Capital account deficit said to be an intended result rather than a sign people are losing confidence in the economy

Capital flows out of China may be accelerating, a phenomenon commonly associated with waning confidence in a nation’s economy, yet the foreign exchange regulator says the change is a step in the right direction.

In the first six months of the year, China’s capital account saw a deficit of US$ 20.3 billion, and its accumulated forex reserves grew to US$ 3.24 trillion, up only US$ 63.6 billion — 77 percent less than the amount added in the first half 2011, data from the State Administration of Foreign Exchange (SAFE) shows.

But this does not indicate capital flight, the regulator said. Instead, it primarily reflects shifting foreign exchange activity from the central bank to domestic institutions and individuals, it says.

From January to June, China received US$ 79.1 billion more than it paid out in cross-border transactions, yet the value of foreign currencies converted into yuan at Chinese banks exceeded that of yuan converted into foreign currencies by only US$ 29.5 billion. In principle, Chinese enterprises and individuals held the difference in their forex account.

This is in sharp contrast to between 2003 and late 2011, when most enterprises and individuals wanted to convert their forex holding into yuan assets, because the yuan was expected to appreciate, said Zhang Bin, a research fellow at Chinese Academy of Social Sciences. Now that the yuan’s exchange rate began fluctuating both ways, the incentive to hold yuan instead of a foreign currency has weakened.

Therefore, companies started adjusting their assets to hold more foreign currencies, he said. Capital outflows resulted from this adjustment are incremental in nature, he said, as opposed to a typical capital flight, where investors lose confidence in a nation’s economic fundamentals and move out their investments for fear conditions may soon deteriorate.

The increasing willingness to keep the U.S. dollar rather than the yuan also explains why this year’s forex reserves grew considerably slower than in previous years, said Wang Qinwei, an economist with the London research firm Capital Economics. There was no need to be concerned about capital flight, he said, because a large amount of forex still remained with Chinese enterprises and residents.

Indeed, the amount of foreign currency deposits in Chinese banks has shot up this year, reaching US$ 137.3 billion in the first seven months, SAFE data shows. This represents an increase of 47.5 percent over the amount for 2011, and is 66.5 percent higher than in the same period last year.

Growing foreign exchange deposits enabled Chinese enterprises to strengthen investments overseas. Meanwhile, the momentum of foreign direct investments into China has decelerated since last November.

As a result, the gap between inbound and outbound foreign direct investments narrowed, resulting in less contribution to the forex reserve.

From January to July, mainland Chinese investors invested US$ 42.2 billion in overseas non-financial projects, up nearly 53 percent from the same period a year earlier, the Ministry of Commerce says.

In comparison, the amount of inbound foreign direct investments fell 3.6 percent year on year, slipping to US$ 66.7 billion.

The Manufacturing Blues

The decline is, of course, partly because the turmoil in the external environment weighed down on foreign companies’ ability to invest overseas, yet domestic factors played a significant role here as well.

Rising labor costs, for instance, were often cited by experts as the primary reason why China is losing its attractiveness as the world’s manufacturing base. As the average Chinese workers’ wages increased, many transnational companies including Nike found their production costs surging and had to move to other countries, such as Vietnam and Thailand, where there was still an abundant supply of cheap labor.

In addition, regulatory restrictions on property development dampened foreign direct investment in the services sector. In the first half year, the amount of foreign direct investment to the real estate sector fell by 12.4 percent year on year.

Yuan settlement in cross-border investment is another factor behind the slowing growth of forex reserves. In the first half of this year, the amount of yuan settlement in cross-border direct investments was 110.6 billion yuan, of which 91.8 billion yuan was from foreign investors to China and the rest from Chinese investors.

The difference between inbound and outbound yuan direct investment was therefore 73.1 billion yuan. Based on the current exchange rate, this reduced the inflow of foreign exchanges by around US$ 11 billion.

Changes in cross-border capital flows inevitably affect China’s monetary policies. Funds outstanding for foreign exchange, which refers to the amount of yuan Chinese banks put into the domestic market when they acquire foreign currencies from individuals or companies, traditionally make up the majority of the domestic money supply.

However, with the inflow of foreign capital slowing and the funds outstanding for foreign exchange declining as a result, concerns are rising that there might be a liquidity shortage in the domestic market.

Yet Zhang viewed the change positively, arguing that it reduces the need for the central bank to interfere with the foreign exchange market. Besides, he said there is an array of alternative instruments such as open market operations that the central bank can employ to adjust money supplies.

Reducing banks’ reserve-requirement ratio (RRR) is another effective method to bump up liquidity, Wang said. Based on his calculation, lowering the RRR to the level of a decade ago, 6 percent, could offset the impact of 1.9 trillion yuan flowing out of China. Yet “it’s almost impossible for such a massive capital flight to occur, unless there is an economic or political crisis that completely shatters the confidence of the middle class,” he added.

Staff reporters Huo Kan and Wang Changyong contributed to this article

By staff reporter Yu Hairong