Capital Flight May Be Hindering Growth

From beachfront properties in the Mediterranean, large private school tuition payments and other large overseas purchases, The Wall Street Journal reports that China’s strict restrictions on cross-border fund flows don’t seem to be keeping its wealthy citizens from moving money abroad:

China hasn’t reported on capital inflows and outflows since last year, but it is possible to gauge more recent flows using trade data, foreign-exchange reserves numbers released Saturday and other economic statistics. A Wall Street Journal analysis of that data suggests that in the 12 months through September, about $225 billion flowed out of China, equivalent to about 3% of the nation’s economic output last year.

“We all noticed what we suspected, which is that there was significant capital flight,” says Michael Pettis, a finance professor at Peking University who witnessed capital flight up close in his previous career trading Latin American distressed debt. “It’s not a good sign when local businessmen begin to think it’s better to take money offshore, especially when the world economy is in such bad shape.”

China officially maintains a closed capital account, meaning it restricts the ability of individuals and businesses to move money across its borders. Chinese individuals aren’t allowed to move more than $50,000 per year out of the country. Chinese companies can exchange yuan for foreign currencies only for approved business purposes, such as paying for imports or approved foreign investments.

In reality, the closed system has become more porous and the rules are routinely ignored. “The wealthy in China have always had an open capital account,” says Eswar Prasad, a Cornell University economist and former International Monetary Fund official.

The report adds that the capital outflow, which can be traced to concerns over falling domestic equity and real estate prices as well as a slower-than-expected yuan appreciation, may help explain why Chinese banks have not met their lending targets this year. And while The People’s Daily denied the possibility of a capital flight when its second quarter capital account slipped into a deficit, asset manager Edward Chancellor discussed the issue in an August Financial Times’ piece:

China’s forex reserves face another dire threat: capital flight. During the second quarter, “other items” on China’s capital account were negative to the tune of $110bn. Victor Shih, lately of Northwestern University, has pointed out that wealth is highly concentrated in China. Rich Chinese have many incentives to take their money abroad – real estate on the mainland is no longer a one-way bet, the threat of inflation is never far away and state-controlled banks pay negative real rates on deposits. There is also the danger that Beijing will seek to appropriate private fortunes.

When capital flees the country, China’s forex reserves will shrink. Professor Shih reckons that the collective fortunes of the top 1 per cent of Chinese households are larger than those reserves. This vulnerability can be viewed from another perspective. Chinese money supply (M2) is not only twice the size of the country’s economic output it is more than four times greater than the forex reserves. Reserves are currently equal to 22 per cent of China’s money supply. By contrast, the forex reserves of the Asian Tigers averaged around 35 per cent of money supply when their currencies collapsed in 1997.

Staff reporter Yu Hairong of Caixin Online, however, wrote in August that China’s capital account deficit was “an intended result rather than a sign people are losing confidence in the economy”:

Capital flows out of China may be accelerating, a phenomenon commonly associated with waning confidence in a nation’s economy, yet the foreign exchange regulator says the change is a step in the right direction.

In the first six months of the year, China’s capital account saw a deficit of US$ 20.3 billion, and its accumulated forex reserves grew to US$ 3.24 trillion, up only US$ 63.6 billion — 77 percent less than the amount added in the first half 2011, data from the State Administration of Foreign Exchange (SAFE) shows.

But this does not indicate capital flight, the regulator said. Instead, it primarily reflects shifting foreign exchange activity from the central bank to domestic institutions and individuals, it says.