Capital controls should be tightened to curb outflows amid depreciation fears

China should consider stepping up capital controls given that investors are showing enthusiasm for dollardenominated assets amid growing concerns about further yuan depreciation.

From November 18, 2015 to Friday the yuan depreciated nearly 8 percent against the US dollar, ensuring a relatively high return rate on dollar- denominated assets. Although China has already limited the amount of money an individual can move out of the country to $ 50,000 per year, if 20 million residents, or about 1.5 percent of the population, each took the maximum that would see largescale capital outflows. As many believe the yuan will weaken further, increasing demand from ordinary Chinese people for dollar- denominated assets is likely to add to depreciation pressure on the currency, which could spark a vicious cycle.

What’s worse, China has left loopholes in the foreign exchange management regime that allow people to break through the $ 50,000 ceiling. Yu Yongding, a China- based economist, said recently he was told that some entrepreneurs in Shenzhen bought dollardenominated assets by using their employees’ quota. Yu also said he felt puzzled as to why there are so many Chinese individual investors buying houses overseas that are valued well above the $ 50,000 ceiling.

Chinese policymakers are trying to maintain economic and exchange rate stability, so the central bank has to use up its foreign exchange reserves to counter large- scale capital outflows and prop up the yuan. China’s foreign exchange reserves fell for the fourth consecutive month in October, decreasing $ 45.7 billion to $ 3.121 trillion. The nation’s foreign exchange reserves have now dropped to the lowest level since 2011.

Although China still has ample foreign exchange reserves, immoderate spending is un- realistic. China will need to implement tougher temporary capital controls, although there might be some side effects in the Chinese economy.

The government should step up its efforts to fix loopholes in capital outflows. Goldman Sachs estimated earlier this year that net capital outflows from China in the first quarter were around $ 123 billion, of which about 70 percent was due to Chinese residents buying foreign assets.

We cannot rule out the possibility that there has been speculation to bet on continued depreciation of the yuan and appreciation of the dollar. Policymakers should consider issuing detailed measures to curb excessive speculation and reduce market volatility.

Ramped- up capital controls, however, would not indicate a retreat from China’s vow to make its currency policy more market- oriented. The yuan should still be allowed to weaken against the US dollar if the currency faces further depreciation pressure. Speculation over an overvalued currency will automatically be dismissed if it depreciates to a level that is roughly in line with market expectations.