China’s Capital Deficit – Not to Worry


China recently reported capital outflows of $142 billion between April and June, continuing a trend that has worried analysts for months. The outflows reflect expectations of a weaker renminbi and increased firm holdings of foreign exchange reserves, and perhaps some concern over a weakening Chinese economy. In order to calm fears of potential crisis, authorities have commented that outflows are not a result of long-term capital flight but rather changing policies and expectations.

While capital outflows have been higher than usual, the foreign exchange deficit posted by commercial banks has shrunk from $91.4 billion in the first quarter of 2015 to $13.9 billion in the second quarter. The State Administration of Foreign Exchange has commented that current account surpluses and capital account deficits will become the “new normal” in China as the capital account continues to open.

Expectations that the US Federal Reserve will shortly raise interest rates present risks of capital outflows from China. Higher U.S. interest rates reduce global liquidity and raise competition among nations for investment, as the U.S. looks more attractive to global investors. Many Chinese investors will likely move funds abroad to the U.S. as more profitable opportunities arise overseas, while international borrowers of U.S. funds will face higher funding costs. When the interest rate hike will occur is unclear. The Federal Reserve leaked a document at the end of June that projected the benchmark interest rate would be raised to 0.35 percent on average in the fourth quarter. Federal Reserve officials are to meet next week, and while interest rate increases right now are possible, Fed Chair Janet Yellen has implied that rates would be raised toward the end of the year.

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Cross-border capital outflows are also being liberalized to some extent as part of China’s financial reform agenda. Financial funds can move out of China under the Qualified Domestic Institutional Investor scheme, the Qualified Domestic Individual Investor scheme, which is in the trial phase, and soon under the Qualified Domestic Retail Investor program. Foreign direct investment abroad is also growing rapidly as China seeks to build the One Belt, One Road program and continues overseas investment for the purposes of gaining resources, technology, and know-how. Capital controls continue to guard to some extent against excessive financial and direct capital outflows from China.

If capital flight were indeed taking place, chances are that this would also be reflected in “hot money” flows out of the country, since the capital account is not fully open. Some of the funds may be moved through remittance companies, which are visible, or through other means such as underground money houses, which are invisible in the capital or financial accounts, and viewable only in the errors and omissions category of the balance of payments. Net errors and omissions have been relatively large and negative from Q3 2014 through Q1 2015; Q2 2015 data is as of yet unavailable. Q1 2015 saw unaccounted-for outflows that weighed in at about $66 billion. This does not mean that hot money outflows are definitely occurring, but that this is a possibility.

Still, it appears that the scale of capital outflows, legitimate or illegitimate, do not present a real threat to financial stability. What is more, some volatility in the capital account can help Chinese officials to prepare the economy for greater shocks given further capital account liberalization. At present, the level of control over capital flows is relatively strong and China-watchers need not lose sleep over potential capital flight.

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