Despite all the attention focused on the credit woes of China, and there are a lot Share, the state of the RMB remains my biggest concern. China has chosen a policy that significantly limits its policy movement reducing its flexibility exactly when it needs it most. Most people continue to focus on the headline FX reserves held by the PBOC, which as I have noted many times, simply are not the best metric here for a variety of reasons.
China has just released additional data from the Balance of Payment and the International Investment Position datasets which give us insight as to what is happening with capital flows and pressure on the RMB. The story continues largely unchanged as net flows continue to decline but with additional detail to help us better understand what is happening.
- Balance of Payment data continues to obscure the state of Chinese financial flows. According to the official BOP data, China enjoyed another bountiful quarter between January and March 2016 with a total net inflow of 256 billion RMB or $39 billion USD at current exchange rates. In fact, if we lengthen the time horizon, since the beginning of 2013, China has had only two quarters of net negative outflows with the last one coming in March 2014. These net outflows total only 250 billion RMB or less than the net inflow enjoyed in Q1 of 2016.
- If you have been following the Chinese economy at all over the past 12-18 months what strikes you about these numbers is that they do not match the large outflows we are witnessing and yes, depletion of foreign exchange reserves. For instance, the 256 billion BOP net inflow includes a large 256 billion RMB net error and omissions outflow. It defies any economic common sense that a country could be running such large and ongoing BOP net inflows while at the same time depleting FX reserves and devaluing its currency. Cumulative in the past four quarters, BOP net inflows have totaled 1.04 trillion RMB or $156 billion. In the past two years this amount rises to 2.35 trillion or $351 billion. If we believe the official balance of payment data, there is absolutely no reason for downward currency pressure. In fact, we would expect this level of net inflow to prompt moderate appreciation pressures.
- BOP data is calculated relying primarily on the official trade data from customs. As I have written about previously, this presents an enormously misleading picture of the trade and currency transactions and the subsequent inflows or outflows of capital. BOP records a 679 billion RMB surplus in goods trade. SAFE and Customs report a 694 billion and 810 billion trade in goods surplus. In other words, official BOP data is highly correlated with other official data like Customs and SAFE data. However, through Q1 in 2016 banks reported a surplus of only 150 billion RMB or only $22 billion RMB in arguably the most important category when considering net inflows. In other words, banks are reporting a trade in goods surplus of 78-82% lower than what BOP is reporting. This matters enormously because essentially all of the reported net positive BOP comes from the goods trade surplus. If you eliminate the goods trade surplus you eliminate the positive BOP position China reports to the world.
- In fact, if you focus on the BOP capital account data, it becomes obvious how delicate the situation is and what is driving these imbalances. First, investment inflows into China, as I have mentioned numerous times previously, are simply borderline collapsing. In Q1 2016, direct investment inflows into China were down 44.4% according to BOP data. Portfolio inflows into China were not just experiencing slower growth but experienced negative growth meaning there was net international disinvestment in China by $19 billion from a positive inflow of $17 billion in Q1 2015. Second, despite all the stories about the flood of Chinese outward investment, there is an important caveat to the overall story. What is happening is that if we incorporate the International Investment Position data, what we see is not a rapid rise in Chinese owned foreign assets but rather a rebalancing of the Chinese portfolio. By that we mean that total Chinese owned foreign assets have actually declined from Q1 2015 to Q1 2016 by $156 billion. In fact, Chinese owned foreign assets peaked twice above $6.4 trillion and most recently in Q1 dipped to $6.22 trillion. However, within this asset basket, we have seen a significant rebalancing. The entire growth in outward FDI and portfolio investment comes from depletion of official reserves assets. As total assets were declining from $6.4 trillion in Q4 2014 to $6.22 trillion in Q1 2016, Chinese owned FDI grew from $744 billion to $1.19 trillion and official reserve assets declined from $3.9 trillion to $3.3 trillion. These offsetting changes explain the entire growth in OFDI and decline to total assets. Furthermore, there is absolutely no way you can have the amount of supposed net inflows and at the same time witness total declines in Chinese owned foreign assets. Those are two contradictory data events.
- One question I frequently get asked is about reports like the BIS 1 ½ page brief talking about how virtually all of the outflows are debt repayment. These types of studies focus on official data like BOP data that simply does not capture the reality of what is happening with Chinese outflows. Furthermore, though there is monthly noise, we see a clear long term structural shift in capital outflows that is simply not reversing.