26 August 2015

by Shirley Shen and Aidan Yao

Research & Investment Strategy

China capital account: only partly opened Stabilising the yuan AND lowering rates are not incompatible

In contrast to the popular view that the Chinese authorities are intending to significantly devalue the renminbi RMB, we think the

People Bank of China (PBoC) actually needs to carefully manage depreciation expectations to prevent a large scale

capital flight. Such outflows would tighten domestic monetary conditions and give rise to financial risks. Acknowledging this helps

to understand why the PBoC intervened in the market most recently and lowered the RRR by 50bps and interest rates by 25bps

shortly after the regime change to support the RMB and signalled that the misalignment in the currency was largely corrected –

both of which runs counter to the argument that China is opting for a competitive devaluation.

This, in turn, raises the important issue of assessing the direction and magnitude of capital flows across China. In this note, we first

explain how we estimate capital flows using two models: one based on the FX purchases of financial institutions, and the other

using balance of payment (BoP) data. These two models give us broadly similar results on the scale of capital outflows

($297bn~$316bn) over the past five quarters.

We then investigate the BoP data further for the drivers of these outflows. We are able to show that increased holdings of foreign-

currency assets by Chinese residents (on the back of yuan depreciation), and (both local and foreign) banks reducing RMB

exposure, and increasing dollar exposure were important influences on capital flows. Recent talk of Chinese companies

actively paying down dollar debt – again driven by expectations of yuan depreciation – is consistent with this assessment.

Finally, we provide some qualitative discussion on the outlook for capital flows, which we think will continue in the near

future. We think the yuan depreciation and capital outflows will trigger a structural rebalancing in China’s macro environment,

namely: 1) an unwinding in the popular yuan carry trade; 2) a rebalancing of dollar holdings between the official sector

(falling reserves) and the private sector (accumulating foreign assets for risk diversification); and 3) counterbalancing a

tightening of liquidity due to capital outflows by easing policy. which was heavily influenced by the management of capital

inflows in the past. The last point means that the bank reserve requirement ratio (RRR) can come down significantly further.

Two capital flows models:

We estimate capital outflows using two models:

1. A monthly model using the total FX purchases by all

financial institutions, netting out trade flows and direct

investment (FDI1 minus ODI

2) flows. We can also

calculate a variation of the model that removes out the

changes in FX deposits by local residents. The residual

figures mimic, more closely, the “hot money” flows

directed by foreigners (Exhibit 1).

2. A quarterly model based on the BoP data. It sums up the

portfolio and banking-related FX flows in the financial

account, again netting out changes in the FX deposits of

local residents.

1 Foreign Direct Investment

2 Outward Direct Investment

Exhibit 1 Capital outflows have outpaced inflows from trade and direct investment lately

Source: CEIC and AXA IM Research

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Capital FX deposit

Direct investment Trade

Total flow

USD bn

China - Capital flow estimation using monthly FX purchases

2 | AXA Investment Managers – 26/08/2015

Exhibit 2 shows that the estimates from the two models yield

similar results on capital outflows, which amounted to

around US$300bn over the past five quarters.

Exhibit 2 Capital outflows have reached around US$300bn in the past five quarters

Source: CEIC and AXA IM Research

What are the drivers of outflows?

To assess the drivers of recent capital outflows, we focus on

the BoP for more granular data. As expected, China’s

financial account has been registering persistent capital

outflows (including FX reserves and residuals), offsetting the

current account surpluses (Exhibit 3).

Exhibit 3 China’s trade surpluses have been offset by outflows from FX reserves in the Financial Account

Source: CEIC and AXA IM Research

Within the financial account, outflows have historically come

from official reserve investment as a way to recycle China’s

trade surplus (light-blue bars in Exhibit 4). Direct investment

(green bars) has brought persistent net inflows, as FDI

growth outstrips that of ODI, while portfolio investment (dark-

blue bars) has been small given the long-lasting capital

controls.

Exhibit 4: Financial Account outflows have been driven by “Other Investment”

Source: CEIC and AXA IM Research

However, this pattern changed since mid-last year, as

outflows from “other investment” (orange bars) started to

dominate. This category mostly comprises of banking-sector

activities, such as loans, deposits and trade credit. Exhibit 5

shows the changes in net positions, which turned negative

(i.e. outflows) in recent quarters, suggesting that banks have

reduced RMB exposure as the yuan started to depreciate (in

spot markets). By splitting the net positions into assets and

liabilities (Exhibits 6 and 7), we can disentangle the changes

attributable to Chinese locals (on the asset side) and

foreigners (on the liability side).

Exhibit 5 Banks have intermediated outflows via deposits and loans

Source: CEIC and AXA IM Research

On the asset side, there were sizeable outflows in currency

and deposits (light-blue bars in Exhibit 6) since early 2014,

mirroring the start of the RMB depreciation and the widening

of the yuan trading-band. This has led some local residents

to switch to US dollar (USD) deposits. As depreciation

expectations persist, Chinese banks also started to increase

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Monthly data measure

Quarterly data measure

China - Comparison of capital flow between the two measures across 5 quarters

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Financial account

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China balance of payment breakdown

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China - Breakdown of financial accounts

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China - Breakdown of other investment in the financial account

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AXA Investment Managers – 26/08/2015 | 3

their dollar lending (dark-blue and green bars), accelerating

outflows in the second half of 2014 and early this year.3

Exhibit 6 Local residents are switching to the USD on expectations of RMB depreciation

Source: CEIC and AXA IM Research

On the liability side, reduced loans extended to Chinese

residents were the dominant driver of outflows. The BoP

data was broadly consistent with the Bank for International

Settlements’ (reporting banks’ external lending) stats,

showing that outflows from this category amounted to

around $150bn since mid-last year. We think this reduction

was driven by a combination of foreign banks trimming

exposure to China on reduced risk appetite, as well as local

borrowers actively paying down dollar debt, given

expectations of RMB depreciation.

Exhibit 7 Loan exposure of foreign banks also fell as Chinese borrowers pay down dollar debt

Source: CEIC and AXA IM Research

3 Unfortunately, we only have the detailed breakdown for Other

Investment until the first quarter of 2015.

Outlook on capital flows and policy implications

We think capital outflows pose a key risk to China’s macro

condition in the coming months, as expectations of yuan

depreciation deepen. The authorities need to carefully

manage market expectations and proactively operate

monetary policy, in order to minimise the risk of a liquidity

shock to the economy.

We think the pattern of capital outflows over the past few

quarters will likely persist in the near future. Expectations of

yuan depreciation will likely drive further shifts towards USD

deposits by local residents. This, in our view, is a favourable

development, as it allows the private sector to diversify its

portfolio, which, until recently, had been heavily

concentrated in RMB assets, given the strict capital controls.

Banks and the corporate sector will likely continue to trim

their dollar debt and may start to accumulate foreign assets

(financed by domestic credit), unwinding the popular yuan

carry trade over the past decade.

These capital outflows will add downward pressure on the

RMB, with the resulting currency depreciation reinforcing

capital flight. While the exchange rate will become more

market-driven under the new fixing regime, we think the

PBoC will retain the discretion to intervene in the market on

macro-prudential grounds. Such an intervention means

China’s FX reserves will likely fall further in the coming

months. We see this (i.e. falling official reserves), in

conjunction with the accumulation of dollar assets by the

private sector, as a favourable rebalancing between the

public sector and private sector balance sheets (i.e. that the

former is reducing excess holdings of reserves, while the

latter is undertaking much-needed diversification into foreign

assets).

As capital outflows reduce domestic liquidity, the PBoC will

need to adjust its policy to keep monetary conditions intact.

We expect two more RRR cuts, targeted liquidity injections

and proactive open market operations to prevent a liquidity

shock to the economy. The RRR reductions can be seen as

part of a great rebalancing in China’s monetary policy. Over

the past decade or so, persistent appreciation in the yuan

had led to strong capital inflows to China. This in turn forced

the PBoC to hike the RRR in order to control liquidity and

prevent an escalation of inflation. Now, as currency

appreciation turns to depreciation and capital inflows

become outflows, the liquidity that was previously locked up

in excess reserves needs be released back to the system.

This will allow the RRR to return to more normal levels and

monetary policy to respond to domestic economic

conditions.

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Other Currency and Deposit

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China - Offshore exposure by local residents - change in assets

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China - Onshore exposure by foreign investors - change in liabilities

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4 | AXA Investment Managers – 26/08/2015

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