Strict outflow controls have helped maintain China's financial stability. But they risk undermining their own utility by keeping funds in the country, driving investors into risky sectors and creating an excuse to postpone overdue reforms in the financial sector.
Years of cheap money and loan-fuelled speculative investments have left China with a knot of problems that is all but impossible to untangle. Time is running out to put the financial system on a more solid footing. Tight capital controls have so far helped to maintain financial stability. But they come at a high cost and do not address the underlying problems.
China remained largely unaffected by the Asian Financial Crisis, which ravaged countries such as Malaysia and Thailand in the late1990s. The plight of others did, however, teach China an important lesson: uncurbed capital flight can cause deep and damaging financial crises. To avoid a crisis of its own, China has erected ever higher walls to keep money from leaving the country.
Between 2014 and 2016, doubts about China’s growth prospects led to capital flight. This forced the central bank, the People’s Bank of China (PBoC), to defend the exchange rate. The bank spent a quarter of its foreign exchange reserves, almost $1tn, to keep the renminbi from depreciating. If the reserves decline below a safe level, the PBoC will be forced to raise domestic interest rates to attract foreign capital and to keep investors from leaving.
Raising interest rates would be a high-risk game
But raising interest rates would be a high-risk game in China. In the years following the 2008 global financial crisis, a large portion of China’s economic growth has been generated by the inflation of asset prices, which in turn was largely driven by loan-fuelled speculative investments by small banks and non-bank financial institutions. Like consumers who pay off the debt on one credit card with another credit card, these players borrow to cover interest payments when investments fail to perform. If interest rates were to increase, refinancing costs could become too high to bear. Firms engaging in extensive rollovers would then be forced to sell assets to make interest payments. A mass sale of assets could bring the entire financial system under severe pressure.
The amount of GDP generated by one unit of credit has steadily declined in China over the past decade — from 1.27 in 2005 to 0.33. This suggests credit is not being put to productive use. During the same period, the level of overnight lending increased. In 2005, 46 per cent of all collateralized repurchase agreements (a kind of loan) were issued overnight; that share has now risen to 85 per cent. Taken together, these two developments indicate that a significant amount of refinancing of existing debt, so-called evergreening of loans, is taking place.
Seeing the risk to financial stability which interest rate hikes represent, Chinese regulators instead introduced stricter restrictions to limit capital outflow and to ensure that capital is invested domestically. Some examples of such outflow controls are strict limits on the amount of money that can be transferred to overseas accounts; higher scrutiny of Chinese companies that wish to acquire assets overseas; or the installation of facial recognition software in ATMs in places frequented by mainland Chinese such as Macau (the PBoC is also considering introducing this system in Hong Kong).
The combination of a weak US dollar and stricter capital controls has been effective at stopping the flight of capital from China. As a result, the renminbi has rallied against the US dollar. In mid-October, the Rmb-USD exchange rate stood at 6.59, which means that the renminbi has appreciated by 5.3 per cent since the beginning of 2017. China’s foreign exchange reserves have increased for the first time since August 2014.
Capital controls undermine their own utility
However, capital controls risk undermining their own utility. Outflow control measures are introduced to ensure that capital flows are either balanced or that more capital flows into the country than leaves it. But strict outflow controls complicate the repatriation of profits for foreign investors. Ironically, this can negatively affect flows into the country. Moreover, Chinese investors’ limited investment options result in capital pooling in certain sectors, causing bubbles to form. When restricted from access to foreign markets, investors will look for high returns within the country. The likelihood of this capital finding its way into the already overheated real estate market or other bubbles is high.
Finally, capital controls severely limit personal freedom. This causes difficulties for ordinary Chinese wanting to accomplish such mundane tasks as paying their children’s tuition fees at foreign universities, buying an apartment abroad or simply shopping while on vacation.
The recent adoption of stricter capital controls will be able to buy the government some time to crack down on rollovers in the interbank markets. Financial institutions must be made to understand that borrowing overnight to invest is risky. More importantly the institutions must be forced to take sole responsibility for the risk they take on instead of counting on state bailouts. If the government were to allow some amount of corporate defaults, this would go a long way to discourage excessive risk taking in the domestic markets. Ahead of important political events such as the 100th anniversary of the CCP in 2021, it is unlikely that anything disruptive will be allowed to happen within the next few years. But when the parades, speeches and fireworks are over, China’s leaders will have some house cleaning ahead of them.
This article was first published on the Financial Times' beyondbrics blog on November 10, 2017.