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
Our assessment this quarter of cross-border investment reform is neutral, the same as last quarter. 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 cross-border investment intensity stagnated at low levels throughout 2017 but slightly recovered in 2018 (to 7.8% in 1Q2018 from an average of 6% in the previous four quarters). This increase is at least partially attributable to Beijing’s efforts to promote the inflow of portfolio and direct investment. However, the value of cross-border flows in relation to GDP remains far below levels of just two years ago.
The increase of capital inflows can be partially attributed to liberalization measures in the portfolio and direct investment channels. In 1Q2018, Beijing implemented additional foreign direct investment (FDI) liberalization measures, including accelerating the opening up of the financial sector and automotive manufacturing and releasing a new set of national and free trade zone (FTZ) negative lists which explicitly ban or curtail investments in certain sectors while leaving all others open. Outward capital flows have remained uncharacteristically stable for the past quarters at between $70 and $80 billion per quarter, almost as if there were a “ceiling” on outflows. In 1Q2018, China maintained its tight regime restricting outward FDI, but it has reinstated several pilot schemes for outbound portfolio investment in recent months.
Looking forward, the macroeconomic situation may force China to double down on its efforts to promote inflows and control outflows. China’s currency has come under pressure as it faces a strong dollar, and Beijing is easing monetary policy to generate growth. The RMB lost 6.25% against the dollar from June 13 to July 26 and further downward pressure can be expected as trade frictions heat up. We therefore expect China to keep tight controls on outward flows or even increase restraints further. On the inflow side, China will have to demonstrate that its FDI promises to open new sectors to freer investment are real by allowing landmark projects to happen. For example, Tesla recently revealed plans for a wholly owned factory in Shanghai, and JPMorgan Chase established a new joint venture in which it will own a controlling share of 51% (up from a previous cap of 49%).
The macroeconomic situation may force China to double down on its efforts to promote inflows and control outflows.
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 Investment Flows as a ratio to GDP. That ratio ticked up to 7.8% in 1Q2018 from an average of 6% in the previous four quarters. Gross cross-border capital flows (inflows plus outflows) reached $244 billion in 1Q2018, which is higher than last year’s quarterly average of $189 million and similar to the 2014–2016 quarterly average of $255 billion. While the volume of cross-border flows recovered to pre-2017 levels, the ratio of gross capital flows to GDP remained below that period’s average of 9%. In other words, total cross-border capital flows are moving back in the right direction, but they are still below the intensity of two years ago and far below where they should be under a reform scenario.
The increase in cross-border investment was mostly driven by strong growth of foreign investment into China while outflows remain flat – and both of those trends are intimately tied to government policy. In 1Q2018, China’s financial account recorded the highest net positive since 4Q2013 ($99 billion) with all three components (FDI, portfolio investment, and other investment) in positive territory. Even with $38 billion in unexplained outflows (net errors and omissions), China still registered net positive inflows of $60 billion for the first time in 15 quarters (see Net Capital Flows).
A breakdown of Cross-Border Financial Flows shows that this divergence between inflows and outflows applies to all three major types of capital flows. FDI outflows decreased from last quarter and remained low at $18 billion, compared to a peak of more than $50 billion per quarter during the 2016 boom, confirming that Beijing’s restrictions on outbound FDI are still largely in place. FDI inflows on the other hand were surprisingly large at $73 billion, the highest first quarter number since 2011. It is possible that some of this increase is driven by Beijing’s push to reduce barriers on foreign investment. However, alternative data points on inward FDI from China’s Ministry of Commerce do not show the same strong growth patterns ($34.5 billion in 1Q2018, up 2% from the same period in 2017), which suggests that financial flows within the FDI channel are to a great extent responsible for the observed inflow increase. A further breakdown of FDI into its components shows that intra-company debt-related inflows totaled $23.2 billion in 1Q2018, the highest level in history. This suggests that companies borrowed in foreign currency from their offshore subsidiaries under the FDI account (reflecting expectations of a weakening U.S. dollar).
Portfolio investment flows were a bit more balanced at $44 billion of inflows (the second highest quarter ever) and $33.5 billion of outflows, a slight decrease from the previous quarter. Both reflect changes in debt holdings – foreigners purchased additional Chinese bonds and Chinese investors lowered their foreign bond holdings. The continued expansion of two-way portfolio investment flows results from a string of reforms to further open up cross-border securities investment (see the Policy Analysis section below). Under the Other Investment account, outflows remained low at $21 billion in 1H2018, compared to a peak of more than $100 billion in 2H2016. Inflows were high at $54 billion, similar to levels in 1H2017.
With net financial inflows, China continued to add to its Foreign Exchange Reserves in 1Q2018. Quarterly buying of reserves under the balance of payments was $26.6 billion. However, this additional buying does not show up in data on total reserves held by the People’s Bank of China (PBoC) (total reserves only increased by $2.9 billion in 1Q2018), which suggests that reserve growth was primarily driven by interest income on existing PBoC reserves, rather than new intervention to buy foreign exchange. This is consistent with more market determination of the exchange rate and the overall direction of 2013 Third Plenum reform pledges, but questions remain about the extent of the PBoC’s withdrawal from the market, either directly or indirectly, via instructions to state banks.
The Share of Foreign Buyers in Total Chinese M&A Activity – which we monitor as an indicator for openness to foreign acquisitions – slightly increased to 13.6%. However, this increase may only be temporary, since it is largely driven by a decline in the total number of transactions in the Chinese market (to 544 from 825).
Finally, Beijing’s 2013 Third Plenum Decisions committed explicitly to accelerating the realization of 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 Globalization of China’s Currency dropped in recent quarters to a three-year low of 1.6% in 4Q2017 and remained at 1.6% in 1H2018. The RMB’s share in global transactions edged up to 1.77% in April and May 2018.
The latest data points confirm that Beijing’s policy approach to external capital flows continues to be focused on controlling outflows while gradually expanding and diversifying channels for inflows. In other words, liberalization is happening but very gradually and mostly on the inbound side.
With regard to outflows, Beijing has not announced any major changes in its tighter regime for outbound direct investment but has made a few symbolic changes to allow greater outbound portfolio investment. In April 2018, it began to reissue quotas for the Qualified Domestic Institutional Investor (QDII) scheme and issued more than $23 billion of new quotas by June. On April 24, the State Administration of Foreign Exchange (SAFE) followed up with another notice on pushing forward the Qualified Domestic Limited Partners (QDLP) and Qualified Domestic Investment Enterprises (QDIE) schemes, two programs that go further than the QDII scheme to allow broader types of domestic players to invest abroad. After being virtually suspended since 2015 (no new quota has been granted for more than two years), SAFE implemented two pilots in Shanghai and Shenzhen and increased the quota to $5 billion. On May 4, PBoC also reopened an RMB-denominated QDII scheme (R-QDII), at the same time underscoring that investors cannot use this channel for purchasing foreign exchange abroad. Overall China maintains a tight grip over the various outbound channels to ensure that the amount of capital outflow can be controlled.
On the inbound side, China continued with bolder reforms of the FDI regime in 1Q and 2Q2018. After announcements to lift several types of equity caps in the financial services industry, in April 2018 China announced a similar reform for the auto sector. Specifically, it will remove foreign ownership caps for the manufacturing of fully electric and plug-in hybrid vehicles in 2018, for the manufacturing of commercial vehicles in 2020, and for the manufacturing of all automobiles by 2022. On June 15, the State Council released another comprehensive directive on promoting foreign investment (after the first one in December 2016 and another one in March 2017). The document pledges additional opening up in the services sectors (transportation, logistics, and professional services) and in the agriculture, mining, and manufacturing sectors (specifically seeds, coal, and nonmetallic minerals mining; automotive, ship, and airplane manufacturing). China also pledged additional opening up in the FTZs in the telecom, culture, and tourism sectors. In addition, the document announced a range of administrative streamlining (for example, projects less than $1 billion not on the FTZ Negative List can be approved at the local level) and supportive policies (in foreign exchange conversion, tax, financing, personnel visas, etc.). On June 28, China followed up on these promises by releasing a new national Negative List and a new FTZ Negative List. Compared to previous iterations, the new negative lists include bolder reforms and opening up in long-awaited sectors, such as automotive manufacturing and financial services. The latest State Council directive also includes items (on intellectual property rights protection and repatriation, for example) that could improve the environment for foreign investment if implemented faithfully.
On portfolio investment, the aforementioned June State Council directive promised further refinement of the QFII and R-QFII rules as well. On June 15, SAFE issued foreign exchange management regulations on inward portfolio investment under the QFII scheme. PBoC also jointly issued a notice with SAFE for improving management of QFII and R-QFII. Regulators scrapped the restriction on QFII investors to repatriate no more than 20% of their total assets in China each month, abolished the three-month lockup period for investment principals for both QFII and R-QFII, and has now allowed investors in the two programs to hedge their foreign exchange exposure in the onshore market. On July 8, the China Securities Regulatory Commission (CSRC) announced that a draft policy to allow foreign investors to directly open accounts to trade on the A-shares market received State Council approval. This new policy would allow some foreigners working in China and overseas employees of A-shares–listed companies to trade in this market. These moves are encouraging to foreign investors and help improve their liquidity issues, but they do not impact the overall scale of foreign portfolio investment in China, which is still limited to participants in these specific schemes and programs.