As 2021 heats up, China is grappling with what might be seen as an enviable problem: more foreign capital zooming its way than Asia’s biggest economy knows what to do with.
With steady efforts to open the financial system in recent years, President Xi Jinping certainly put out the welcome mat. These upgrades are now dovetailing with the globe’s best post-Covid-19 recovery and the highest yields among major economies.
So the taps are on – full blast. The last 12 months saw a 62% surge in foreign buying of mainland stocks and a 47% jump in demand for bonds.
Yet Xi’s government is rapidly confronting a “be-careful-what-you-wish-for” dilemma. All that capital rushing its way can leave just as quickly if investors see opportunities elsewhere.
Worse, in the eyes of Xi’s inner circle, it gives overseas financiers a growing say in the nature of the financial system China is constructing before the world’s eyes.
China’s enviable problem
Again, these are arguably good challenges to have in 2021.
The US, for example, is struggling to tame the coronavirus and revive a traumatized economy at a moment of extreme gridlock in Washington.
Japan is battling the forces of deflation that many investors thought had been eradicated.
Europe’s fourth wave of Covid-19 infections is a dark cloud over asset markets.
China, by stark contrast, managed to expand 2.3% in 2020 and Beijing is targeting a 6% pace of gross domestic product growth this year. That outperformance in part explains why Chinese government 10-year debt yields are 3.3% compared with 1.6% for comparable US Treasury bonds.
It’s a problem nonetheless. And it is one years in the making.
In the short run, the dynamic presents Xi’s team with a Catch 22. As part of Beijing’s commitment to deregulate the economy, regulators have banks curtailing lending. The more their actions tighten credit conditions, the more resulting higher yield levels attract even more capital.
This conundrum is growing before Xi’s eyes as China diverges from other top economies.
The biggest worry for Xi’s Communist Party is losing control. The government’s paranoia about being subject to the whims of investors is now colliding with its big-picture aspirations to become the globe’s go-to financial center. Cracking down on money flows as, say, Malaysia did in 1997, would precipitate an exodus of capital.
This tension will preoccupy Xi’s 2021 – and beyond.
Where it started
Much of this paranoia stems from 2015. That year saw a chaotic yuan devaluation that quaked world markets. Summer 2015 also featured a near stock market crash that saw the Shanghai bourse lose 30% in six weeks.
Since then, authorities have maintained stern control of capital entering and leaving China. And don’t forget China’s 2013 experience, says economist Larry Hu at Macquarie Capital.
Back when Xi was just beginning his reign, China was forced to intervene in currency markets as capital flows caused the yuan to gyrate. Yet, Hu says, doing so might be hard this time, “as Beijing is trying to improve its relationship with Washington.”
China’s reform marched on, of course.
In 2016, People’s Bank of China officials had their wish of having the yuan included in the International Monetary Fund’s special drawing rights framework, only the fifth currency to do so. Clear-eyed PBOC officials saw the outside pressure from the IMF that this imposed on Xi’s party as a useful reform insurance policy.
The government has since won a place for mainland stocks in leading global indices, including MSCI. It methodically scored spots for the $18 trillion government bond markets in debt benchmarks, most recently the FTSE Russell.
The catch, though – and we are repeating ourselves – is that the more Chinese assets move into financial primetime circles, the more Beijing must tolerate the whims of traders.
The perils of prudence
The scale of related inflows has Xi’s team worried about froth and bubbles. Such imbalances will implode if government officials are too assertive with deleveraging efforts.
“The size of recent capital inflows is historically unusual for China and has drawn a lot of public attention and official comment,” says analyst Wei He of Gavekal Research.
“The resulting combination of bigger inflows and bigger outflows means that gross capital flows are now the biggest in a decade. But the impact of larger capital outflows has been mixed so far, and authorities remain wary of dramatic moves to further open the capital account.”
Concerns about the external sector abound, too.
Last month, banking regulator Guo Shuqing said he’s “very worried” that froth-related turmoil abroad could shake global growth, which, in turn, would imperil China’s growth. Yi Huiman, Beijing’s top securities regulator, called for large “hot money” flows to be strictly controlled.
These warnings came in the same month China increased the quota for domestic funds looking to bet on overseas securities markets to a record $135 billion.
And China is hoping to increase the two-way flow of investments in other ways. In December, Hong Kong disclosed ongoing talks to allow China-based punters to do more bond trading in the city.
To be sure, China is still doing a better job avoiding “hot money” outflows than many emerging-market peers.
As economist Jonathan Fortun at the Institute of International Finance points out, “the beginning of 2021 has seen a scaling back in EM equity flows.” By contrast, he says, “the overall flows picture has been supported mainly by China.”
Scary benchmarks
The message to Beijing, though, is to work faster and more transparently to upgrade its financial system – or suffer its own 1997-like reckoning.
Comparisons for risks confronting Beijing often focus on the 2008 Lehman Brothers crisis. Sure, China’s $10 trillion shadow banking system and its labyrinthine network of local government financing vehicles, or LGFVs, generated many a subprime asset.
Yet it is the risks that toppled Indonesia, South Korea and Thailand in the late 1990s that are more relevant to China’s 2021.
Just like developing Asia back then, Xi’s economy risks seeing demand for mainland assets overwhelming financial stability. China, in other words, runs the risk of too much unproductive foreign cash chasing too few transparent, world-class investments. The same goes for the micro-economic plumbing needed to insulate the broader financial system from volatile hot-money movements.
In a sense, China is putting the cart before the proverbial horse. It spent recent years vastly increasing the number of channels for investment to zoom China’s way.
Along with the inclusion of yuan-denominated assets in global indices, Xi’s team has championed trading links between Hong Kong, Shanghai and Shenzhen. The hope is that waves of inflows would, in and of themselves, make China Inc. more efficient and innovative. Having pension funds gorge on stocks and bonds, the thinking went, is always preferable to speculators.
Half-hearted reforms
Yet Xi’s reform team has been slower to turn rhetoric about letting market forces play a “decisive” role into reality. That would mean cutting bureaucracy; increasing transparency and efficiency; building a first-world credit-rating system; trusting governing institutions with some independence; allowing for defaults by irresponsible borrowers; moving toward full exchange-rate convertibility.
China, in other words, must get under the financial system’s hood.
A recent Bank for International Settlements report found that of 12 central banks studied, the PBOC is most on the frontlines of “sharp exchange rate fluctuations and large capital flows” that could “threaten financial stability and have negative real economic consequences.”
In China, BIS officials note, “the financial sector has been opened up in order to promote more stable two-way flows, with recent measures covering institutions such as wealth management companies and pension funds.”
Yet underlying reforms are more important. The to-do list includes accelerating steps to reduce the dominance and political influence of state-owned enterprises, reining in the multi-trillion-dollar shadow-banking universe festering with risks, and strengthening corporate governance.
Trouble is, steps to date to tame the amplitude of capital shifts have been incremental. This suggests that underneath Xi’s bold talk of reforms lurks deep trepidation about unleashing too much volatility.
Granted, the Federal Reserve in Washington isn’t making it easy for the PBOC. Fed Governor Jerome Powell’s ultralow interest rate regimen is creating control problems for monetary authorities everywhere.
One wild card: what if the Fed’s aggressive policies, and US progress on vaccine distribution, prompt investors to re-evaluate the US, suddenly pulling capital away from China?
“Potential continued strength of the dollar, narrowing growth gap between the Chinese and United States economies and less capital inflows are factors that imply potential overall depreciation pressure on the yuan against dollar in the near-term,” said analyst Marco Sun at MUFG Bank.
Ready or not, though, China will be on the receiving end of more and more capital. Few economies can absorb the kind of historic liquidity sloshing around the global system seeking sound investment destinations.
With its nearly $11 trillion equity market and an $18 trillion bond market, fast-growing China is an obvious lure for investors everywhere.
“China has long been very careful about opening its capital account, and that cautious approach is still the most probable one,” Gavekal’s He says. “Encouraging capital outflows at an inopportune moment could create volatility in financial markets and add to downward pressures on the economy.”
China’s 2021 problem may be a good one to have. But it’s a challenge nonetheless. It requires urgent attention.