Cap­i­tal flight de­liv­ers a ver­dict on China

The Pak Banker - - OPINION - Noah Smith

CHINA'S growth is slow­ing, prob­a­bly for good. But the form that the slow­down is tak­ing isn't yet known. The ques­tion is whether China's trou­bles will be more like a typ­i­cal emerg­ing-mar­ket cri­sis, or more like the typ­i­cal bust in a large de­vel­oped coun­try.

Ev­ery na­tion un­der­goes a growth slump at some point. For good back­ground on the phe­nom­e­non, check out the pa­pers by Barry Eichen­green, Donghyun Park, and Kwanho Shin. Ja­pan, for ex­am­ple, ex­pe­ri­enced a slow­down in the early 1990s, fol­lowed by South Korea and many South­east Asia coun­tries in the late '90s. China is sim­ply tread­ing the nor­mal pat­tern in this re­spect.

But not all such episodes are cre­ated equal. In emerg­ing mar­kets, slow­downs are of­ten ac­com­pa­nied by a sud­den stop, in which cap­i­tal abruptly ceases rush­ing into the coun­try and starts flow­ing out at a rapid pace. Many peo­ple be­lieve that th­ese sud­den stops cause cur­rency crises, which are an­other hall­mark of emerg­ing mar­ket tur­moil. Ac­tu­ally, the his­tor­i­cal cor­re­la­tion is not that strong -- emerg­ing mar­ket slow­downs can fea­ture one with­out the other. But cap­i­tal out­flows un­de­ni­ably tend to weaken a cur­rency, since they re­quire swap­ping the do­mes­tic cur­rency for a for­eign one. If you want to move money out of South Korea and into the U.S., for ex­am­ple, you would trade won for dol­lars. That de­creases the de­mand for won, which puts pres­sure on its price. Some coun­tries man­age to pre­vent their cur­ren­cies from crash­ing in re­sponse to cap­i­tal out­flows, but oth­ers don't, and are forced to al­low a de­val­u­a­tion. Any­one in­ter­ested in emerg­ing­mar­ket crises can read much more about them at a Na­tional Bureau of Eco­nomic Re­search web­site de­voted to the topic.

Crises in large in­dus­tri­al­ized coun­tries, how­ever, tend to look very dif­fer­ent. The U.S. in the Great De­pres­sion and Ja­pan in the 1990s both saw rel­a­tively lit­tle cap­i­tal leave the coun­try. In­stead of mov­ing their money else­where, in­vestors in th­ese coun­tries tend to sim­ply put it in cash, or safe as­sets. A long, grind­ing de­fla­tion­ary bust tends to fol­low.

Why should we care whether China fol­lows the emerg­ing-mar­ket model or the in­dus­tri­al­ized-coun­try model? Cur­rency spec­u­la­tors ob­vi­ously care, since it will de­ter­mine the value of their bets on the Chi­nese yuan. Many other peo­ple in the fi­nan­cial in­dus­try will also be af­fected, since cap­i­tal flow­ing out of China will make a big dif­fer­ence in many mar­kets. Flee­ing Chi­nese money will drive up real es­tate and other as­set prices in other coun­tries, and flood the cof­fers of hedge funds, pri­va­tee­quity and ven­ture-cap­i­tal firms.

In de­ter­min­ing whether cap­i­tal will flow out of China, there are two ba­sic ques­tions. The first is how much Chi­nese cap­i­tal ac­tu­ally wants to leave. The se­cond is how well China will be able to pre­vent it from leav­ing.

Cap­i­tal is cer­tainly leav­ing China in large amounts. The Chi­nese govern­ment uses cap­i­tal con­trols to try to pre­vent this from hap­pen­ing, but th­ese turn out not to be that hard to get around. For an in­sight into the most com­mon method of eva­sion, read this ex­cel­lent blog post by Pek­ing Univer­sity pro­fes­sor and Bloomberg View con­trib­u­tor Chris Bald­ing. Ba­si­cally, if I'm in China, I can get money out of the coun­try by buy­ing and sell­ing things to and from Hong Kong at over­stated or un­der­stated prices, and there's just very lit­tle the govern­ment can do about it.

The ques­tion is whether th­ese large cap­i­tal out­flows rep­re­sent gen­eral Chi­nese sen­ti­ment, or sim­ply the ac­tions of an eas­ily fright­ened mi­nor­ity. Cap­i­tal out­flows of $1 tril­lion equal about 15 per­cent of China's gross do­mes­tic prod­uct. That's nowhere near the high­est in his­tory. But even if $1 tril­lion is an over­es­ti­mate, it still is very high, es­pe­cially com­pared with Latin Amer­i­can coun­tries that suf­fered crises in the last few decades. If you're los­ing more cap­i­tal than Ar­gentina in the early 2000s, you have a prob­lem.

But th­ese huge num­bers may be tem­po­rary. China is a big coun­try, and the peo­ple try­ing to move their money out may rep­re­sent only a mi­nor­ity. If there's a larger num­ber of Chi­nese in­vestors out there who trust the cen­tral govern­ment to main­tain the value of the cur­rency and bring the un­fold­ing cri­sis un­der con­trol, then th­ese cap­i­tal out­flows could soon slow or re­verse. Al­ter­na­tively, the cap­i­tal flight could be­come a stam­ped­ing herd, in which case it would be self-per­pet­u­at­ing.

The other ques­tion is whether China's govern­ment can and will stop cap­i­tal flight. China now is sell­ing off part of its vaunted hoard of for­eign-ex­change re­serves in an at­tempt to prop up the yuan. One rea­son it is do­ing that is in or­der to avert the kind of mob be­hav­ior that would re­sult in a self-ful­fill­ing cur­rency panic -- if peo­ple think China will de­fend the yuan, then they won't try to get their money out, and the cur­rency will be sta­ble.

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