from Follow the Money

China’s capital controls and the RMB

September 6, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Today China is spending about 1% of its GDP a month to keep its currency from appreciating - it is on track to spend about 15% of its GDP fighting appreciation this year.  And unless something changes, it will do the same next year.

China is on track to run a current account surplus of at least $120 billion (and probably more -- $150b is not out of the question, though much depends on whether oil import volumes pick up).  It will probably attract about $60 billion in (net) FDI this year.   That generates a $180 billion surplus in the fx market at the current exchange rate.  

That surplus could be used to finance the outflow of hot money - think bank depositors trying to get out of bad Chinese banks.   But it is not.  Right now, hot money is flowing into China.  So China's reserves are on track to increase by much more than $180b, or even $200b.   $275-300 b is a realistic range.

That is why I am bit skeptical of claims, including the claims made by a former Bush Administration Commerce Under Secretary, Grant Aldonas, that if China got rid of its capital controls, the RMB would depreciate. 

Hello 10% of GDP Chinese trade surpluses.  Hello 30% y/y export growth for the next three years ...

No doubt, China's capital controls have a big impact on the operation of China's exchange rate regime, and thus on the pressures on China's "de facto dollar peg disguised as a managed float."  The controls work both to keep Chinese savings inside China, and in the Chinese banking system - and to keep outside investment out of China.  They wall China's financial system off from financial globalization.  

But I do not think the controls are all that stands between China and a big fall in the RMB.  Rather,  I would bet that the RMB would rise if China's controls were lifted and China's central bank stopped intervening in the foreign exchange market.


Three reasons:

First, the $180 billion a year coming in from China's trade surplus (and its current account surplus) and from foreign direct investment in China  provides a huge cushion of support for the RMB.

Suppose today's hot money inflows turned into hot money outflows, it would take a capital outflow of $180 billion just to keep China's reserves from continuing to rise.

$180 billion is about 10% of China's GDP.  It is a huge sum.   Argentina was brought to its knees by a capital outflow of only a bit larger than 10% of its GDP. (edited for clarity)

Moreover, even if hot money outflows exceeded $180 to $200b, China would not have to let the RMB to fall.  It could just dip into its reserves.   It will have about $900 b in the bank.  That provides a ton of options.

Bottom line.  Barring massive capital flight, far more dollars are coming in to the China on an ongoing basis than are going out.

Second, The controls don't just trap Chinese savings inside China, they also keep outside savings out of China.

Aldonas's analysis strikes me as off in another way: he assumes that without capital controls, "trapped" domestic deposits would flow out of China, but no money would flow into China.  I suspect the flow would go in both ways. 

After all, right now, Chinese assets are cheap by almost any measure for international investors, but China's capital controls keep those assets out of international hands.   "Real assets" are cheap: US firms might swoop in to buy into the fast growing Chinese market.   Speculators, who now can only bet on the RMB in the (expensive) offshore market, might suddenly flood China with speculative inflows.    I think Li Deshui is wrong: more hedge funds are itching to bet that the RMB will rise than are itching to bet that it will fall.

Short-term rates in Japan and the eurozone are even lower than the interest rate on RMB deposits inside China.  Why not borrow in yen at next to nothing, sell the yen to the PBoC, and buy short-term Chinese treasury bills?    It seems reasonable to think that over time the RMB will appreciate v. the yen.   Same with the euro.   And the negative carry on RMB central bank bills is probably not enough to deter even dollar funded bets on RMB appreciation.

Remember, as I discussed in a previous post - speculative capital right now is trying to get into China despite China's controls, not trying to get out.    China has been liberalizing controls on capital outflows to try to get private Chinese citizens to hold dollars (and to convince Chinese firms to buy foreign companies) in order to try to limit the increase in the central banks reserves.  Conversely, it has been tightening controls on inflows coming into China, notably by clamping down on Chinese banks' borrowing dollars abroad to lend domestically.   The available evidence suggests that there is more suppressed demand (at the current exchange rate) for money to get into China than for money to get out of China.

Third, China's policy makers would not sit still in the face of a 10% of GDP "hot money outflow."

That kind of outflow from China would bring deposit growth - and lending growth - in China to a standstill, slowing the economy.

An aside: A slowing economy, even in the absence of any exchange rate depreciation, would produce an even larger trade and current account surplus.  Consequently, barring a collapse of FDI, if hot money started to flow out of China in a big way, China would have even more than $180 b a year in inflows to finance "hot money" outflows. 

More importantly, China's policy makers almost certainly would not sit on their hands and do nothing in the face of that kind of outflow from their banking system.  What could they do?  They could increase deposit rates for one.   They could accelerate the recapitalization of the banking system for another.    China could swap bad banks and low levels of government debt for good banks and high levels of government debt rather easily.

And if the situation really got out of hand,  China could, of course, just reimpose capital controls - so this entire debate is rather theoretical.   The evidence we have doesn't suggest that China's capital controls work perfectly, but it does suggest that they work.

One last point: right now, Chinese citizens with dollars if good banks offshore are trying rather desperately to move their savings into bad "onshore" banks that offer RMB deposits.   And households with dollars on deposit in China have shifted into RMB deposits.    That might change dramatically if China got rid of its controls and they started to worry that everyone in China might shift their savings abroad.  Expectations matter. But the available evidence suggests that Chinese citizens are more inclined to bet on the RMB in bad banks than to seek the (comparative) safety of the global financial system.

Who knows, perhaps Chinese depositors are reading Raghuram Rajan, and are worried that the international financial system is a bit riskier than it looks ...

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