A major factor driving the fall in China’s foreign exchange reserves is the unwinding of the carry trade.
With foreign debt levels manageable and incentives shifting away from rapid outflows, that is unlikely to exhaust China’s US$3.2 trillion in foreign exchange reserves.
In past years, China’s high interest rates and expectations of yuan appreciation looked like a winning bet.
The result has been a lucrative carry trade, with substantial offshore borrowing in dollars and funds parked in China.
In 2014, that changed. Expectations of a shrinking interest rate differential, combined with fears of yuan depreciation, made the trade less appealing.
Funds that were flowing in started to flow out.
How much foreign debt did China accumulate on the way up, and how much has already been paid off on the way down?
Answering that question is made more difficult by breaks in the statistical series and the likelihood that not all overseas borrowing is captured in China’s data.
With that in mind, it makes sense to look at low and high-end estimates.
The low-end estimate is based on People’s Bank of China (PBoC) data on foreign debt, with historical numbers adjusted to take account of a break in the series.
The peak was about US$2 trillion in the third quarter of 2014 and foreign debt fell to US$1.5 trillion in September 2015, the latest data is available.
Since then, about US$495 billion has flowed out of China, based on Bloomberg Intelligence Economics’ estimates.
Assuming that went mainly to repay foreign debt, the total could have dropped to US$1 trillion.
The high-end estimate is based on the same PBoC data but adds an estimate of overseas borrowing by Chinese firms that might not be captured in the official numbers.
That could happen if, for example, borrowed funds came onshore illegally through the trade account.
Assuming 50 percent of lending by Hong Kong banks ended up in the mainland, and holding all the other elements of the calculation unchanged, China’s foreign debt would be US$1.3 trillion.
Neither of those estimates is particularly alarming. In both cases, China’s capital outflows likely have some distance still to run.
But in both cases also, even if the entire quantity of foreign debt flowed out, China would still be left with substantial foreign reserves.
There are additional reasons to steer clear of excess alarm:
• Since the middle of January, the yuan has stabilized and expectations of US rate increases have been reduced. That tamps down incentives for moving funds out of China.
• Not all overseas borrowing is a short-term play on rate differentials and yuan appreciation. Some, perhaps most, is invested in stickier long-term projects.
• Not all overseas borrowing is in dollars. With negative rates in Europe and Japan, anyone borrowing in euro or yen will probably be content to leave it in China.
China’s capital outflows are unnerving and uncertainty remains.
The carry trade is not the entire story and an outflow in foreign portfolio funds or (worse) domestic household funds would add to the alarm.
But based on evidence from the size of China’s overseas borrowing and the shift in incentives as the yuan stabilizes, carry trade outflows should slow and ultimately end long before China’s foreign reserves are exhausted.
February’s reduced drop in reserves — US$29 billion versus US$99 billion in January — may prove to be the shape of things to come.
The views expressed in this article are those of Fielding Chen and Tom Orlik, economists at Bloomberg Intelligence
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