China is deeply engaged with the global economy through trade links. While trade integration runs deep, China is minimally engaged on the broader globalization dimension of cross-border capital flows. It has been deeply cautious in opening its financial accounts and concerned about domestic financial volatility and maintaining monetary policy autonomy. However, China has reached a development stage where financial account opening is critical for sustaining growth, increasing discipline and efficiency in financial intermediation, fostering the transition to a new economic model, and ensuring the global competitiveness of Chinese companies. 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 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
China’s financial account showed greater stability than at any time since late 2014, allowing leaders to claim victory over the large-scale capital flight that affected the country in 2015 and 2016. However, this stability resulted not from economic reforms, but from a combination of capital controls, policy guidance, and most importantly a favorable global macroeconomic environment. Moreover, it was not a costless victory: confidence that Beijing was ready to allow foreign investment to freely enter and leave China was sacrificed.
China’s financial account stability in 2017 was largely rooted in a changing global macroeconomic environment, but it also reflected policy interventions.
Present macroeconomic and financial conditions are prone to change. If and when global exchange rate expectations, interest rate dynamics, or other variables shift, capital outflows could resurface as a problem. Though Beijing maintains that financial account liberalization remains on track, it imposed new formal and informal mechanisms to control capital outflows and intervened as needed throughout 2017. We expect China to remain in the defensive mode as it strives to keep capital outflows at the present subdued levels for the coming year. At the same time, Beijing is clearly eager to promote inflows. Some incremental policies were announced, and we expect additional policies in coming months. Whether these policies are actually implemented will be revealed by our data in future quarters.
This Quarter's Numbers
Our primary indicator shows that the Ratio of Cross-border Capital Flows to GDP slightly recovered in the second and third quarters but remained well below pre-2017 levels. China’s gross cross-border capital flows rose from US$146 billion in 1Q2017 to US$192 billion in 2Q2017 and US$206 billion in 3Q2017. The ratio of total cross-border capital flows to GDP was 6.2% in the first three quarters, well below the 8% to 9% average of recent years.
As shown in Net Capital Flows, the financial account balance remained positive in the third quarter, but net inflows through official channels were balanced by large unexplained outflows (net errors and omissions). Within the financial account, we witnessed an important shift in patterns: net inflows through the “other investment” account largely disappeared, while net inflows of “portfolio investment” jumped to US$38 billion, the highest surplus in this channel on record.
Breakdown of Cross-border Financial Flows provides more details on the composition of inflows and outflows. Total outflows under the financial account were below US$100 billion in each of the first three quarters of the year, compared to an average of US$180 billion in 2016. After Beijing tightened controls on direct investment, outbound foreign direct investment (OFDI) dropped from US$50–60 billion per quarter last year to US$20–25 billion in 2017. Outflows under the other investment account peaked at US$130 billion in 3Q2016 and dropped dramatically to less than US$40 billion per quarter in 1Q2017 to 3Q2017. This reflects capital controls but more importantly a big shift in exchange rate expectations toward a stronger RMB (incentivizing market participants to switch from US$ to RMB assets).
A recovery of inflows also contributed to the financial account surplus: at US$125 billion, these were the highest seen since 1Q2014. In the first two quarters in 2017, gross inflows were driven by strength in the other investment account as buyers acquired RMB assets. Those other investment inflows dropped significantly (to US$29 billion in 3Q2017 from US$75 billion in 2Q2017) but were made up for by an unprecedented US$61.5 billion of portfolio investment inflows. Those resulted from the launch of the Bond Connect program in July 2017, resulting in a sharp increase in foreign holdings of high-yield negotiable certificates of deposit. Inflows in both channels (other investment and portfolio investment) were in large part driven by overseas subsidiaries of Chinese financial institutions, rather than by foreign investors. Inflows of FDI slightly increased to US$32 billion but remained at low levels compared to previous years despite recent investment liberalization promises from Beijing (see Policy Analysis discussion).
The stable surplus in the financial account supported net accumulation in China’s reserves (see Currency Intervention), which were back up to US$3.1 trillion at the end of the third quarter. The Share of Foreign Buyers in Total Chinese M&A Activity continued falling to a new low of 11%, illustrating the persistence of market access barriers for foreign acquirers as well as high valuations of Chinese assets. The Globalization of China’s Currency (as reflected in the share of international payments made in RMB) edged up slightly to 1.9%, but it remained well below a peak of 2.5% in 2015.
In November, Beijing announced that it would further open up the financial services sector to foreign investment.
Policy Analysis: 3Q2017
China’s financial account stability in 2017 was largely rooted in a changing global macroeconomic environment, but it also reflected policy interventions. In the third quarter, the Chinese government continued to cement and fine-tune restrictions on capital outflows while advancing policies to encourage inflows.
Regarding outflows, Beijing formally implemented a new regulatory system for outbound FDI in August based on lists for “encouraged,” “restricted,” and “prohibited” sectors. In the fourth quarter, just beyond our review period, regulators followed through with enforcement rules, which included the establishment of a black list to record and punish violators of outbound investment rules. In late December, China’s foreign exchange regulator also expanded the crackdown on households moving money offshore, capping withdrawals from Chinese ATM cards at RMB 100,000 (US$15,870) per year.
On inflows, China made incremental progress on FDI reforms. In July, the Ministry of Commerce (MOFCOM) clarified that a new recording system for FDI applies to acquisitions, rescinding mandatory approvals for foreign acquisitions of Chinese companies. In November, Beijing announced that it would further open up the financial services sector to foreign investment: equity caps for foreign ownership in securities, fund management, and futures companies will increase to 51% and be fully removed in three years; the equity cap for FDI in life insurance will relax to 51% and be completely removed in five years; and the equity caps for foreign investment in banks and financial asset management companies will be removed entirely in one step. In response to U.S. tax reforms, Beijing in December announced that it would temporarily exempt foreign firms from provisional income tax on profits they reinvest in encouraged sectors in China. These steps, if faithfully implemented, could promote inward FDI in future quarters, provided a host of other factors impacting market expectations cooperate.