Feiyang Shi discusses the motivations behind Chinese capital control policies and their implications on investor relations
The last year has seen a series of Chinese governmental actions against capital outflows. Investigations have started on companies’ overseas investments and entities; related M&A activity expects setbacks and pressure has been building on the stocks of some Chinese companies. For consumers, new sanctions are now in force to cap citizens’ oversea withdrawals. Although these actions can help to keep assets inside the border, they have a negative effect on foreign investors’ perception of the economy. What motivated this fast-forward economy to start zipping its purse? Part of the answer may lay on the other side of the globe.
Where’d The Money Go?
It is often argued that China ‘freerode’ on the Federal Reserve’s (Fed) quantitative easing (QE) after the financial crisis, seizing the opportunity of the Chinese Yuan’s (CNY) appreciation against US dollar (USD) to expand its own monetary base. This allowed the Chinese government to undertake a $586 billion fiscal stimulus project, boosting growth and reducing the unemployment to 4% — all the while maintaining a stable currency. The shortcomings of this strategy, however, are now becoming apparent. The Fed is now tapering its QE programme. Unless China slows its monetary expansion, this winding down of the Fed’s balance sheet will put serious downward pressure on the CNY against the USD.
These problems are casting a shadow over the economy. To prevent depreciation, the People’s Bank of China sold off about 25% of its foreign exchange reserves, about $1 trillion, during 2014-2016. However, selling foreign reserves is effectively burning money and may still be insufficient in practice. Furthermore, adjusting interest rates, despite being common practice, is not ideal — an increase in the interest rate could build credit pressure. Implementing capital controls to improve the inflow outflow balance, which Beijing has opted for, appears to exert relatively little pressure and direct impact on the value of the currency and the economy. Capital controls also mean that the economy needs to limit overseas investment and asset purchases, decreasing the capital outflow to defend the currency. The consequences of these capital control policies for investors, as well as the general economic outlook, may affect the long-term trajectory of the Chinese economy in terms of investment inflows and the import of foreign technologies. Moreover, China’s institutions and infrastructure are still underdeveloped — and with a higher interest rate environment likely, important development projects and investments funded by borrowed money may become more expensive. This could strengthen the longstanding argument that China is heading towards a credit crisis.
Stuck In The Middle
Capital outflow restrictions implemented by the Chinese government are causing concern among foreign investors. The EU Chamber of Commerce reported that China is preventing some European companies from moving cash offshore at times. These cases may deter inbound investments. Historically, Beijing has encouraged Chinese investment into foreign high-tech industries to foster innovation and cooperation. However, because the new quota forbids foreign exchange purchases of over $15,400 per individual per annum, any Chinese investors that took the government’s advice found themselves unable to complete their cross-border investments. The implications of such unintended consequences may be a reduction in growth opportunity and a slower pace of structural developments in the economy. The difficulties associated with converting CNY has also affected borrowers, compelling some to borrow in USD debt — leading to an increase of 11% in USD denominated debt from mid 2015 to mid 2017 among Chinese businesses. The re-leveraging towards USD for domestic Chinese businesses arguably increases the economy’s exposure to Fed policies.
There is no doubt that the end of the US’s QE program has created a delicate situation for China. The poor performance of USD in 2017 gave CNY some relief, but this is not a sustainable solution for China. To resolve the problem, China not only needs to carefully balance the current inflow and outflow to safeguard CNY, it also needs to focus on the development of domestic industries. China needs to provide the world with better investment opportunities, attract more inbound investments and revitalise the investment flows.