The latest data on China’s foreign exchange reserves, showing a rise of $130 billion to $3.4 trillion, suggest that capital is flowing into China again after an apparent outflow ahead of the change of government in late 2012. There is also growing evidence of Chinese residents smuggling capital into China by disguising it as exports. The manipulation of export and import data to avoid capital controls is an old trick, explained below.
Fiddling current account transactions to evade capital account controls
Controls on the flow of capital into and out of a country were normal, indeed mandatory, during the Bretton Woods international financial regime that lasted from 1944 (when the treaty was signed – full implementation didn’t happen till the late 1950s) to the early 1970s, when the US took the dollar off gold and exchange rates started floating. Many emerging economies have kept capital controls right up to the present, as a means of influencing their exchange rate while keeping some degree of independent monetary policy. Without capital controls, you can have either independent monetary policy (the freedom to set interest rates) or a managed exchange rate, but not both. Capital controls insulate the domestic financial system from the rest of the world’s.
But there will always be those that wish to evade the controls and the easiest way to do so, at least for companies, is to fiddle their export and import data, which many analysts now suspect is happening on a large scale in China. Since most countries encourage trade, or at least exports, they have relatively liberalised current accounts, meaning companies are fairly free to buy and sell FX for activities related to foreign trade. This provides a loophole for evading capital contorls.
Moving capital out of the country
Even with capital controls, the monetary authorities allow companies some scope to buy and sell foreign exchange. So a domestically based importer requests FX from the central bank, paid for with domestic currency, in order to pay a foreign supplier. If it over-invoices (overstates the value of) the required payment then it will have some FX left over after paying the foreign supplier, which it can then deposit in a foreign bank account. This is illegal but hard for the central bank to spot.
Similarly a company selling its goods and services abroad and receiving FX in payment, should declare the full amount to the central bank, which will then buy it by paying the company with domestic currency. This stops the company holding FX and it prevents the FX dropping back into the market and affecting the exchange rate. The Chinese central bank requires this sale of FX, which causes an increase in domestic RMB in circulation, that must then be sterilised (prevented from causing excessive liquidity in the economy) by requiring the banks to hold large reserves at the central bank. The FX then ends up in the reserves managed by SAFE (the State Administration of Foreign Exchange), which is the world’s largest asset manager.
Equivalently, if a company under-invoices its exports then it can keep some of the FX received from the foreign buyer of its products and put this into an offshore bank account, again illegally but with little risk of detection. Since many manufacturing companies routinely import and export they can fiddle both sides of their trade to move funds into or out of the country.
The Chinese case: moving capital into the country
While it was apparently the case last year that many Chinese were moving funds offshore as a hedge against unexpected government policy changes or instability over the transition to new leaders (see this blogpost), it now seems that Chinese companies are moving capital into the country, using the reverse of the techniques above. In particular there has been an implausibly large increase in exports from mainland China to Hong Kong. Hong Kong’s own, independent trade statistics show much lower volumes. So it is likely that companies are over-invoicing exports, that is they are declaring larger receipts of FX to the central bank than they have actually received.
Why do this? Whenever governments put up barriers to market flows they create the possibility of arbitrage. Arbitrage is the purchase and sale of an identical asset at different prices for a risk free profit. RMB in mainland China and Hong Kong are identical but the separation in the markets puts a wedge between the value of RMB offshore and onshore. The vast majority of RMB is in mainland China, behind the capital controls. But there is a growing offshore RMB market, mainly in Hong Kong, but growing rapidly in other centres such as London. This is a welcome development for the Chinese authorities, who are (apparently) planning on one day seeking a global role for their currency. For that to happen the RMB must be widely traded in liquid international markets, freely available for reserve use (that is, to be held as a store of value by central banks, which is starting to happen) and used as a means of payment for trade (also starting to happen).
But until the internal and external markets are fused through the ending of capital controls (“full convertibility”) there is the likelihood of different rates of interest and different exchange rates in each market. Offshore RMB is of limited use at present and if it just accumulates in Hong Kong bank accounts it will be worth less than it is onshore. So Chinese companies are apparently trying to move their offshore RMB into the domestic market to take advantage of its higher value there.
When I meet Chinese bankers and government finance people these days we nearly always get onto the subject of when and how the RMB can be opened up to full convertibility and how this should be sequenced with liberalising of domestic interest rates (currently held down in favour of Chinese bank profitability and as a subsidy to their borrowers, typically state owned enterprises and local governments). The recent trade data show how the strains in the system are growing. Once you start the liberalisation process, it’s quite hard to stop or even control the pace of events. Liberalising the Chinese financial system, internally and externally, is one of the greatest economic policy challenges the world has ever seen. So we have to hope the government gets it right.