Loong on China: The big gap in China’s 5-yr Plan: capital outflows

By Pauline Loong

06 March, 2016

Beijing formally unveiled the outline of its draft policy blueprint for the next five years – known as the 13th Five-Year Plan (2016-2020) – at the meeting of China’s legislature, the National People’s Congress, which opened at the weekend.

Notably missing from the Plan is any mention of strategies to deal with possible large-scale capital outflows once the currency barrier is dismantled and exchange controls are finally abolished. The commitment to open up the capital account was repeated in the clearest terms in China’s economic blueprint for the next five years. “Currency exchange controls over outbound investment will be relaxed”, the state-owned Xinhua news agency reported.

Unmentioned (and perhaps unmentionable) is the elephant in the room for investors: the massive plunge in foreign exchange reserves in recent months. Outflows reached US$513 billion in 2015 and had already reached US$128.1 billion for the first two months of this year.

These outflows are not “cyclical” or the result of some self-limiting, one-off event. As we explained in a previous note, the slow-down in GDP growth and the increase in corporates paying off foreign-currency loans tell only part of the story of why the sudden exodus from the Chinese currency.

The shrinkage of offshore renminbi deposits indicates that markets still view the Chinese currency as a speculative bet rather than a long-term store of value. Analysts who try to seek comfort in a distinction between confidence in the currency and confidence in Chinese assets are splitting hairs as Chinese households and Chinese businesses at this juncture do not really have that choice.

The clever money – both domestic and foreign – has always known that China is about risk even more than reward. And risks are rising. Among them are sudden and unpredictable shifts in economic policy and commercial rules, such as effectively making it illegal for investors to short A-shares during the recent stock market rout. Or getting caught up as collateral damage in China’s anti-corruption crackdown.

In the current environment, the incentives for China’s corporates and “high net worth” class to seek overseas havens are very strong. And concentrating minds among families with children studying abroad is fear that a sudden lockdown (whether in remitting money overseas or the conversion of renminbi into foreign currency) would leave them scrabbling for dollars, pounds and Euros to pay the overseas school fees. For the present, the government is forced to retain administrative hurdles to slow outflows (as it has been doing of late).

Nevertheless, under the new Five-Year Plan, there is a clear commitment to allowing a free flow of currencies in and out of China. Successful implementation of this major financial reform will require a very high level of sophisticated market management by China’s central bankers and currency controllers. They have yet to convince investors.

The long-sought goal of renminbi globalization seemed tantalizingly within Beijing’s grasp this time last year. But despite the change in market sentiment in 2016, the government could still achieve its ambitions for the renminbi. Confidence in the prospects of both the currency and the national economy could be restored if the public oratory and closed-door lobbying by Premier Li Keqiang at the current session of the National People’s Congress manages to convince the nation’s elite.

Capital exodus may never happen but to ignore the possibility given the huge outflows following the drop in the renminbi’s exchange rates and the commitment to dismantle currency barriers is a notable gap in what is a major policy blueprint.

The closest reference to capital outflows in Premier Li Keqiang’s Work Report is 26 words on the renminbi exchange rate buried halfway down the document.

The rate, we are told, will be kept generally stable and at an “appropriate and balanced” level. The report gave no details of how that might be achieved although Xinhua earlier mentioned “a negative list for foreign exchange management” but without elaborating.

Stabilizing the exchange rate by continuously buying renminbi, which is what the government has been doing, is costly. And, despite the size of China’s foreign exchange reserves (at US$3.2 trillion in February), propping up the currency this way is not sustainable if the outflows are too large. By some estimates, China needs to maintain at least about US$1 trillion to cover six months import needs, short term debt obligations, and resident corporate foreign exchange demands.

Other signals from the NPC:

  • Pain ahead: Beijing is preparing the nation for tough times ahead. The message is that even growth of 6.5%-7.0% a year on average over the next five years will be a “difficult battle”.
  • Stimulus: Beijing is keeping to its goal of doubling 2010 GDP by 2020. And 6.5% growth a year is the minimum needed to achieve that. Fiscal stimulus, perhaps by another name and in a less headline-grabbing guise, is highly likely if growth looks likely to fall below that floor.
  • Trade: No numerical growth target was set, unlike in previous Plans. The goal is simply “a steady rise” in import and export volumes. This absence of a numerical target is both positive and negative for investors.
    • Positive in that it signals Beijing’s realistic acknowledgement of domestic and global uncertainties and of limits to the power of a command economy.
    • Negative in that it reflects the many variables and difficulties facing the government in assessing the trade environment that could lead to spectacular miscalculations, as for 2015. The growth target for trade was set at 6%. Actual growth last year was negative – falling 7% in renminbi terms and 8% in dollar terms.
  • Supply-side reform. This is a distraction. This slogan, intentionally or unintentionally, evokes the policies of Reagan and Thatcher to boost production. But Beijing’s plan of action is in the opposite direction. China’s problem is lack of demand and industrial overcapacity. Despite the new slogan, the government is not about to introduce a new strategy for growth remotely comparable to those in Reagan’s era.
  • Market reforms: The real question is not whether Beijing is fudging on its stated goal of market reforms but whether policymakers realize and accept the reality that they cannot have their reforms and yet have market forces behave in line with government goals. Until this conflict is resolved, there can be no genuine and lasting change in China’s economic structure.