Forex tide turns outward in China

China, which was until recently awash in a ‘hot money’ tsunami, is now likely experiencing “very, very large, unexplained” capital outflows, say economists, and the trend reversal could have implications for China’s overseas investments, and the future of the US dollar.

Official foreign exchange reserves rose in the fourth quarter of 2008 by $40 billion to $1.95 trillion, “but once adjusted for valuation changes in the portfolio, total inflows may only have been $10 billion, which means, according to our model an ‘unexplained’ foreign exchange outflow in Q4 of $240 billion,” says Standard Chartered economist Stephen Green.

“Even if the scale is not as large as the headline figure suggests, the trend is pretty clear: ‘unexplained’ money (which includes ‘hot’ money) is leaving China,” he adds.

Any estimate on capital outflows must be treated with caution, reasons Royal Bank of Scotland economist Ben Simpfendorfer. Even so, he estimates that “a decline in foreign exchange reserves of ‘up to’ $300 billion cannot be entirely ruled out.”

China’s commercial banking officials have noted a sudden increase in foreign exchange demand in recent months. Additionally, Chinese yuan-denominated deposits in Hong Kong have fallen in anticipation of a slowdown — and perhaps even a reversal — in the appreciation of the yuan as officials pull out all stops to rescue exporters battling a falloff in orders from the US and Europe.

Morgan Stanley Asia chairman Stephen Roach, however, reckons that the recent data is not entirely worrisome. “Net-net, the rate of foreign exchange reserve accumulation has slowed a lot, but it is still increasing. The capital outflows issue has tempered the rate of reserve accumulation, but it has not swung it into negative territory.”

In any case, with about $2 trillion in reserve, he says, China “has a cushion that no country has ever had on the reserve front.”

Others believe that the trend reversal could prompt a change in China’s investment preference.

 “A lack of support from foreign investors will see the Chinese government further tighten rules on capital outflows,” reckons Moody’s Economy.com economist Sherman Chan.

“Bargain-hunting in the global marketplace will be curbed, as funds are preferred to be allocated to local projects that are needed to keep the domestic economy afloat.”
The trend reversal, if confirmed, may also have implications for China’s foreign exchange reserve accumulation in 2009, reasons Green. “It will also have implications for China’s purchases of US securities,” he adds.

The trend could likely prompt China’s central bank to target a stable yuan over the next six months in order to deter a further rise in capital outflows, says Simpfendorfer. “The experience of early December, when the yuan’s weakness sparked a surge in US dollar demand, was a timely warning on the risks of permitting the currency to weaken.”