Herbert Poenisch: From Capital Outflows to Capital Inflows in China—Role of Banks and Issuers of Debt Securities

Herbert Poenisch, Member of IMI International Committee, Former Senior Economist of BIS The years 2016 and 2017 have seen a dramatic reversal in the China’s recent pattern of capital flows, from outflows to inflows. According to recent BIS statistics, both banks resident in China as well as Chinese nationals as borrowers in the international debt securities markets have been the main movers of the changing tide. The other one was a sharp decline in outward FDI. This article will outline the broad trends as well as the breakdown into sectors, instruments and currencies. This will be followed by an attempt to explain the reasons behind this change in direction. Was it market driven or by guidance from the authorities? Finally, what does this mean for the internationalisation of RMB and China playing a bigger role in international finance?

1. The cross border banking business

The BIS and SAFE publish the cross border business of banks resident in China, including the Chinese Policy Banks and subsidiaries of foreign banks. This corresponds to the balance of payments, section other investments. It can be assumed that most cross border business is carried out by Chinese owned banks rather than by subsidiaries of foreign banks. The total assets, expressed in USD increased from USD 931bn in 1Q17 to USD 997bn in 4Q17, an increase of 7%. Total liabilities increased from USD 1067bn in 1Q17 to 1278bn in 4Q17, an increase of 19.8%. With liabilities increasing more than assets, this represents a capital inflow. Traditionally, banks in China have been net importers of capital. This net result can be due to a decline in claims or an increase in liabilities. The BIS statistics also capture the cross border positions of all Chinese owned banks worldwide. This does not compare with China’s balance of payments. The total claims increased from USD 1767bn in 1Q17 to 1984bn in 4Q17, an increase of 12.3%. Total liabilities increased from USD 1669bn in 1Q17 to USD 1889 in 4Q17, an increase of 13.1%. As assets exceed liabilities, Chinese banks in their global activities continue to supply the world with net funds. The constituent components of these flows, by currency breakdown into local currency, ie RMB or USD, by counterparty, banks or non banks and by instrument, loans and securities on the claims side and deposits and securities issued on the liabilities side,  constitute a differentiated picture as in table 1. Table 1 Changes in assets (A) and liabilities (L), in bn USD, during quarterly periods Just a reminder that increases in assets constitute a capital outflow, a decrease a capital inflow, triggered by residents. The inverse is true for liabilities where an increase constitutes a capital inflow whereas a decrease is a capital outflow, both triggered by non-residents. The following picture emerges. Massive increases in total assets turned into modest decreases by the end of 2017, ie capital inflows. Massive increases in liabilities were recorded towards the end of 2017, also recorded as capital inflows in the balance of payments. It should be noted that increases in net liabilities raise the international debt of China. The currency shares of the outstanding claims and liabilities remained largely unchanged in the course of 2017. Foreign currencies made up 88% of all claims, the USD alone 70% and RMB 12%; as shares of liabilities foreign currencies made up 70%, USD only 37% and RMB 30%. Regarding the adjusted changes, the currency composition changed. Lending in both, RMB but mostly in USD contracted towards the end of the year. Liabilities increased mostly in RMB but also in USD. Both components together make up the capital inflows for the whole year. Regarding counterparts, lending to banks decreased towards the end of the year, whereas deposits by banks increased, but declined in the last quarter. Lending to non banks had a mixed picture but deposits by non banks continued strongly. The same picture of capital inflows emerges. Finally, the breakdown into instruments, China resident banks reduced their loans in the latter part of the year whereas deposits increased apart from the last quarter. The modest purchase of debt securities continued whereas new issuance surged in the latter part of the year. This again confirms the picture of massive inflows towards the end of 2017. The breakdown shows that within the overall picture of declining claims versus massive increase in liabilities, both deposits and securities issued, there are marked changes which raise questions for analysis. Why is cross border lending declining in times when Chinese banks are supposed to support Chinese projects abroad? Why has the USD continued to play such a dominant role when the rhetoric has suggested otherwise? Has the weakness of the USD played any role? Why has lending to other banks declined, and lending to non banks only picked up recently? Why has lending in RMB declined when liabilities in RMB surged? Which non banks, Chinese or foreign have massively increased their deposits or bought banks’ debt securities? Answers will be attempted in the third section.

2. Borrowing by international debt securities

China’s issuing activities of debt securities in various markets have continued at a brisk pace. The BIS records net flows of debt securities issues as well as amounts outstanding. In table C3 they distinguish between resident issuers, ie those resident in China and Chinese national issuers worldwide. Residents issue domestic debt securities and international debt securities. The major sector is the domestic issues which increased y-o-y by 25% between 4Q16 and 4Q17 with a total outstanding amount of USD 11.4 tr at the end of 2017. International outstanding amounts issued by Chinese residents in RMB and foreign currencies  increased y-o-y by 38% to USD 193bn, albeit small, compared to domestic issues. International outstanding amounts issued by Chinese nationals increased equally strong y-o-y by 39% to USD 888bn at the end of 2017. Drawing any conclusion for capital flows is difficult as the share of domestic securities bought by non residents is unknown, estimated at some 2%. International issues can be assumed to be purchased by non residents, thus posing capital inflows, provided the proceeds are repatriated in the reporting period. The following table 2 gives a breakdown into various issuers and currencies, notably RMB and USD. Table 2: Debt securities issued, net flows in bn USD during quarterly periods The BIS publishes in table C3 a breakdown by issuer, by currencies, by maturities and by interest type. International organisations are a separate category, not residents of any specific country. The currency breakdown does not show as explicitly, only as local currency in issues by Chinese residents, in international issues by Chinese nationals only included in other currencies. Non Chinese residents and Non Chinese nationals issuing in RMB are included under other currencies issue of their respective country, eg UK government issuing treasuries in RMB. Regarding the issue activity in domestic debt markets, the dominant ones are the general government and financial institutions. Non-financial have issued rather modestly during 2017. In international debt markets, financial institutions are dominant, with non-financials picking up in the last quarters of 2017. Regarding currencies, issuing in RMB by Chinese residents has declined, whereas issuing in USD has picked up markedly. In international issues by Chinese nationals the USD has been dominant as always. The maturities of these issues are exclusively long term. Issues at fixed interest rates dominate the international issues of Chinese residents as well as Chinese nationals. As in the cross border banking business, questions arise to explain the structural developments. What are the driving factors behind the issue activities of various issuers, market conditions, demand for funds and exchange rate expectations?

3. Factors for banks’ cross border business and Chinese debt issuance in international markets

The concerns of authorities about capital outflows have turned  into national pride with capital flowing in, the RMB appreciating, in particular in the run up to the 19^th CPC Congress in October. This success might have been due to certain guidance by the authorities but mostly due to market developments. This matches the declaration by Chinese leaders that markets should play a bigger role. Without having insight into the quarterly market conditions, in the domestic as well as international debt securities markets some tentative explanations based on trends can be offered. The first is the ample supply of USD in the bond markets when concerns about US debt sustainability led to a sell off of US treasuries. Emerging market USD issuers, first and foremost by good borrowers, such as Chinese nationals has been an attractive alternative for international investors searching for good credit risk. Secondly, as Chinese domestic capital markets remain barred for most investors, the only chance to take on Chinese good credit risk is to invest in international debt securities, issued by them in USD. Thirdly, the outlook for the dollar weakened in 2017, so borrowing in USD, even during times of tapering USD interest rates provided good prospects for Chinese international issuers. All these arguments show that China is playing along with international financial markets, where the USD continues to play the predominant role, rather than seriously challenging the lynchpin of the western financial system, the USD. As a result, the internationalisation of RMB has been rather slow in 2017, lacking the support from banks and bond issuers. If China were to challenge the USD and seriously push the internationalisation of RMB, both banks and international Chinese issuers would change their behaviour. Banks would increase their lending in RMB, particularly linked to the Belt and Road initiative. Increasing banks’ liabilities in RMB shows that foreign investors are ready to hold RMB deposits in their portfolio. In the short run, however this means RMB flow back into China, as they are not recycled into RMB lending. From the figures available, Chinese nationals as bond issuers have continued issuing mainly in USD. This ignores the opportunities given, countries reach financial maturity by issuing in their own currency. For the world reserve currencies until today this has given an enormous boost to the GBP and the USD when they started issuing in their own currencies. Other countries have attempted to issue in ZAR, MXP, CZK but with mixed results. China has the economic clout to support such a bold move at present, which would advance the internationalisation of RMB on an unprecedented scale. The Japanese experience of the 1980s has shown that a timid strategy to internationalise its currency has led to the JPY playing a minor role among reserve currencies. China should grasp the opportunity of the moment, lend freely in RMB, first and foremost within the BRI and secondly, cover its international borrowing requirement by actively issuing in RMB. International investors will be following as there will be adequate trust in the Chinese globalisation strategy.

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