China's Problem with Capital Outflows

The past year has been a difficult one for the Peoples Bank of China, as they attempt to paper over the rapidly cracking façade that is the Yuan. Although capital flight has always been a thorn in the side of the regime, recent market turmoil has seen it accelerate to levels previously unseen. Subsequently, given that rate of decline in the country’s foreign currency reserves, there is mounting speculation that either a sharp fall in the value of the Yuan or increased capital controls could be on the way.

Although China has recently taken steps to stem much of the out flows, those measures appear to remain largely circumvented by those disposing of large amounts of Yuan. In fact, January saw a significant reduction in foreign currency reserves by over $99.5 Billion, bringing the total decline of reserves to $762 Billion since the middle of 2014. This represents a significant dent in the PBOC’s war chest and signals that a problem is afoot in the Asian powerhouse’s economy.

Obviously, China possesses a huge amount of foreign currency reserves and the current declines still leave the PBOC in a strong position. However, the numbers are starting to become real, and point to a significant swing against the Yuan, as companies and individuals seek to move their capital offshore. In addition, such a large capital flow also has the potential to impact both business sentiment and growth within the economy. Subsequently, it begs the question at what point will the central bank take action to stop the large draw upon its war chest, and what form will that take.

The reality is that the PBOC has quite a way to go before they need to act to protect their position. The two likely scenarios revolve around either finding ways to stop the capital outflows through additional regulation or to significantly devalue the Yuan. It is highly unlikely that the first instance of action would involve any significant devaluation of the Yuan. Such a move would focus the world’s attention upon the current health of the Chinese economy and lead to some serious questions over the reliability of their current economic reporting.

Subsequently, the more likely scenario is one of increased capital controls within China, which although not conducive to foreign investment, would likely be more palatable to the PBOC compared to a sharp devaluation. However, given the Chinese propensity for getting around rules and regulations, it is questionable as to what long term impact that would actually have in stopping the drain on foreign currency reserves.

Ultimately, the Chinese central bank is going to have to face some tough choices in the coming six months, as their reserves start to decline to critical levels. Subsequently, expect to see increased capital controls in the ensuing quarters and then possibly a sharp devaluation in the Yuan. Regardless of the chosen course of action, it’s clear that the global economy has a ticking time bomb in China.