China's capital flows - a reform dilemma

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This article was written by Berkeley CoxDavid Olsson and Andrew Fei. 

Newly announced policy changes are designed to encourage overseas companies to play a bigger role in China's economy (including its financial sector) – presenting opportunities for foreign investors wishing to tap into China's market potential. These changes are playing out in the context of decisions by China's policymakers to impose tighter restrictions on foreign currency conversions and outbound capital flows. In this article we consider China's domestic financial reform agenda, as well as what these new developments mean for market participants.

Open for business to foreign investors

In an address last week at the World Economic Forum in Davos, China's President Xi Jinping said that China will expand market access for foreign investors. This is all part of a high-level opening up of the Chinese economy to help attract overseas capital and ease downward pressure on its currency, the renminbi (RMB). On the same day, China's State Council announced that greater access would be granted to foreign firms across a range of sectors in the Chinese economy, including financial services (banking, securities, investment management, futures, insurance, credit ratings and accounting), manufacturing, resources, telecommunications, internet, transport, education and infrastructure. Qualifying foreign firms would also be encouraged to raise equity and debt in China's capital markets.

As yet, there is no timetable for the implementation of these policy directives, however they have been cautiously welcomed by commentators (including Chinese commentators, who affectionately refer to the State Council's announcement as "20 rules on attracting foreign investments").

A journey of a thousand miles… 

The pathway towards further reform of China's financial markets and the liberalisation of its financial system has seen, over recent years, the gradual opening up of the capital account (to permit a freer two-way flow of capital) and the internationalisation of the RMB.

A tangible recognition of the reforms was provided in October 2016, when the renminbi was formally included in the basket of currenciesthat determine the value of the International Monetary Fund's (IMF) foreign reserve asset – known as the Special Drawing Right (SDR).

This was, with some justification, seen as an important milestone in China's path to becoming a more open economy, a prelude to its currency becoming more freely used and exchanged by foreign and domestic investors.

A number of capital controls were eased by the Chinese authorities prior to the SDR announcement and the IMF statement. This was interpreted by many (both in China and abroad) as a mechanism that China's policymakers would use to drive the difficult but necessary transition from a growth model that emphasises exports and heavy industry, to one that focusses on innovation, services and greater domestic consumer demand.

A fine balancing act

Maintaining stability in the domestic financial system in an environment of freer capital flows and greater exchange rate volatility is challenging and requires a careful management of China's domestic monetary system which includes moving away from a model which allocates capital according to centrally dictated quotas, and towards one which allocates capital according to market forces.

It requires a delicate balancing of many reforms and policy considerations at the same time.

In this regard and to support economic growth during this significant economic transition, China has eased monetary policy in various ways, including reducing reserve requirements for banks which has allowed them to lend more. At the same time, China has continued a process of reforming and opening up its capital markets. Notably, private Chinese citizens are now allowed to invest some of their savings abroad, up to a limit of US$50,000 per person, and foreign institutions are encouraged to participate in the domestic capital markets for example through quote systems and stock exchange linkage frameworks.

In 2015, for the first time since the opening up of China over three decades ago, China's capital flows reached a tipping point – outbound direct investment exceeded foreign direct investment. China has become a global net capital exporter.

These capital out flows are partly reflected in direct investments by government-owned and private Chinese enterprises seeking to expand internationally as part of the Go Global Strategy. But significantly, they are also due to certain enterprises and individuals moving money out of China in the face of continuing depreciation of the currency (particularly against the US dollar), and in search of better returns.

This has resulted in a flight from the RMB into other currencies that has in turn put pressure on the exchange rate.

In the short term, this has been managed by China, in part, through selling some of its massive stocks of dollar-denominated securities and buying RMB – indeed, nearly US$1 trillion of China's reserves have been used to slow the slide in the value of the currency. Although there is still capacity to manage the exchange rate with remaining reserves of around US$3 trillion, the downward trend is significant.

Not an outright ban

To reduce pressure on the RMB and slow the outflow of capital, authorities are also imposing a range of administrative controls on the overseas use of its currency.

Chinese regulators have increased efforts to rein in shadow banking, targeting off-balance sheet transactions and wealth management products. To curb capital outflows, tougher restrictions are reported to have been imposed on certain outbound investments by some Chinese companies, overseas bank card transactions, and offshore RMB loans. Concerned about speculation, China's insurance regulator has also revised policies on related-party transactions and insurance company shareholding rules.

While the regulators are increasing their scrutiny, the restrictions fall far short of an outright ban on overseas investments by Chinese companies. Indeed, top regulators have publicly emphasised that Chinese investors can still make genuine outbound investments – and are encouraged to make investments that are consistent with their corporate strategies and consistent with national strategies, such as the Belt and Road Initiative.

As recently as yesterday (26 January 2017), China's State Administration of Foreign Exchange (SAFE) issued a notice specifying additional requirements (seemingly aimed at verifying the genuineness of the investment) in connection with outbound investments involving foreign exchange.

Further reform to follow

And herein lies the dilemma. As the Chinese economy continues to experience the "new normal" of single digit GDP growth and structural reforms, while the US dollar strengthens over time, foreign investors may sell more RMB assets and Chinese households may seek investments in other currencies. All this adds to pressure on the RMB exchange rate which, in turn, may result in more capital outflows – breaking this vicious cycle might be challenging.

In the lead up to China's once-in-a-decade power reshuffle, the pursuit of stability (economic, political and ultimately social) is looming as the paramount economic priority. The mantra of market-based reforms and innovation seems very likely to continue however, for the time being, increased risk management and regulation to get the balance right is likely to continue too.

In our view, there will be further reform and further opening up, particularly of China's financial markets, attracting more foreign investment to balance RMB outflows. And in this respect, President Xi's recent remarks on trade and investment liberalisation and openness, as well as the State Council's announcements on greater foreign access, present cause for optimism – particularly against a backdrop of protectionist tendencies in other parts of the world.

We will continue to monitor and report developments on China's economic and legal reforms. In the meantime, if you would like to discuss what the most recent developments mean for your business, please contact one of our China practice consultants.

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