China may liberalise its rigid exchange rate regime sooner than most observers expect. But what will happen if the renminbi is allowed to float freely? In this article, we argue that the Chinese will maintain an extremely high savings ratio, resulting in continued Chinese capital flows into foreign markets. Contrary to the expectations of many observers, we do not envisage a strong appreciation of the renminbi over a long-term horizon following any floating of the renminbi. US Treasuries would be the major losers.
Status Quo: Free Trade, Strictly Regulated Capital Transactions
China has largely liberalised its trade in goods and services – particularly since joining the World Trade Organisation (WTO) in 2001. As a result, foreign trade has soared and the current account surplus has widened. Capital transactions, on the other hand, are still heavily regulated. Direct investment is subject to authorization and cross-border portfolio transactions are only permitted in a few exceptional cases. Restrictions on Chinese investors who want to invest capital abroad are more relevant than those on foreign investors who are investing in China. In particular, direct investment by foreigners is usually approved without major difficulties, provided certain conditions are met.
The regulatory treatment has left its imprint on China’s balance of payments: On the back of strong exports, the country is running a big current account surplus. This surplus, however, does not result in private accumulation of net foreign claims against foreigners. China’s central bank, (the People’s Bank of China, PBoC) collects the foreign currency claims through the domestic banking system and compensates with local currency at the administered exchange rates. In the end, export proceeds therefore increase the PBoC’s foreign reserves, but do not affect the capital account. On top of that, the capital account is running a high surplus (with the exception of the crisis year 2008), thanks to high net direct investment inflows. The central bank is also receiving foreign currencies from this front, which it also invests as reserves. Thus, the surpluses in the current and the capital account are offset via the build-up of FX reserves.1
Where Will the Capital Flow Once Capital Transactions are Liberalised?
China looks set to liberalise its exchange rate regime in the years ahead. On the one hand, the government is likely to largely ease restrictions on capital transactions. On the other, the PBoC should refrain from further stocking up FX reserves. Consequently, the renminbi exchange rate would be primarily driven by private supply and demand.
There is widespread agreement that there would likely be an immediate and sharp appreciation of the renminbi following any significant liberalisation, as supply of foreign currency would rise sharply once the PBoC ceases to intervene. The long-term effects, on the other hand, are less clear. Over a long-term horizon, much will depend on the adjustments in China’s balance of payments following the liberalisation of capital transactions. Once the surpluses in the current and capital account are no longer offset via the PBoC adding to FX reserves, either the current account or the capital account has to slip into deficit. This means that China has to either change from a net exporter of goods to a net importer or it has to export more capital than it imports.
| Chart 1: PBoC Reserve Accumulation Offsets Surpluses in the Current and Capital Account
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Chart 2: China Has the Highest Saving Ratio in the World
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Why Are the Chinese Saving So Much?
Which of the above scenarios is more likely to emerge? This depends on the extent to which the high overall savings ratio in China will decline from its elevated levels following the liberalisation. That would leave fewer funds for offshore investment. In 2010, China’s savings ratio stood at 52%, which was much higher than in the other “BRIC” countries, and well above the global average (Chart 2, page 24). We consider it highly unlikely, however, that the high savings ratio will decline to any great degree:
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- China‘s private households are saving 39% of their disposable income and account for 43% of total savings. For quite some time, the high savings ratio was a mystery to economists. Recent studies suggest that low population growth, higher spending on children and low pensions are the key reasons why the Chinese are putting aside so much money.
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- Chinese companies finance two-thirds of their investments via savings, rather than external financing. They contribute 37% to China‘s total savings. The reason is more obvious in this case: China’s financial system is still heavily regulated. Moreover, in the absence of key elements such as a developed market for corporate bonds, Chinese companies are primarily dependent upon internal financing to fund the rapid rise in investment.
- The remainder of total savings in China is contributed by the public sector. Thanks to the strong economic expansion, growth of government revenues by far exceeds the moderate rise in public expenditure on consumption and infrastructure investment.
While most of the above causes for China’s high savings ratio will at least be moderated in the years ahead, leading to a lower savings ratio, China’s economy is likely to still set aside a lot of money for savings even after the liberalisation of capital transactions. But what is going to happen with these savings? So far, a large share has been invested in FX reserves. Following a floating of the renminbi, two scenarios are possible: Either Chinese investment starts to rise at an even stronger rate or some of China’s savings are still directed offshore – not via the accumulation of FX reserves but via private investments.
| Chart 3: China is Hoarding Treasuries
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Chart 4: Capital Account Likely to Move into the Red
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Investment Unlikely to Rise at a More Rapid Pace
In our view, it is fairly unlikely that growth in investment will come in any higher, as gross fixed capital formation is already running as high as 48% of GDP as of 2010. And in the corporate sector, at least, there are strong signs of overinvestment, given that growth in gross fixed capital formation by Chinese companies since 2001 is 3 to 5 percentage points higher than growth of their gross value added – a clear indication that part of China’s savings were better invested abroad (though this is obviously not possible given restrictions on capital transactions).
Much the same holds for in-bound foreign investment to China. While, judged by the abundant inflow, direct investment seems to yield attractive returns; things might look different for portfolio investment, as this requires an efficient financial system. Moreover, leaving the managerial control with the investor is one thing; having to abandon it, as it is the case with portfolio investment, is another thing altogether. The deregulation of foreign portfolio investment in China might boost capital inflows in the short run. However, in the light of the existing overinvestment problem, this would merely result in a capital market bubble, which would not prove sustainable.
US Treasuries and the Dollar Are Set to Be the Major Losers
Keeping in mind China’s high savings ratio and the already existing overinvestment in the corporate sector, we argue that the country will continue to export a considerable share of its overall saving after the liberalisation of its capital account. However this process will no longer operate via the PBoC, which invests the FX reserves abroad, but via private investments. The impact on global financial markets would be significant:
Chinese yuan (CNY) exchange rates: Over a long-term horizon, the renminbi would appreciate far less sharply than expected by some observers. After all, capital inflows and outflows would remain virtually unchanged, only the institutions involved would no longer be the same. There would likely be an immediate and sharp appreciation of the renminbi should there be a “Big-Bang” liberalisation, but this would likely be quickly corrected.
Current account: However, in the absence of a massive long-term renminbi appreciation, China’s huge current account surplus would remain in healthy surplus. The economic effect of a currency and capital market liberalisation in China would, at best, be limited, contrary to expectations of some politicians in the USA and other Western countries. Such a development would also reveal that it does not make much sense to continue discussing “global imbalances”. Even without government regulation, China’s exports of goods would exceed its imports, given the high savings ratio.
US dollar: China’s private households and companies would likely distribute their foreign investment differently to the current pattern chosen by the central bank when investing its FX reserves. More likely than not, the PBoC holds a majority of its reserves in US$ (detailed data are not available), as the renminbi exchange rate is managed against the US currency. Against this backdrop, a liberalisation would weaken the US dollar versus other currencies.
US Treasuries: Another major loser would be US bonds. The PBoC invests a large chunk of its FX reserves in safe-haven US bonds, in particular US Treasuries. Less risk-averse private investors might behave differently. According to US Treasury statistics, Chinese investors (i.e. almost exclusively the PBoC) hold over US$1tn in US Treasuries, or more than 11% of all outstanding bonds. And this probably understates the true figure, as not all PBoC purchases can be traced back from the Treasury’s statistics to the Chinese central bank.
Notes:
1 Given entry and assessment errors, a minor residual “balance of statistically unclassifiable transactions” is included in the official statistics.