China embraces rising capital inflows as rivalry with US intensifies

Cissy Zhou
·7-min read

Beijing is relishing its current role as a darling for global investors, despite rising tensions with Washington, as large inflows of portfolio and fixed-asset investment funds make their way into China.

While the US Federal Reserve and central banks of other major economies are splashing out money to protect economic activities and jobs, China is seeing a steady flow of funds into its bonds, stocks and investment projects. This is allowing the People’s Bank of China to take a prudent monetary stance and to keep its benchmark interest rate relatively high, which in turn is helping attract more capital inflows while helping offset Washington’s attempts to decouple from China.

The momentum could give Beijing a chance to advance its strategic goals of boosting the international profile of the yuan, while integrating its domestic market more closely with the world, according to public speeches by Chinese officials, as well as government researchers and economists the Post talked to.

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Analysts agree that the current capital inflows are a good thing. But they also point out that the trend could be reversed by a stronger US dollar, if the US Federal Reserve increases interest rates, or if China lowers interest rates.

Yu Yongding, a leading Chinese economist and a former adviser to China’s central bank, said the country’s export surplus, as well as optimism among foreign investors on the outlook for the Chinese economy, is helping to strengthen the yuan and drive money into China.

“Traditionally, China would mitigate the risks of so-called hot money through the control of cross-border capital flows and adjustments in its exchange rate and monetary policy,” Yu said. “But I think it is too early to take any measure at this stage, as there is no obvious pressure yet.”

The dual listing in Hong Kong and Shanghai by Jack Ma’s Ant Group will be the largest initial public offering in history. Speculation about the decline of the US dollar is gaining traction in China, and there are signs that China’s state-owned foreign exchange reserve managers are selling US Treasuries. Wall Street houses, from Goldman Sachs to Bridgewater, are knocking at the door again, seeking greater access.

Foreign investors owned 2.94 trillion yuan (US$438 billion) worth of interbank market bonds at the end of September – a 4.9 per cent increase from August – and the balance of yuan-denominated bonds held by foreign investors has nearly tripled since September 2017 thanks to the recent entry of those bonds into investment benchmark indices such as the Bloomberg Barclays Global-Aggregate Index. Investment rules of many Western funds require them to invest in bonds included in such indices.

The stream of capital inflow comes as China is forecast to be the only major economy to grow this year, while the United States and Europe continue to grapple with record-breaking numbers of new coronavirus infections.

The world’s second-largest economy began recovering in May from the coronavirus-induced slump, and its gross domestic product grew by 4.9 per cent in the third quarter, year on year. That followed growth of 3.2 per cent in the second quarter, and a steep contraction of 6.8 per cent in the first quarter.

While keeping its interest rates relatively high, China in September reported its strongest export performance since March 2019, with a 9.9 per cent increase year on year. But with the coronavirus continuing to spread unabated across Europe and the US, external demand is difficult to predict. China’s overall trade surplus dropped sharply to US$37 billion in September, down from US$58.93 billion in August due to a strong increase in imports.

China’s 10-year bond yield has increased from 2.5 per cent in May and posted a yield topping 3.2 per cent on Friday, above the 0.80 per cent yield on US Treasury 10-year notes and well above the negative 0.65 per cent yield on German 10-year bonds, the benchmark for Europe. The US Federal Reserve is likely to maintain a near-zero interest-rate policy for the next three years, while central banks in Europe and Japan are expected to continue their negative interest rate policies to help boost their domestic economies.

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Shao Yu, chief economist at Orient Securities, noted that portfolio capital inflows include the carry trade – borrowing in a low interest rate currency and investing the borrowed money in higher-yielding assets denominated in another currency.

“Capital for the carry trade is always there, but once this type of capital starts flowing out on a massive scale, the [Chinese currency] will depreciate and trigger further capital outflows, and foreign exchange reserves will subsequently drop,” Shao said.

And Guan Tao, global chief economist at BOC International, noted that portfolio investments are a typical form of short-term capital flow – so-called hot money.

“China used to open its capital account to encourage long-term investments, but its attitude towards short-term capital flows has changed over the past few years as it is speeding up the opening of domestic bonds and the stock market,” said Guan, a former official with the State Administration of Foreign Exchange. “So, it is fair to say that China is prepared, both institutionally and psychologically, for short-term capital flows.”

We have been relying more on market instruments to regulate cross-border capital flows; the government won’t step in unless unusual or extreme circumstances occur

Guan Tao, BOC International

“So far, we have been relying more on market instruments to regulate cross-border capital flows; the government won’t step in unless unusual or extreme circumstances occur in the future,” he said. “The authorities have not taken any measures to limit capital inflows. They would rather manage the balance of payments by, for example, increasing the flexibility of the exchange rate, as well as by increasing the channels for capital outflows, to avoid one-way excessive inflows or outflows.”

Earlier this month, the People’s Bank of China cut the cost of betting against the yuan – “shorting” the currency – to curb the surging yuan by scrapping the reserves that financial institutions had to set aside when conducting trading in forward contracts that predict the future value of the currency. Previously, financial institutions had to set aside 20 per cent of the previous month’s yuan forwards settlement amount as foreign exchange risk reserves.

The yuan exchange rate depreciated from 6.69 to 6.75, relative to the US dollar, after the central bank’s announcement. However, it touched 6.65 per dollar last week, an 18-month high, and stood at 6.69 on Friday.

Ding Shuang, chief Greater China economist at Standard Chartered Bank, said the current capital inflows are more of an asset allocation rather than “hot money”, and the capital influx will continue in the next year. This is supported by British index provider FTSE Russell’s announcement last month that Chinese sovereign bonds will be included in its World Government Bond Index, indicating that Chinese debt is still quite “attractive”, Ding said.

“The current capital inflows are expected, as Chinese authorities have taken concrete steps to further open up the financial market to foreign investors,” he said. “Meanwhile, besides stocks and bonds, there are quite notable capital outflows too, and the authorities may use this opportunity to issue more Qualified Domestic Institutional Investor quotas [which allow Chinese to invest abroad].”

Moving forward, Ding speculated, Chinese authorities may consider ways to discourage short-term speculation, but the central government would not simply curb capital outflow out of the blue, as that would greatly undermine market confidence.

He said it could start with the introduction of a so-called Tobin tax, a tax on currency transactions that would be levied on all inbound and outbound cross-border capital account flows. Central bank governor Yi Gang proposed the same idea in 2014 when he was the deputy governor.

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