China is deeply engaged with the global economy through trade links. However, it is far less integrated with the world’s cross-border capital flows. China has now reached a development stage where financial account opening is critical for sustaining growth by increasing discipline and efficiency in financial intermediation, easing the transition to a new economic model, and ensuring the global competitiveness of Chinese companies. This does not come without trade-offs, however, with policymakers concerned that a mismanaged opening of its financial account could see market volatility affect domestic stability, in addition to the loss of monetary policy autonomy. In its 2013 Third Plenum decisions, China pledged two-way opening of its capital markets and improved cross-border capital convertibility.
To gauge overall external financial liberalization progress, we sum the gross volumes of capital flows into and out of China on a quarterly basis and divide by the gross domestic product (GDP) in the same quarter. This primary indicator of China’s degree of financial integration tells us how China’s opening to external capital flows is progressing compared to overall economic growth. We supplement this picture with other charts: the balance of cross-border capital flows by category plus net errors and omissions, the breakdown of inflows and outflows by type, the buying and selling of foreign exchange reserves by China’s central bank, the role of foreign buyers in total Chinese mergers and acquisitions, and the share of the Chinese currency in global payments.
Quarterly Assessment and Outlook
We upgrade our assessment of cross-border investment liberalization to a slight positive. China’s 2013 Third Plenum reform agenda recognized the importance of freer portfolio and direct investment flows in allocating resources efficiently and fostering new comparative advantages. The government specifically pledged to “promote the opening of the capital market in both directions” and to “raise the convertibility of cross-border capital.” To gauge Beijing’s progress, our primary indicator tracks the sum of China’s cross-border investment flows as a share of GDP. The indicator shows that cross-border investment intensity was stagnating at low levels throughout 2017 but has slightly recovered in 2018 (from an average of 6% in the previous four quarters to an average of 7.4% in 1Q2018 and 2Q2018).
The increase of cross-border capital inflows can partially be attributed to liberalization measures in the portfolio and direct investment channels. In 2Q2018, the inflow of foreign portfolio investment reached all-time quarterly highs of $65 billion, driven by Beijing’s opening of the bond and equity market to foreign investors and anticipation that domestic bonds would soon be included in leading emerging market bond indices. Foreign direct investment (FDI) inflows also remained strong, partially because Beijing implemented previously announced FDI liberalization measures through approving high-profile wholly foreign-owned projects in sectors such as chemicals and automotive manufacturing. While this sort of piecemeal liberalization is seen on the inbound side, capital controls keep outflows low. Despite a 5.5% drop in China’s exchange rate, outflows through the “other investment” channel remained modest in the review period. Outbound activity through FDI and portfolio investment channels also remained much lower than what they would have been under an open financial account.
Looking forward, we see additional pressure on China to promote capital inflows and suppress outflows. A drop in the renminbi (RMB) exchange rate and growing interest rate spreads between China and the United States are recreating the conditions that triggered large-scale capital outflows in 2015 and 2016. The U.S.-China trade war adds further pressure as tariffs weigh on trade surplus, possibly pushing China’s current account into deficit for the year. Under these conditions, it is improbable that China will remove controls on outbound flows anytime soon. It will be critical to double down on efforts to reassure foreign portfolio investors, who are increasingly important for balance-of-payments (BoP) stability.
A drop in the renminbi (RMB) exchange rate and growing interest rate spreads between China and the United States are recreating the conditions that triggered large-scale capital outflows in 2015 and 2016.
This Quarter's Numbers
To measure Beijing’s progress in fulfilling its 2013 Third Plenum reform commitments on investment and trade, we track gross Cross-border Capital Inflows as a ratio to GDP. That ratio ticked up to 7.8% in 1Q2018 from an average of 6% in the previous four quarters. In 2Q2018, gross cross-border capital flows (inflows plus outflows) reached $217 billion. For the first two quarters, that number totaled $461 billion ($230 billion on average per quarter or 7% of GDP), which is similar to the 2014–2016 period.
With $124 billion in inflows and $94 billion in outflows, China’s financial account remained in surplus (see Net Capital Flows). The other investment balance returned negative to the tune of $54 billion as Chinese corporations and households switched to foreign currency assets in response to the drop in the value of the Chinese currency. The FDI balance remained positive, reflecting continued foreign appetite to invest in China as well as strict controls on the outbound side. The biggest marginal contribution – and significant deviation from previous quarters – is an unprecedented surplus of $61 billion in the portfolio investment balance.
A Breakdown of Cross-Border Financial Flows illustrates that this big surplus in the portfolio investment channel in 2Q2018 was primarily driven by foreign investors piling a record $65 billion into Chinese securities. This surge can be attributed to China’s decision to open up the government bond market to foreign investors and to open additional channels for foreigners to acquire Chinese equities. Additionally, Chinese outbound portfolio investment dropped to only $4 billion, the lowest since 3Q2015 (compared to peaks of $45 billion in 4Q2017 and $33.5 billion in 1Q2018). This resulted largely from a sharp fall in the utilization of cross-border investment channels linking the Shanghai and Shenzhen Stock Exchanges to the Hong Kong Stock Exchange.
The foreign direct investment surplus can be attributed to healthy inflows and suppressed outflows. Inflows were $53 billion in 2Q2018, down from $80 billion in 4Q2017 and $73 billion in 1Q2018, yet the figure is still elevated compared to the 2014-2016 period. Alternative data confirm that FDI inflows are up in 2018, at least partially because of Beijing’s push to reduce barriers on foreign investment. However, the high level of inflows in the past three quarters suggests that financial flows within the FDI channel (companies borrowing in foreign currency from their offshore subsidiaries under the FDI account) continue to be at least partially responsible for the surplus.
The other investment account returned to net outflows ($54 billion) for the first time since 4Q2016, reflecting a halt of inflows ($5.6 billion) and a surge in outflows ($59.5 billion). Most of that happened in “currency and deposits,” which shows that households and corporations were switching short-term holdings of cash from Chinese yuan to U.S. dollars in a period of severe downward pressure on the Chinese currency. Unaccounted flows (“errors and omissions”) have remained negative in 2Q2018 for the 17th quarter in a row, but net outflows remained relatively low compared to previous quarters ($11 billion).
With net financial inflows, China continued to add to its Foreign Exchange Reserves in 2Q2018, to the amount of $23 billion. However, the change in total reserves held by the People’s Bank of China (PBoC) was negative for the quarter, which suggests that exchange rate dynamics had a negative impact on the stock of existing reserves.
The Share of Foreign Buyers in Total Chinese M&A Activity, which we monitor as an indicator for openness to foreign acquisitions, slightly decreased to 12.7% in 2Q2018. The role of foreign investors has rebounded from 2011 lows of only 11%, but it is still far from the 30% seen five years ago. Recent steps to allow foreign companies to take majority control of their ventures in financial services and other areas may boost these figures in coming quarters if properly implemented, although heightened U.S.-China bilateral tensions are very likely to cast a shadow over these opportunities.
Finally, Beijing’s 2013 Third Plenum Decisions committed explicitly to accelerating the realization of RMB convertibility. This should advance the currency’s international use, which we track in our supplemental indicators. The Global Use of China’s Currency dropped in recent quarters to a three-year low of 1.6% in 4Q2017 but since then edged up again and reached 1.78% in 2Q2018. In July and August 2018, the RMB’s share in international payments climbed to 2% and 2.1%, respectively. However, this RMB appetite was likely driven by currency forward contracts being pushed offshore after Beijing imposed a 20% reserve requirement on domestic onshore forward transactions in early August in an attempt to stymie investors betting on a weaker currency.
Liberalization is happening, but only gradually, and mostly on the inbound side. Facing growing capital outflows, Beijing continued its approach of a heavily managed outbound investment regime.
The latest data points confirm that Beijing’s policy approach of external capital flows continues to be focused on controlling outflows while gradually expanding and diversifying channels for inflows. In other words: liberalization is happening, but only gradually, and mostly on the inbound side.
Facing growing capital outflows, Beijing continued its approach to a heavily managed outbound investment regime. Policies on outbound FDI remained strict and controls effective. Portfolio investment outflows remain even more tightly controlled, but the government undertook some small steps to allow greater portfolio outflows through programs that it could control. In April, it began to reissue quotas for the Qualified Domestic Institutional Investor (QDII) scheme. QDII funds have outperformed returns in the domestic markets thus far in 2018 (averaging a 3.1% gain from 1Q2018 to 3Q2018, compared to a drop of more than 15% in the Shanghai Composite), so market participants are eager to take advantage of these new channels, albeit on a small scale. It also moved forward with the Qualified Domestic Limited Partners (QDLP) and Qualified Domestic Investment Enterprises (QDIE) schemes by implementing two pilot programs in Shanghai and Shenzhen. In May, the PBoC also reopened the R-QDII scheme but emphasized that investors could not use this channel for purchasing foreign exchange abroad.
On the inbound side, China continued to implement and fine-tune inward FDI reforms. A range of new projects has been announced since the beginning of 2018, showing a response to Beijing’s favorable policies. Several of these investments are awaiting approval, for example, foreign investment banks taking control of their Chinese securities ventures. If these approvals get through quickly, it may send a signal to other foreign investors. In September, China reiterated commitments for FDI opening during a State Council Executive Meeting. The meeting also announced that China will allow investments that qualify as key construction projects to be granted favorable treatment in land/sea usage. This includes expedited approvals and an expanded range of foreign investments temporarily exempt from income tax withholding, increasing the range from the “encouraged” list to those on the “encouraged” plus “restricted” lists.
After a strong second quarter for portfolio inflows, which was largely driven by China’s inclusion in global bond indices, China continued efforts to deepen market access for foreign investors to Chinese bonds and stocks. In June, PBoC and the State Administration of Foreign Exchange (SAFE) issued new regulations that scrapped the restriction on QFII investors to repatriate no more than 20% of their total assets in China each month, abolished the three-month lockup period for investment principals for both QFII and RQFII, and allowed investors in the two programs to hedge their foreign exchange exposure in the onshore market. In August, Beijing announced exemptions for foreign investors from paying income tax and value-added tax on their onshore bond investments for a three-year period, addressing a key uncertainty facing foreign investors. In June, A-shares were formally included in the MSCI Emerging Markets index. In September, FTSE Russell announced that it would add China’s A-shares to its emerging markets index with a weighting of 5.5% starting in June 2019.