Credit Excess, Not Capital Outflow, is Beijing’s Real Enemy

Capital outflows from China have commanded wide attention in recent months, leading to market worries of an impending yuan depreciation that could trigger a round of competitive devaluations in Asia. After Beijing subjected overseas investments by both firms and households to tighter scrutiny in late 2016, the yuan-dollar exchange rate and China’s foreign exchange reserves stabilized. But despite these recent signs that Beijing may have staved off massive outflows by imposing stringent capital controls, this is likely to prove just a temporary reprieve.

That is because capital outflows reflect something more fundamental about the Chinese economy—and problems that need to be addressed to mitigate future volatility. Rather than becoming over-concerned about such outflows, Beijing should instead appreciate that they serve as leading indicators of pressures building up in the domestic economy. Indeed, China’s 2017 Q1 Balance of Payments (BOP) data suggests that the current state of calm has more to do with administrative restrictions on foreign investment than with any underlying improvement to China’s economic fundamentals. China’s overseas direct investment figures for the past quarter are the lowest since 2014 Q1, and more than 60% lower than Q1 2016.

When looking at the problem of outflows from China, it is important to first understand that capital flows are not especially meaningful in and of themselves. Rather, outflows are a natural occurrence in every economy that participates in the global economic system.

Still, a sudden rise in capital outflows has tended to correlate with some kind of illness in the domestic economy, at least when viewed through the prism of economic history. For China, it seems, capital outflows are increasingly driven by the private sector simply voting with their feet, betraying a lack of confidence in the domestic economy as these players shift from selling dollars to buying dollars. In other words, it is the nature of current Chinese capital outflows that are worrying rather than the mere fact of the outflows.

The following chart shows clearly that China’s foreign assets are increasingly held by China’s private sector. (In BOP, a positive number for foreign assets indicates a reduction in the holding of foreign assets.)

Figure 1. Changing Composition of China’s Foreign Investment (in $100 million)
Source: Quarterly BOP data, State Administration of Foreign Exchange.

Behind this shift lie a host of factors. These range from the relatively benign—such as the fact that the Chinese private sector previously owned relatively few foreign assets (in other words, a low-base effect)—to much more troubling factors, such as poor returns on domestic assets combined with concern about the safety of those assets. The sudden change in the Chinese private sector’s appetite for foreign assets suggests that what is happening now is more likely caused by a recent decline in the relative attractiveness of yuan assets, further bolstered by the fact that foreign investors are fleeing yuan assets as well.

The recent credit excess is responsible for the unattractiveness of yuan assets. Since medium- to long-term economic growth is largely independent of credit growth, a rapid credit buildup will reduce the inflation adjusted return on any financial asset.

China’s credit and debt growth has been a notable phenomenon of the past few years. And today, both Chinese and foreign investors have legitimate reasons to worry about the soundness of yuan assets. In a globalized world, investors can directly compare the valuation of domestic assets with that of foreign assets.

In my judgment, this is basically what’s happening in China today: because domestic assets look expensive when compared to foreign ones, capital is, quite naturally, moving to countries that offer more attractive returns. That means moving out of China. And so China’s recent capital outflows are primarily the result of credit excess that has distorted asset prices. As domestic credit tightens, the valuation of domestic assets should also fall back to a more reasonable level and, I presume, attract investors again.

That points to a central policy dilemma: rather than tackling the underlying problem of easy credit, Beijing has instead chosen to impose tighter controls to stem capital outflows. That is a mistake. These measures may seem to have been effective in stabilizing outflows, at least for the moment, but now that Beijing has bought time to more ably manage the economy, it can use this ability for either progressive or regressive ends. In other words, it can tackle the vulnerabilities within its financial system and clean it up, or it can punt by taking this newfound stability for granted, sustaining China’s financial repression, and continuing to misallocate credit for a longer period.

Unless Beijing chooses the former option, capital outflow pressure will not recede and will surely return, perhaps even with more ferocity that inflicts greater damage. Trying to achieve financial stability by restricting capital outflows will ultimately prove self-defeating.

In some sense, capital outflows are to any financial system what a pressure valve is to a boiler—a means to release excessive pressure to avoid an explosion; without turning off the heat, the boiler will eventually overflow. Chinese policymakers should, in fact, appreciate that capital outflows are a symptom of the underlying fragility and health of the financial system.

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