Opening Remarks

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

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>