Capital Outflow in Q2 Marks Turning Point for Yuan

The headline is deceptive: China sees more capital inflows in H2, uncertainties linger

"The renminbi (yuan) exchange is now near equilibrium and two-way cross-border capital flows have become a new norm," he said.

......China was under pressures from capital inflows in the first quarter, but the tide turned in the second quarter as volatility in the yuan fuelled outflows, Guan said.

......China's central bank and commercial banks sold 88.3 billion yuan ($14.3 billion) worth of foreign exchange on a net basis in June, according to a Reuters calculation based on central bank data released on Tuesday.

China's current account surplus may widen in the second quarter, but net inflows under its capital account may decline sharply, or even show a deficit, Guan said.

The decline in June was the first new outflow in 10 months.

An end to forex inflows has implications for China's money creation. The central bank swaps renminbi for forex held by banks, businesses and individuals, but if capital inflows turn stable or even switch into reverse, money creation will need to come from other policy tools. Another factor is the cost: it is expensive for China to continue this system.

China’s trade surpluses and the cost of sterilization

China’s trade surplus in itself has become the driver of more rapid implementation of financial liberalization. The PBoC must sterilize a large portion of the capital inflows generated by trade surpluses that otherwise would create far too many renminbi deposits and ultimately to excessive domestic credit creation. Over the past 10 years of large surpluses, the PBoC has sterilized about 75% to 80% of its net capital inflows and, notwithstanding this huge intervention, domestic money supply consistently has increased 15% to 20% per year, well in excess of nominal GDP growth. After a decade of intervention, this sterilization has created US$3.1 trillion in deposit reserves held by the PBoC on behalf of state-owned banks plus about $700 billion in bonds issued by the PBoC to further withdraw bank liquidity. The PBoC must pay interest to the banks on these assets, which now carry a rate of around 3.7%. This subsidy to banks now amounts to 1% of GDP (see table below) and in my opinion has reached a tipping point whereby the PBoC needs to speed up financial liberalization both of the exchange rate and interest rates because the cost of the subsidy rises inexorably in tandem with the trade surplus. China was able to take its time in opening the capital account during the early years of large trade surpluses because bank's deposit reserves and the cost of sterilization were small. Now that the cost is escalating rapidly, however, China has little choice except to allow two-way capital flows and greater renminbi flexibility.

If capital flows do stabilize or reverse, how will the central bank inflate?

China central bank gives CDB 1 trillion yuan

China’s central bank has provided 1 trillion yuan ($171 billion) to China Development Bank (CDB) for re-lending to the reconstruction of shanty towns, Caixin reports.

The People’s Bank of China (PBOC) is channeling the funds via a new monetary tool called "Pledged Supplementary Lending" (PSL) to test medium-term interest rates according to China Business News.

The PSL is a new type of supplementary lending instrument backed by collateral that is used to inject liquidity into the market. It is hoped the tool can play the role of benchmark interest rate in the medium term.

PBOC Mulls New Tool for Regulating Money Supply, Guiding Rates

For most of the past decade, the central bank's monetary policy has largely hinged upon the condition of foreign capital inflows, which were mostly converted into the yuan at banks.

When inflows surged, the central bank would strengthen operations to mop up excess liquidity; when they ebbed, it would make up the shortfall by increasing money supply through open market operations and other ways.

The growth of foreign capital inflows has slowed and started fluctuating widely in the last two years, raising the demand for the central bank to manage money supply more actively than by just responding to changes in cross-border capital flows, the source said.

Here is Yu Yongding on China's capital account situation and the risks of capital outflows: China’s experience in capital account liberalization