China’s money flow may not reverse if growth prospect does not improve8 October, 2012, 18:01. Posted by Zarathustra
China’s capital outflow situation has been a very important theme here. For many months, we have been suggesting that net capital outflow, if large enough to offset trade surplus, means that the Chinese central bank will be forced to shrink monetary base (or balance sheet of the central bank), which is not exactly a very welcoming sign for China, especially when the economy is slowing.
A lot of commentators are trying to downplay the seriousness of the outflow, or to exaggerate claims by the bearish side regarding the negative impact of outflow. A very common objection to our view is that China has US$3.2 trillion of foreign reserve, which gives, many reasoned, a huge firepower against outflow. This objection completely misses the point that we are not suggesting a crisis like the 1997 Asian Financial Crisis is imminent. In fact, with US$3.2 trillion foreign reserve, China has the ability to withstand US$1-2 trillion of “capital flight” without being forced to devalue Chinese Yuan in a very dramatic fashion as in many countries during the Asian Financial Crisis. But the mere fact that China has a large foreign reserve does not mean that capital outflow will not be negative for the Chinese economy. Capital outflow has already done damage for China as foreign reserve accumulation has already stopped, so that China’s central bank balance sheet gets smaller relative to the size of the economy, tightening liquidity at the time when liquidity is more needed than before.
Another response to our negative assessment of the impact of outflow is that part of what appears to be outflow is not outflow at all. For instance, some believe that part of what appears to be outflow is simply that Chinese companies and households are accumulating foreign currencies in Chinese banks account, so the funds have not been moved away from China, so that negative assessment from people like us is unwarranted.
It is absolutely true that simple derivation from the change of forex purchase as per PBOC’s statistics does not actually give us the breakdown of the destination of “outflow”, and it is absolutely possible that part of this “outflow” simply reflects the accumulation of foreign currencies locally, not money being moved out of the country. But as we pointed out very clear, the destinations and and motivations of these “outflow” are not important, because the impact on domestic Chinese Yuan liquidity is exactly the same, namely, it tightens liquidity:
Nevertheless, the impacts of outflow, outbound investment, weak foreign investment flow, accumulation of foreign currencies by households and corporations, and households moving money away for emigration on foreign assets of PBOC are the same. There is absolutely no point to distinguish the sources and motivations of various outflow as far as this big picture view is concerned.
OMT and QE-Infinity have improved risk appetite somewhat immediately after the announcements, although the positive impact is currently fading. After the announcement of potentially unlimited central banks’ balance sheet expansion from the Fed and the ECB, we pointed out that if these actions are able to reverse money flow pattern, QE-Infinity and OMT will help China is the short-term. But after the unusually serious liquidity crunch ahead of the Golden Week holiday, we were forced to rethink our initial positive assessment.
It boils down to whether money tends to flow into China during QEs, and if so, how large and for how long the flow will persist. Goldman Sachs believes that drivers of “hot money flow” included interest rate differential between China and the US, global and China risks. Controlling these factors, they found that the impact of quantitative easing on money flow has been mixed. Specifically:
We did a simple event study to assess this view based on past QE experiences, and to see whether QE affected hot money flows via channels that are above and beyond those of the fundamental drivers of the interest rate differential and risk factors. To net out the effect of these drivers, we look at the residuals of the monthly version of our regression reported above to see how the hot money flow dynamics changed around the past episodes of QE (QE1 in November 2008 and March 2009; and QE2 in September 2010). Overall, the evidence is mixed. While there seems to be a broad uptrend in flows around the first round of QE1, effects of the subsequent rounds of QE are much less discernible (see Exhibit 6). Therefore, it appears that QE3 alone may not generate a pronounced and sustained impact on hot money flows, unless it also causes tangible improvement in the fundamental drivers, particularly global and China prospects as measured by our risk factors.
Source: Goldman Sachs
In other words, QE-Infinity alone is not enough to shift the trend of money flow pattern unless there is improvements in the market perception on the global and Chinese economic growth prospect. Although we were only looking for some short-term relieve from QE-Infinity as far as Chinese liquidity is concerned, it appears that there is a possibility that we have already overestimate the positive impact from QE-Infinity.