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‘Underground money’ slipping through China’s capital outflow controls

‘Underground money’ slipping through China’s capital outflow controls

The latest figures on Chinese capital flows show the government is succeeding in curtailing outflows, but the problem of illicit outflows – so-called ‘underground money’ – continues unabated.

In recent years, the Chinese government has scrutinised Chinese firms’ foreign acquisitions in a bid to stem outflows and exert downward pressure on the renminbi. It appears these efforts are bearing fruit, with the Q1 figure of $21 billion down from Q4 2016’s $161 billion.

However, there is one component of the official quarterly flows data called ‘errors and omissions’, widely understood as flows originating from illicit channels, which has risen in recent years.

In the Q1 figures $58 billion of capital outflows fall into this category. ‘This suggests that there were indeed increased flows that cannot be captured by the official channels of measurement,’ said Aidan Yao, senior economist at AXA Investment Management. ‘Underground money market transactions are obvious candidates for these flows.’

Besides so-called underground money, Yao said ‘capital/portfolio flows disguised as current account transactions, which is done to avoid capital controls, and as well as direct investments’ also form part of the ‘errors and omissions’ component.

Speaking on condition of anonymity, one investor told Citywire Asia: ‘There are always going to be capital outflows, due to the liquidity needs of subsidiaries of Chinese companies, that find ways to skirt the law.’

Clampdown in effect

Nonetheless, the figures clearly show that the government’s efforts to stem outflows via mainstream channels are working.

Compared to Q4 2016, capital outflows have fallen by $140 billion in the latest reporting period. ‘This shows the control policy has been effective,’ Yao said. ‘At least [when it comes to] curbing the outflows via legal channels, including outbound direct investment, cross border lending by banks, foreign exchange purchases by citizens and offshore insurance purchases by locals.’

Kevin Kearns, portfolio manager and senior derivatives strategist at Loomis, Sayles & Company also agrees that the policy has been ‘highly effective’. ‘What we had seen before the capital controls was that a lot of money followed into real estate specifically, we see now that has dried up.’

The Q1 capital outflows figure of $21 billion includes a net change in foreign assets (-$54 billion), a net change in foreign liabilities ($91 billion), and errors and omissions in the balance of payments (-58 billion), according to Julian Evans-Pritchard, China economist at Capital Economics, who wrote a report on the latest figures. He added that outflows in Q1 were partly a result of China’s need to fulfil its ambitious Belt & Road Initiative.

The reduction in capital outflows is also related to China’s financial deleveraging, said Wenjie Lu, BlackRock’s China investment strategist. He said Chinese policymakers have no problem with Chinese companies pursuing overseas positions or investments generally. However, if those companies have to rely on a very high level of leveraging or even employ shadow credit tools then they will fall under the restrictions.

Chinese assets such as government bonds also look more attractive than many offshore assets right now, Lu added, which is also contributing to the decline of capital outflows.

Preliminary figures for Q2 will be published in August and investors will need to wait until September for a detailed breakdown, according to Evans-Pritchard.


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