China’s Vulnerable External Balance Sheet

By Joseph Joyce. Originally published at Capital Ebbs and Flows

China’s capital outflow last year is estimated to have totaled $1 trillion. Money has been channeled out of China in various ways, including individuals carrying cash, the purchase of foreign assets, the alteration of trade invoices and other more indirect ways. The monetary exodus has pushed the exchange rate down despite a trade surplus, and raised questions about public confidence in the government’s ability to manage the economy. Moreover, the changes in the composition of China’s external assets and liabilities in recent years will further weaken its economy.

Before the global financial crisis, China had an external balance sheet that, like many other emerging market economies, consisted largely of assets held in the form of foreign debt—including U.S. Treasury bonds—and liabilities issued in the form of equity, primarily foreign direct investment, and denominated in the domestic currency. This composition, known as “long debt, short equity,” was costly, as the payout on the equity liabilities exceeded the return on the foreign debt. But there was an offsetting factor: in the event of an external crisis, the decline in the market value of the equity liabilities strengthened the balance sheet. Moreover, if there were an accompanying depreciation of the domestic currency, then the rise in the value of the foreign assets would further increase the value of the external balance sheet. and help stabilize the economy.

After the crisis, however, there was a change in the nature of China’s assets and liabilities.Chinese firms acquired stakes in foreign firms, while also investing in natural resources. The former were often in upper-income countries, and were undertaken to establish a position in those markets as much as earn profits. Many of these acquisitions now look much less attractive as the world economy shows little sign of a robust recovery, particularly in Europe.

Moreover, many of these acquisitions were financed with debt, including funds from foreign lenders denominated in dollars. Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated that Chinese borrowing in dollars, mostly in the form of bank loans, reached $1.1 trillion by 2014. The fall in the value of the renminbi raises the cost of this borrowing. Menzie Chinn points out that if the corporate sector’s foreign exchange assets are taken into account, then the net foreign exchange debt is a more manageable $793 billion. But not all the firms with dollar-denominated debt possess sufficient foreign assets to offset their liabilities.

Declines in the values of the foreign assets purchased through Chinese outward FDI combined with an increase in the currency value of foreign-held debt pushes down the value of the Chinese external balance sheet. This comes at a time when the Chinese central bank is using its foreign exchange assets to slow the decline of the renminbi. The fall in reserves last year has been estimated to have reached $500 billion. Moreover, foreign firms and investors are cutting back on their acquisition of Chinese assets while repatriating money from their existing investments. China’s external position, therefore, is deteriorating, albeit from a strong base position.

Policymakers have a limited range of responses. They are tightening controls on the ability of households and companies to send money abroad, as the head of the central bank of Japan has urged. But controls on capital outflows are often seen as a sign of weakness, and do not inspire confidence. Raising interest rates to deter capital outflows would only further weaken the domestic economy, and may not work. Such moves would be particularly awkward to defend in the wake of the IMF’s inclusion of the Chinese currency in the basket of currencies that the IMF’s Special Drawing Rights are based on.

China’s remaining foreign exchange reserves and trade surplus allow policymakers some breathing room, as Menzie Chinn points out. The Chinese authorities retain a great deal of administrative control over financial transactions.  As policy officials are shuffled around, those still in office seek to reassure investors that the economy remains in good shape. But injecting more credit into the economy does not alleviate concerns about mounting debt. The economic measures promised by the leadership are being judged in the financial markets, and the verdict to date seems to be one of little or no confidence.

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  1. PlutoniumKun

    Given that nearly every independent analyst seems to think that credit controls are the best option available to China, I’m really surprised that they’ve been so slow to stop the money bleeding out. I think the only thing that is stopping even more money leaving is that they are running out of obvious safe havens. The penny must surely be dropping that, for example, the billions invested in Australia by Chinese investors large and small must look very vulnerable.

    On an anecdotal basis, my Chinese friends, who mostly live in second and third tier cities away from the most prosperous centres, talk casually about ‘the bad economy’ and are generally battening down the hatches financially. I notice that nobody asks me about the European property market anymore (I suspect that dropping property prices means people have lost liquidity in their investments). I think the situation away from Beijing/Shanghai etc., is weaker than is generally reported. But the gradual tightening of censorship is having one noticeable effect – I find my English speaking Chinese friends who follow business are becoming increasingly out of touch with whats happening outside China, as they simply can’t access so many of the usual news sources. I wonder if this is deliberate (i.e. the government is using it as a subtle means of stopping ‘small’ investors knowing how to invest abroad), or if it is an unintended by-product of government security moves.

  2. Chauncey Gardiner

    I may be missing something here, but it seems to me that the author has conflated China’s external public and private sector liabilities. Are sovereign nations now liable for the failed foreign investments of their citizens? I don’t think so.

    IMO this article could be improved by a table detailing China’s most recent offshore private sector capital investment numbers, both foreign currency debt they have extended and equity investments if available. Also, the amounts of foreign currency borrowed offshore and onshore by China’s private sector, including its banks; versus by large, state-owned enterprises or sovereign wealth vehicles.

    Writing off impaired offshore assets and investments by China’s private sector and letting foreign creditors absorb the losses?… Meh. Seems to me that would impair the reported “net worth” of some wealthy and well-connected individuals in China, and of their foreign counter-parties, but what are the broader implications of doing so? I don’t see that action as systemically material to China’s overall economy.

    And from a practical perspective, the offshore capital losses from nonproductive foreign investments have already occurred. They simply haven’t been recognized.

  3. RBHoughton

    Is it appropriate to consider this subject in nationalistic terms?

    Think of the global economy and China’s share – that’s the important measure. Profitability is secondary.

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