China’s capital outflow problem

So much for the notion that China’s capital outflow problem might be stabilizing. Judging by the latest Chinese international reserve numbers, more than US$110 billion in capital left China in the month of November alone. This is close to an all-time monthly record capital outflow from China and takes the total capital outflows for the year to around US$ 800 billion. This is clearly a pace of capital outflow that even China with its still massive international reserve holdings cannot sustain for very long.

Financial Times

The very rapid pace of capital outflow is hardly an expression of confidence in the Chinese economy. Rather it has to be viewed as yet another symptom of a slowing Chinese economy recovery that is likely to require considerable monetary policy easing to arrest. That easing will be occurring at the very time that the US Federal Reserve is poised to start raising interest rates that will further increase the Chinese attraction to foreign asset purchases. The large capital outflows also have to be viewed as a reflection of the fears of Chinese households and enterprises that the Chinese currency will be allowed to weaken further and that Chinese capital controls will soon have to be tightened considerably.

The renewed pick up in capital flight comes at an awkward time for the Chinese authorities. Since it comes fresh on the heels of the Chinese government trumpeting that the IMF’s recent decision to include the Chinese currency in the IMF’s Special Drawing Rights basket was an indication of China’s arrival as a major force in the international financial system. On deciding to include China in its SDR basket, the IMF argued that the Chinese currency was both “widely used” and “freely tradeable”. Such a claim might be difficult to sustain should China indeed soon be forced to re-impose draconian capital controls.

Many countries before China have learned that in formulating macro-economic policy countries are faced with an impossible trilemma. That is to say a country may have only two out of the following three policy options. Namely, independent control over its interest rate policy, a fixed exchange rate, and an open capital account.

It would seem that China certainly needs monetary policy independence to revitalize its flagging economic recovery. It would also seem that political considerations, especially in a US presidential election year, will preclude China from allowing its currency to float freely downward. This would seem to strongly suggest that China will soon have to resort to a re-intensification of capital controls to resolve the problem it would otherwise face with the impossible policy trilemma.

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