Open­ing Re­marks

With cap­i­tal fly­ing out of China, what’s Xi Jin­ping to do?

Bloomberg Businessweek (Asia) - - CONTENTS - By Peter Coy −With Enda Cur­ran and James Re­gan

You don’t need to be a fi­nance ex­pert to know that some­thing’s wrong when an in­ter­est rate reaches al­most 70 per­cent. With China’s growth out­look dark­en­ing and cap­i­tal flow­ing out of the coun­try, spec­u­la­tors have been bet­ting heav­ily against the yuan. The Peo­ple’s Bank of China ef­fec­tively de­clared war on them in early Jan­uary, di­rect­ing state banks to buy large sums of the cur­rency in Hong Kong to sup­port its value and burn the short sellers. With the yuan sud­denly scarce in Hong Kong, the an­nu­al­ized cost of bor­row­ing it overnight there hit 66.82 per­cent on Jan. 12—more than 10 times the usual in­ter­est rate. (It re­ceded to 8 per­cent the next day.) Michael Ev­ery, head of fi­nan­cial mar­kets re­search at Rabobank Group, called the rate spike “mur­der­ous” and pre­dicted that things wouldn’t end well for Chi­nese au­thor­i­ties. Cen­tral banks “usu­ally win a round like this, but lose in the end,” he told Bloomberg.

China’s cen­tral bank isn’t freestyling. It takes its in­struc­tions from the govern­ment, which means Pres­i­dent Xi Jin­ping. Xi has shrewdly con­sol­i­dated power since his as­cen­sion in 2012, but he seems be­fud­dled by free mar­kets, at times al­low­ing them to op­er­ate and at times try­ing to throt­tle them—as with the cir­cuit break­ers that have failed to ar­rest the slide in stock prices (page 38).

One of the big ques­tions for the global econ­omy in 2016 is what Xi will do next to stop the flight of cap­i­tal, which threat­ens to sap funds from China when growth is al­ready weak. One op­tion is to lure money back by mak­ing the coun­try more invit­ing to both Chi­nese and for­eign in­vestors. That would in­volve de­con­trol­ling in­ter­est rates and halt­ing di­rected lend­ing to heav­ily in­debted state-owned en­ter­prises and lo­cal gov­ern­ments. But do­ing so would re­quire loos­en­ing the Com­mu­nist Party’s con­trol over the econ­omy and harm some

pow­er­ful do­mes­tic con­stituen­cies, like long-fa­vored com­pa­nies and pro­vin­cial chiefs. So the temp­ta­tion to amp up com­mand-and-con­trol will be great. True, a clam­p­down would jeop­ar­dize China’s am­bi­tion to be­come an equal of the U.S. in global fi­nance. But it would in­su­late China from the un­govern­able swings of the global fi­nan­cial mar­kets, which in­vestor Ge­orge Soros once mem­o­rably said are more a wreck­ing ball than a pen­du­lum.

Some China watch­ers say the ques­tion of Xi’s di­rec­tion is al­ready be­ing an­swered. “China will be­come in­creas­ingly closed to the rest of the world,” pre­dicts Ali­cia Gar­cia-Her­rero, chief econ­o­mist for Asia and the Pa­cific at Natixis Asia, a unit of Groupe BPCE, France’s se­cond-largest bank­ing com­pany. “Xi Jin­ping’s mind­set is one in which China is at the cen­ter of the world’s econ­omy but not nec­es­sar­ily open to the rest of the world, or at least not vul­ner­a­ble to it.”

Xi seems to re­al­ize that he paid a high price for the honor of hav­ing the Chi­nese yuan in­cluded, start­ing this Oc­to­ber, in the In­ter­na­tional Mon­e­tary Fund’s bas­ket of re­serve cur­ren­cies along with the dol­lar, the euro, the yen, and the Bri­tish pound. To be in­cluded in the bas­ket, China had to demon­strate that the yuan was “freely us­able.” That forced it to lower some in­vest­ment bar­ri­ers—en­abling the cap­i­tal flight now be­dev­il­ing the lead­er­ship. The In­sti­tute of In­ter­na­tional Fi­nance es­ti­mated in Oc­to­ber that net cap­i­tal flows out of China would reach $478 bil­lion in 2015. New es­ti­mates due this month could show even larger out­flows, the IIF says.

It’s worth tak­ing a close look at what “cap­i­tal flight” re­ally means for China. Cap­i­tal flows out of the coun­try aren’t nec­es­sar­ily bad; they’re sim­ply the mir­ror im­age of its trade sur­plus. When­ever China chooses to use a dol­lar, euro, pound, or ring­git earned from ex­ports to buy a for­eign as­set, it’s send­ing cap­i­tal abroad. Many for­eign ac­qui­si­tions strengthen the coun­try, eco­nom­i­cally and po­lit­i­cally.

The prob­lem now is that more money wants to get out of the coun­try than wants to get in. Here’s the math: Last year, the IIF es­ti­mates, China had a lit­tle more than $250 bil­lion com­ing in from the sur­plus on its cur­rent ac­count, the broad­est mea­sure of trade. It got an ad­di­tional $70 bil­lion or so in net cap­i­tal from non­res­i­dents, in­clud­ing Chi­nese com­pa­nies’ over­seas af­fil­i­ates. But those in­flows were swamped by a record $550 bil­lion in net out­flows by in­di­vid­u­als and com­pa­nies in­side China.

Who stashed all that money abroad? The Bank for In­ter­na­tional Set­tle­ments at­tempted to an­swer that ques­tion in its Quar­terly Re­view in Septem­ber us­ing the ex­am­ple of a hy­po­thet­i­cal Chi­nese multi­na­tional. Dur­ing the boom years, BIS econ­o­mist Robert McCauley wrote, such a com­pany made money by bor­row­ing at near-zero rates in the U.S. and Europe, con­vert­ing the money to yuan, and in­vest­ing in China at higher yields. Now, he wrote, it was re­vers­ing course: bor­row­ing more in yuan and hold­ing more money in for­eign cur­ren­cies.

That’s the dy­namic the govern­ment is try­ing to over­come with its yuan-buy­ing. The IIF pro­jected in Oc­to­ber that the govern­ment would need to sell off more than $220 bil­lion of its re­serves last year to meet the de­mand for for­eign cur­rency. The ac­tual num­ber was prob­a­bly closer to half a tril­lion. The na­tion’s stock­pile of for­eign ex­change re­serves has dwin­dled to about $3.3 tril­lion. The cush­ion is shrink­ing. “Con­sid­er­ing China’s for­eign debt, trade, and ex­change rate man­age­ment, it needs around $3 tril­lion in for­eign ex­change re­serves to be com­fort­able,” says Hao Hong, chief China strate­gist at Bocom In­ter­na­tional Hold­ings.

What Xi is run­ning up against is what in­ter­na­tional econ­o­mists call the trilemma, or the im­pos­si­ble trin­ity. It says that a coun­try can’t have all three of the fol­low­ing things at once: a flex­i­ble mon­e­tary pol­icy, free flows of cap­i­tal, and a fixed ex­change rate. They fight one an­other. As soon as China started al­low­ing free (or at least freer) flows of cap­i­tal, it was in­evitable that it would have to give up on one of the other two ob­jec­tives. If it wanted to keep the yuan from fall­ing, it would have to raise in­ter­est rates higher than is good for the do­mes­tic econ­omy, es­sen­tially giv­ing up on set­ting an ap­pro­pri­ate mon­e­tary pol­icy. Or, if it wanted to set in­ter­est rates as it pleased, it would have to al­low the yuan to sink.

“It re­ally is a puz­zle,” says Steven Wei Ho, a Columbia Univer­sity econ­o­mist. “We can only spec­u­late,” he adds, which op­tion the lead­er­ship will choose. To Univer­sity of Ma­cau econ­o­mist Vinh Dang, the an­swer is ob­vi­ous: Be­cause flex­i­ble mon­e­tary pol­icy is es­sen­tial and China is too big to wall it­self off from the world, “ex­change rate con­trol must be given up,” he wrote in an e-mail.

Judg­ing from China’s stop-and-go poli­cies, its lead­ers haven’t com­pletely wrapped their heads around the idea that they must make a choice. They still want all three parts of the im­pos­si­ble trin­ity. Calls for a large de­pre­ci­a­tion are “ridicu­lous,” Han Jun, the deputy di­rec­tor of China’s of­fice of the cen­tral lead­ing group on fi­nan­cial and eco­nomic affairs, said on Jan. 11 at a briefing in New York.

It can’t be easy for Xi to suf­fer the in­dig­nity of los­ing a fight against the world’s fi­nan­cial mar­kets. That’s one rea­son to think he’ll try to es­cape the trilemma by restor­ing at least some con­trols on cap­i­tal. Gar­cia-Her­rero, the econ­o­mist for Natixis, pre­dicts that per­mis­sion to send or keep money abroad will be doled out more stingily in the fu­ture. The One Belt, One Road ini­tia­tive to make China a hub of Asian com­merce should have no trou­ble get­ting fi­nanc­ing, she says, but an in­vest­ment that doesn’t ob­vi­ously serve the na­tional in­ter­est could be re­jected. Chi­nese au­thor­i­ties will re­main open to in­vest­ing or ex­tend­ing credit out­side the coun­try when it’s fully un­der their con­trol, she pre­dicts. An ex­am­ple would be the nascent “panda bond” mar­ket, which al­lows for­eign­ers to bor­row money in yuan in­side China.

Kevin Yan, an an­a­lyst at Strat­for, a geopo­lit­i­cal in­tel­li­gence firm based in Austin, agrees with Gar­cia-Her­rero that the short­term trend is to­ward clos­ing China off from the world, but he’s more op­ti­mistic about the long term. “It’ll be open­ing and clos­ing, open­ing and clos­ing, but slowly mov­ing in a pos­i­tive di­rec­tion, prob­a­bly over the next 5 to 10 years,” Yan says.

The worst thing China’s lead­ers could do now would be to fall back on the tired old trick of sup­port­ing em­ploy­ment by build­ing roads, bridges, and apart­ments (page 16). Gun­ther Schn­abl, a pro­fes­sor at the Univer­sity of Leipzig, says that lax lend­ing merely keeps zom­bie en­ter­prises on their feet: “If you do not have a hard bud­get con­straint, you do not have an in­cen­tive to put for­ward dy­namic, in­no­va­tive in­vest­ment.” Judg­ing from the amount of cap­i­tal flight that China is ex­pe­ri­enc­ing, a lot of peo­ple in the Middle King­dom are wor­ried about pre­cisely that. <BW>

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