By Maximilian Kärnfelt
Since 2015, the specter of capital flight has been haunting the Chinese economy. In that year, faced with the threat of a currency devaluation and an aggressive anti-corruption campaign, investors and savers began moving their wealth out of China. The outflow was so large that the central bank was forced to spend more than $1 trillion of its foreign exchange reserves to defend the exchange rate.
The Chinese government was eventually able to dam up the flow of capital out of its borders by imposing strict capital controls, and China’s balance of payments, exchange rate and foreign currency reserves have all stabilized. But even the largest dam cannot stop the rain; it can only keep water from flowing further downstream. There are now several signs that the conditions that originally led to the first massive wave of capital flight have returned. The strength of China’s capital controls might soon be put to the test.
Before listing the reasons why a second bout of capital flight is looking increasingly likely, let us first address the underlying question: is capital flight truly so damaging for a country that fighting it can be economically justified? In the case of China, the answer is probably yes, for the following reasons:
- First, a government’s ability to pay for its domestic and foreign expenditure can be affected by capital flow out of the country. Large flows out of the country reduce the tax base, potentially reducing government revenue. Outflow can also result in a currency depreciation, increasing the cost of foreign investments. The Chinese government has large commitments both at home and abroad, so this is naturally a great concern.
- Second, asset price bubbles need a constant supply of liquidity. If capital flight is severe, such bubbles are deprived of funding and can subsequently burst, potentially causing a damaging crisis. China’s real estate market is clearly vulnerable to this.
- Third, as the Mundell-Flemming trilemma states, a country can only choose two of the following three: independent interest rates, free capital flows and a fixed exchange rate. If a country tries to have all three at once, then once the country enters a depreciatory cycle, foreign currency reserves must be committed. And once they are depleted, the fixed exchange rate can no longer be maintained. The Chinese central bank’s controlling rate is not the same as the US Fed’s, and the country manages its exchange rate. Therefore, it must control the flow of capital.
These three reasons make it clear that without capital controls, the Chinese government could face considerable difficulties in meeting its obligations and ensuring stability.
Capital flight stems from a combination of fundamental and psychological factors. Interest rate differentials between foreign and domestic investment and savings opportunities, as well as differences in tax rates are fundamental factors than can lead to cross-border flows. Psychological factors are related to the anticipation of changes in the socioeconomic environment which could negatively affect wealth holders. Such anticipations can largely be distilled into the suspicion that if capital is not moved outside of the country’s borders a large portion of it will be soon be appropriated or lost. And since investors are somewhat like herd animals, if one scares, panic often follows.
There are currently both fundamental and psychological factors that point to the possible return of capital flight. The West seems to have finally emerged from the Great Recession that followed the Global Financial Crisis in 2008. Western economies are once more returning to their long-run economic growth trends.
On top of this, central banks in the United States, Europe and Japan have begun reducing their balance sheets and are increasing controlling rates. These factors are driving rates up, narrowing the interest rate differential. Chinese rates are still higher than those in the West, but regular savers do not have access to the returns in the interbank market. For complex reasons related to China’s developmental model, rates paid for regular bank deposits are instead purposefully kept below the rate of inflation. Tax cuts in the United States will also make it a more attractive investment destination.
There are also real or imagined economic and political risks that could cause investors to decide to move their money abroad. The Chinese financial system—and corporates in particular—have since 2009 rapidly become highly leveraged. This means that a bailout of the financial system, either through raised taxes or the printing press, is not out of the question.
Secondly, the existing capital controls ironically have resulted in the RMB appreciating close to the level that it reached in 2015, just before the devaluation. Exports have begun to fall and there have been reports that exporters see this as a greater problem than potential tariffs. If exports continue falling, policy makers might be tempted to devalue the currency to support exports. All the above risks could easily persuade wealthy Chinese that moving capital out of the country is the best insurance policy against potential future losses.
However, a key point remains: if a large enough group of investor-savers decide to move their capital out of the country, the currency will come under pressure. A relatively small number of actors can in this way cause an enormous chain reaction. As Chinese foreign exchange reserves equal only 10% of money supply, a large-scale capital exodus would quickly deplete liquid currency reserves.
There are many signs that the difficulties China struggled with in 2015 could return. Even in the current calm, few would doubt that outward capital flows would be immense if controls were completely relaxed. Perhaps the most likely cause of renewed capital flight would be a possible bailout of the financial system as a part of the ongoing deleveraging campaign. Few wealth holders would like to be subjected to the taxation or inflation that would have to follow and would try to move their wealth abroad if they suspected a bailout was imminent.
The dams are keeping the water in for now. But time has passed, and no one can be sure if they will hold once the rain begins anew.
Maximilian Kärnfelt is an economic analyst at the Mercator Institute for China Studies (MERICS), where his research focuses on China’s macroeconomy, monetary policy, and financial markets. Prior to joining MERICS, he worked as an economic consultant for several companies. In 2016, he received his master’s degree in economics from Peking University, where he also worked as a research assistant.