You may have heard a lot of discussion about Chinese capital controls and its currency exchange rate recently. It’s a fascinating subject, though one which is poorly understood. You see, in macroeconomics, there is a concept called the “impossible trinity”. It basically states that, of the following three characteristics, a country/currency area can have any two of the three, but not all three: (i) free capital flow, (ii) a fixed exchange rate, or (iii) independent monetary policy.
Tried as it has to have all three, even China cannot fight the impossible trinity. In a perfect world, China would have free flowing capital across borders – a requirement for a globally-connected economy; a fixed exchange rate to the US$, or some other basket of currencies; and control over its own monetary policy – or its domestic money supply.
But it cannot. And it has to choose which of the three to let go. And we do not yet know the answer. Perhaps the Chinese have not yet decided.
Let’s start with something the Chinese have broadly believed in for some time: a currency peg with the US$. To implement a currency peg, a country’s central bank needs to intervene directly into currency markets to ensure that the rate of demand growth for a particular currency is exactly offset by the rate of supply growth; and vice versa. It buys and sells currency – both domestic and foreign – in the precise amount that ensures effectively zero movement in the exchange rate.
Now of course, selling domestic currency to buy foreign currency is easy for a central bank, since it can create domestic currency out of thin air. There is no theoretical limit to how much domestic currency a central bank can sell. And in return, it is buying foreign currency and building up a stash of what are called “foreign reserves.”
Now, most western economies do not have a fixed exchange rate. Instead they have a floating exchange rate which basically means the central bank typically does not intervene into the foreign currency markets. With no intervention, the exchange rate is free to fall when supply growth of domestic currency is higher than demand growth for domestic currency; and rise when demand growth of domestic currency is higher than supply growth of domestic currency.
Without this intervention, the central bank is free to determine the rate of money supply growth within its economy. If it wants to accelerate money supply growth (a.k.a. monetary policy easing), it can; or if it wants to slow the rate of money supply growth (a.k.a. monetary policy tightening), it also can. That is, the central bank has full control over its monetary policy – even as citizens and corporations move capital across borders freely.
In this instance, China does not have control over its money supply, since its money supply is determined, at least in part, by the requirements to buy or sell domestic currency to ensure the fixed exchange rate.
The way for China to retain control of its domestic money supply (i.e. its monetary policy) under a fixed exchange rate regime is to forcefully control capital flows across its borders. If it can control capital flows, then it can better control the supply and demand for domestic currency as well as the overall rate of growth of the domestic money supply – which is its monetary policy.
OBSERVATIONS OF CHINA’S APPROACH TO THE IMPOSSIBILE TRINITY
So what do we know? We know that the Chinese Renminbi had been steadily increasing (albeit very modestly) against the US dollar in the years up to 2014. Over this period, China also built up a significant trove of foreign reserves.
We interpret this dynamic as follows:
- During the period to 2014, significantly more capital was flowing into China than flowing out from China. This dynamic stemmed from China’s current account surplus (which simplistically means that the value of China’s exports was larger than its imports); as well as foreign investors’ demand to invest in the country.
- In a free-floating exchange rate, this would have resulted in a significantly larger appreciation in China’s currency exchange rate than what was observed.
- Instead, China kept a relatively fixed exchange rate system by selling Renminbi (and buying foreign currency, or “foreign reserves”) at a rate not too dissimilar to the rate of demand growth for its domestic currency. Hence, the significant build up in foreign reserves to over US$4 trillion.
Next, we observe that, from 2014, China’s currency exchange rate began to depreciate against the US dollar – as did its quantity of owned foreign reserves.
We interpret this dynamic as follows:
- Demand growth for domestic currency started to wane as domestic investors sought to move their capital out of the country; and foreign investors’ appetite for Chinese domestic investments began to fade. This stemmed from expectations of a deterioration in China’s domestic economy as well as fears of a potential financial crisis in its banking sector.
- In a free-floating exchange rate, this would have resulted in a significantly larger depreciation in China’s currency exchange rate than what was observed.
- Instead, China kept a relatively fixed exchange rate system by buying up Renminbi (and selling its foreign reserves) at a rate not too dissimilar to the rate of supply growth for its domestic currency. Hence, the US$1 trillion decline in foreign reserves.
Now, one can immediately see the unsustainability of this strategy by China’s central bank. In the face of significant capital outflows, China can defend its currency (i.e. keep it more elevated than it would otherwise be under a floating exchange rate system) only to the extent it has sufficient foreign reserves to exchange for domestic currency. Once these run out, China has no choice but to move to a free-floating currency regime. That is, the currency peg breaks.
Another, more subtle, problem with this approach relates to the resulting monetary tightening that effecting a fixed exchange rate has on the economy. As capital flees China, the central bank needs to effectively buy it all back (by selling down foreign reserves) in order to maintain the fixed exchange rate. But this act is removing money supply from the Chinese economy which is the same as monetary tightening – or negative stimulus. Here, the impossible trinity is at work – with a fixed exchange rate system and free-flowing capital across borders, China gives up control of its monetary policy. It is being forced to tighten monetary conditions when it would rather not.
But the reason why money is fleeing the country is because of expectations of a slowdown in China. Negative monetary stimulus only exacerbates these expectations and accelerate the outflows creating a negative spiral.
In response, China has pursued a two-pronged strategy to regain control of its economy, in our view: (i) it has engaged in a significant fiscal stimulus during 2016 in order to boost expectations of Chinese growth and stem the capital flight from the country; and (ii) it has started to explicitly restrict capital from leaving the country. If successful, less capital will leave the country which will reduce the amount of foreign reserves that are required to keep the exchange rate relatively fixed; and, more importantly, the amount of domestic currency that needs to be bought up by the central bank.
Over recent months, we have observed numerous reports of Chinese authorities making it more difficult for individuals and corporations to get their money out of the country – not to mention some pretty innovative techniques to do just that. Here are just a few:
- (Bloomberg) PBOC Said to Boost Yuan Curbs as Banks Told to Balance Flows: China has asked some banks to stop processing cross-border yuan payments until they balance inflows and outflows, as authorities step up a campaign to curb a record amount of money leaving the nation in the local currency. (January 2017)
- (SCMP) Beijing takes aim at Macau gaming industry to cut currency flight: Move to slash in half the amount China UnionPay bank card holders can withdraw from ATMs in enclave expected to take effect Saturday. (December, 2016)
- (SMH) China to tighten controls on overseas investments: China’s central government has ordered tighter controls on offshore investments made by state-owned enterprises amid concerns over accelerating capital outflows. (December 2016)
- (Bloomberg) China Said to Boost Scrutiny of Foreign Currency Purchases: The State Administration of Foreign Exchange will require extra documentation for people seeking to sell yuan from Jan. 1, 2017. (December 2016)
- (WSJ) Aluminum Billionaire Planning Escape From China: Giant aluminum stockpile in Mexico and Vietnam may represent an effort to get wealth out of China by Liu Zhongtian, chairman of China Zhongwang Holdings (December 2016)
- (Reuters) China scrutinizes foreign insurers in fight against illegal HK sales: China, which is seeking to halt illegal outflows of funds, is concerned that buying overseas insurance has become a way for Chinese to move money abroad amid concerns over yuan depreciation, volatile stock markets and a slowing economy, avoiding capital restrictions. (October 2016)
- (Reuters) Hong Kong cracks down on illegal money flows from China trade: Hong Kong is conducting a multi-pronged customs, shipping and financial sector crackdown against so-called fake trade invoicing that allows billions of dollars of capital to leave China illegally. (May 2016)
- (WSJ) China Capital Flight 2.0: Lose A Lawsuit On Purpose: Now, American lawyer Dan Harris says at least one Chinese company is attempting a new way to beat Beijing’s tightening regime of capital controls: by faking a breach-of-contract lawsuit with an offshore entity which the Chinese company intends to “lose.” (February, 2016)
- (FT) China halts overseas investment schemes: Beijing has mothballed two pioneering outbound investment schemes, according to people with knowledge of the situation, in its latest bid to stem capital outflows and shore up the renminbi. (February 2016)
So as we stand here today and look out over 2017, we know that China will have to choose one of the following three options:
- Allow its currency to depreciate further; or
- Allow its domestic interest rates to rise (i.e. domestic monetary conditions to become tighter); or
- Impose even tighter capital controls on individuals and corporations.
We will continue to monitor closely with interest.