Market Confidence Recovers But Capital Outflows Continue
Big swings in cross-border capital flows and significant changes in China's foreign exchange reserves continued to affect the currency market last year. What conclusions can we draw from these cross-border capital flows? How do we reach an objective understanding of the changes in China's foreign exchange reserves? And how do we rationally assess the relationship between exchange rate policy and cross-border capital flows?
In general the capital outflow trend has slowed,but the pressure should not be underestimated.
In the first three quarters of 2016,the accumulated deficit in international payments under the capital and financial account totaled US$303.2 billion,showing a year-on-year decrease of 5.2%. If net errors and omissions are included,the broad-based capital and financial-account deficit was US$466.5 billion,essentially equal to the total in the same period of 2015. However,foreign exchange reserves continued to be under pressure as the basic international payments surplus declined substantially.
The difference between the current account balance and direct investment is an indicator of the balance of international payments,and is therefore referred to as the basic balance of payments. In the first three quarters of 2016,China's basic balance of payments showed a surplus of US$97.1 billion,for a 67% decline from a year earlier. This reflected a 28% drop in the current account surplus over the same period. At the same time,there was a net deficit of US$75.7 billion in direct investments,compared with a surplus of US$54.1 billion in the same period of 2015.
The substantial fall in the surplus of the basic balance of payments greatly increased the risk to the nation's foreign exchange reserves from capital outflows. In the first 11 months of 2016,foreign exchange reserves fell US$278.8 billion,and that reduction was 31% more than the year-ago figure. However,if we remove the effect of currency fluctuations,the fall was even greater. In the first nine months of the year it was US$299.2 billion,up 32% from the year-ago period. In the third-quarter alone,the decline in foreign exchange reserves reached US$135.5 billion,making it the second highest quarter on record after the US$160.6 billion in the same period of 2015.
As of the end of September 2016,the balance of foreign exchange reserves had fallen a total of US$826.8 billion compared with the level reached at the end of June 2014. A total of US$155.6 billion of that was due to currency valuations. If we look at the first three quarters of 2016,foreign exchange reserves decreased by US$164 billion.
Since the second quarter of 2014,China has seen a general trend of net capital outflows. Debt repayment and foreign exchange in the hands of individuals - rather than the state - are the key channels for capital outflows. However,prior to the third quarter of 2015 there was a net outflow on the asset account while there was a net inflow on the debt account. After the August 2015 exchange rate reform - which effectively devalued the renminbi - there were net outflows on the debt account for three consecutive quarters starting with the third quarter of that same year.
Since the second quarter of 2016,there has been a net inflow under the debt-account,and this has reflected the fact that a wave of foreign debt repayments by domestic enterprises subsided. At the end of September 2016,China's outstanding foreign debts were US$1.432 trillion,up US$67.5 billion from the end of the previous quarter. At the same time,overseas institutions began to look more closely at China's economic fundamentals,increasing their holdings of renminbi assets. According to SAFE statistics,in the second and third quarters of 2016,the accumulated increase in net foreign holdings of domestic renminbi bonds and equity assets reached US$45 billion,reversing an earlier trend. From the third quarter of 2015 to the first quarter of 2016,there was a US$45.3 billion decrease in these holdings.
In the first three quarters of 2016,total net debt account inflows amounted to US$147.8 billion compared to US$40.4 billion in the same period of 2015. Net inflows of foreign direct investment amounted to US$101 billion,or a year-on-year decrease of 45%. The net inflows of foreign securities investments were US$26.1 billion,for a year-on-year rise of 63%. The net inflows of "other investments" amounted to US$20.7 billion and there were net outflows of US$232.1 billion in the same period of last year. These were the main reasons for the reversal on the debt account to surplus from deficit.
Over the first three quarters of 2016,there was a continuing deficit on the asset account,with an accumulated net outflow of US$451 billion,up 61% from the same period of 2015.The net outflows of foreign direct investment reached US$176.6 billion,up 45%,while net outflows of foreign securities investments were US$69.8 billion,up 22%. The net outflow of foreign investment was US$204.5 billion,up 104%. In the third quarter,the net outflows under the asset account reached a record US$215.1 billion,for a quarter-on-quarter increase of 71%,while there was a quarter-on-quarter increase of net inflows under the debt-account.
Adequate Reserve Level
During the Asian financial crisis,as the foreign exchange markets were in turmoil,the Chinese government promised not to devalue the renminbi. Moreover,China did not need to use its foreign exchange reserves to stabilize the exchange rate. As a result,there was almost no discussion of whether the US$140 billion in foreign exchange reserves at the time were really sufficient. The foreign exchange rate is an effective tool in dealing with capital outflows and currency devaluation pressures. As of the end of December 2016,foreign exchange reserves had fallen US$982.7 billion from the end of June 2014,and 65.5% of that decline was recorded after the August 2015 exchange rate reform. The question of what constitutes an adequate level of reserves now appears to be of critical concern to the market.
The use of foreign exchange reserves to stabilize the exchange rate is mainly based on the government's judgment of the adequacy of foreign exchange reserves. As early as at the end of 2006,the Central Economic Work Conference of that year pointed out that the main contradiction in China's balance of international payments had changed from a shortage of foreign exchange to an overly large trade surplus and excessive growth of foreign exchange reserves.
Promoting a balanced international payments position is an important part of maintaining economic stability. In 2006,China's foreign exchange reserves were enough to cover 16.2 months of imports and were equal to 5.35 times the nation's short-term foreign currency debt. As of the end of 2014,China's foreign exchange reserves were enough to cover 23.5 months of imports and were equal to 2.96 times the total of short-term foreign currency debt. In recent years,the government has actively promoted other uses for the nation's foreign exchange reserves,setting up sovereign wealth funds (such as the Silk Road Fund,the China-Africa Development Fund,the China-Latin America Fund,etc.),the establishment of multilateral international development institutions (such as the Asian Infrastructure Investment Bank,the BRICS Development Bank,etc.),and making use of entrusted loans,currency swaps and other forms of support for domestic enterprises to "go global."
Since the second half of 2014,and most obviously since the August 2015 foreign exchange reform,China's foreign exchange reserves have experienced a significant decline. By the end of September 2016,foreign exchange reserves amounted to US$3.17 trillion,enough to cover 24.0 months of imports and 3.54 times all types of short-term foreign debt. This was higher than the level at the end of 2014 and far higher than the level of end-2006. It can be seen that,despite the continuous decline in foreign exchange reserves over the past two years,China's basic foreign exchange situation has actually strengthened. We can therefore look to the future when the renminbi actually achieves a "clean float" and the central bank has withdrawn from foreign exchange intervention.
Certainly,there are no absolute criteria for judging whether foreign exchange reserves are sufficient. This depends on the subjective feelings of the market. Market concerns over the size of reserves are not unwarranted. On one hand,the declines in reserves and the weaker exchange rate are related. They both reflect pressure from capital outflows. Therefore,the extended decline in foreign exchange reserves has an impact on market confidence and the continuing rise in the marginal costs. At the same time,the use of foreign exchange reserves to stabilize the exchange rate is the government's major weapon. If a large volume of foreign exchange is used up defending the exchange rate yet the desired result is not achieved,this will affect the government's reputation.
Market Confidence
Capital o