measure Beijing’s progress in fulfilling its 2013 Third Plenum reform commitments on investment and trade, we track gross cross-border capital inflows as a ratio to GDP. That ratio was flat in 4Q2017 at 6.16%. For the full year 2017, China’s gross cross-border capital flows totaled $755 billion, a drop of 29% compared to 2016. The ratio of total cross-border capital flows to GDP therefore fell to 6.2% for the year, compared to 9.5% in 2016. These numbers show that policy heavily suppresses market-based cross-capital flows. Despite a period of calm, Beijing continues to limit outflows through various foreign exchange policies, as well as informal tactics (including a public campaign to crack down on aggressive private outbound investors).
As in previous quarters, the financial account balance remained positive in 4Q2017 (see Net Capital Flows), but unexplained outflows (net errors and omissions) increased and balanced out those inflows, keeping China’s net capital flows negative for the 15th consecutive quarter. Compared to 2015 and 2016, China’s external capital flows remain stable in the aggregate, but several data points from 4Q2017 illustrate the fragility of that status. The financial account surplus in 4Q2017 was largely driven by a seasonal adjustment of inward FDI. Without that extra boost, the financial account would have dipped back into negative territory. Moreover, several indicators suggest continuously high capital outflows through gray channels. Errors and omissions, usually a reliable indicator of the direction of speculative capital flows, totaled $221.9 billion in 2017 – almost the same level as in 2016 ($229.5 billion). Tourism-related outflows in the current account, which also serve as good proxies for gray capital outflows, continue to be high and expanding. In other words, outflow from Chinese residents persists, and if global macroeconomic conditions change, China could quickly find itself facing acute outflow pressure as it did in 2015 and 2016. As a result, Beijing remains reluctant to implement its promises of a more liberal outbound investment regime and instead prefers to stick with policies that tightly control outflows.
A Breakdown of Cross-Border Financial Flows illustrates two-way flows under each category. It shows that the big positive shift in the FDI balance was largely driven by greater FDI inflows, which mostly reflect a seasonal year-end adjustment that China’s statisticians make every year to include FDI that was previously unaccounted for. This jump in FDI is a seasonal anomaly and does not reflect bullishness by foreign investors due to reform momentum. Meanwhile, outbound FDI had fallen to a three-year low in 1Q2017 due to Beijing’s greater scrutiny of outbound capital flows, but it gradually recovered to $36.9 billion in 4Q2017 (which is the same level as in the second half of 2014). Flows under the “Other Investment” channel slowed down dramatically from previous levels as exchange rate expectations were stable. Portfolio investment activity was strong in both directions in 4Q2017, but flows largely balanced out, leaving only a small deficit. This shows that Beijing is trying to promote two-way portfolio investment through existing and new programs – which does not represent full-blown liberalization but is still a positive step since it allows expansion of market-driven flows within controlled parameters.
China continued to add to its Reserves in 4Q2017, as the combined financial and current account surplus remained larger than unexplained outflows. Total reserves reached $3.14 trillion at the end of 2017 and slightly increased to $3.143 trillion by the end of March, although official indicators show limited PBoC intervention in the foreign exchange market throughout 2017. The Share of Foreign Buyers in Total Chinese M&A Activity remained stable compared to the previous quarter at 11%. This is a result of investment barriers for foreign capital and also the inability of Chinese investors to transfer money overseas, which drives up domestic asset prices so high that they become unattractive to foreign buyers. Finally, Beijing’s 2013 Third Plenum Decisions committed explicitly to accelerating the realization of renminbi (RMB) convertibility. This should advance the currency’s international use, which we track in our supplemental indicators. After reaching a peak of 2.5% in 3Q2015, the Global Use of China’s Currency dropped in recent quarters to a three-year low of 1.6% in 4Q2017.
Beijing’s policy approach for cross-border capital and investment policy continues to be driven by the primary goals of limiting and managing outflows and expanding and gradually diversifying channels for inflows. In other words, the government’s approach to reform remains incremental despite our data showing that 2013 Third Plenum commitments are unfulfilled.
For outflows, regulators focused on fine-tuning China’s new outbound FDI (OFDI) policy framework and addressing risks arising from the rapid expansion of over-leveraged private conglomerates. In February 2018, China’s insurance regulator took over the management of Anbang Insurance, as its chairman Wu Xiaohui was charged with economic crimes. Ye Jianming, chairman of CEFC, which is another active Chinese outbound investor, was also reportedly placed under investigation. Several of China’s largest and highly leveraged private outbound investors (Anbang, CEFC, HNA, Wanda) put up some of their overseas assets for sale in recent months after Beijing increased scrutiny of the companies. These high-profile cases illustrate the importance of reforming the domestic financial system and improving corporate governance for Beijing to be confident about Chinese firms’ overseas expansion and, ultimately, to make progress on its investment liberalization commitments.
On January 25 2018, the Ministry of Commerce (MOFCOM) issued comprehensive guidelines on foreign investment review, further clarifying instructions for and responsibilities among different agencies on overseeing OFDI approval and review. The guidelines stressed continued scrutiny on sensitive investments and investments of more than $300 million. In February, the National Development and Reform Commission (NDRC) published its first “Outbound Investment Sensitive Industries Catalog,” which includes sectors already outlined in earlier August 2017 regulations (real estate, hotels, movie theaters, entertainment, sports clubs, investment funds, or platforms without physical projects abroad), as well as three additional ones (military equipment development, production, and repair; cross-water water resources development and use; and news and media). In February, the China Insurance Regulatory Commission and the State Administration of Foreign Exchange (SAFE) jointly issued a notice on regulating nei bao wai dai (domestic guarantees for lending abroad) for insurance companies’ outbound investment. The regulations impose new qualifications and requirements for these loans and thus tighten financing under this channel.
Meanwhile, regulators seem more comfortable with portfolio investment outflows, though only under specifically designed schemes that utilize quotas and allow the government to monitor trends. In 2017, Chinese residents invested $40 billion in overseas securities through the Hong Kong Stock Connect and other programs (an increase of 45% from 2016), investment by domestic banks and financial institutions in overseas stocks and bonds reached $72 billion (up 27%), and investments through two schemes allowing domestic investors to invest abroad (QDII and RQDII) were $6.5 billion (up 18%). In February 2018, China revived the Qualified Domestic Limited Partnership (QDLP) program, a smaller outbound investment scheme. In April, SAFE announced that it is studying expanding the QDII scheme and reportedly began discussing a new issuance of quotas. SAFE did not approve any new quotas for three years as China battled large capital outflows.
For inflows, China’s immediate priority continues to be the reform of its traditional FDI regime. In 4Q2017 and 1Q2018, China made additional announcements but relatively little tangible progress on abolishing market access barriers. At the end of 2017, China announced that it would temporarily exempt foreign firms from taxes on profits reinvested in certain industries specified by Beijing, mostly in response to U.S. corporate tax reforms. The only other tangible progress was the further opening up of service sectors in the city of Beijing and regulatory changes to support a less restrictive investment regime in the country’s free trade zones. During the Bo’ao forum in April 2018, President Xi reiterated and announced further commitments to FDI opening, including promising to lift equity restrictions in financial services and suggesting China might also lift them for automotive manufacturing. The new PBoC governor Yi Gang announced that China will lift ownership restrictions on banks and financial asset management companies and allow foreign investors to take majority stakes in securities, fund management, futures, and life insurance companies “within months.” These policy changes are important and should create new channels for inbound investment if implemented faithfully.
Promoting portfolio investment inflows also remains on the agenda of Chinese policymakers. In 2017, inflows grew rapidly, partially because of new schemes to promote these flows. Inflows through the Hong Kong and Shenzhen Stock Connect programs jumped to $25 billion (2.6 times the 2016 value); foreign investment in the domestic bond market jumped to $57 billion (up 53% from 2016), $13 billion of which came in through the new Bond Connect. As mentioned previously, in 1Q2018 it was announced that Chinese bonds would be added to the Bloomberg Barclays Global Aggregate Index in 2019, which should raise foreign investors’ demand for domestic bonds. The inclusion of China’s A-shares in the MSCI Emerging Markets Index this June will be another important test-case, though initial inflows are expected to be modest. No other concrete policies were implemented in 4Q2017 and 1Q2018.