Since June 2014 private capital has been flowing out of China, a shift that has given rise to two competing narratives: Investors are selling mainland assets en masse and Chinese firms are paying down U.S. dollar debt.
Looking closer at the issue, BIS economists Robert McCauley and Chang Shu found that the paydown of debt was the most likely explanation. However, they also found that both narratives missed a crucial point: the shrinkage of offshore renminbi deposits.
In the years following the global financial crises, China’s renminbi rose steadily against the U.S. dollar, setting up the conditions for firms with access to dollar credit to borrow offshore and convert them to renminbi.
Chinese firms would seek to profit not only from the steady rise in the renminbi but also from the higher interest rate on renminbi deposits vis-a-vis the dollar.
One interesting point noticed by McCauley and Shu in the latest BIS quarterly review was that these deposits were retained in offshore banks outside China.
“Talk of “capital outflows” gives the impression that only financial flows that cross the border actually matter,” said Hyun Song Shin, economic adviser and head of research at BIS.
“But flows across currencies are often more illuminating in helping us understand current market stresses whether or not money actually crosses the border," he added.
But since early 2014, and especially since the People’s Bank of China in August 2015 effectively devalued the renminbi, the dollar has strengthened with the effect that borrowers have reversed these carry trades by repaying their U.S. dollar debt, which then also leads to a decline in renminbi deposits.
“The combination of reduced offshore renminbi deposits and Chinese firms’ paydown of foreign currency debt reflects the unwinding of carry trades and explains the downward pressure on China’s currency,” Shin said, adding that it also shows why the offshore renminbi trades at a discount to the onshore rate during periods of market stress.
In the third quarter of 2015, there was a record $175 billion net decline in cross-border loans to China by major global banks, almost double the outflow seen in the first quarter. Of this, $12 billion was due to an increase in Chinese official foreign exchange reserves at banks outside China.
But this left $163 billion of non-reserve outflows, with McCauley and Shu finding that these outflows reflected a reduction in renminbi deposits offshore, net dollar debt of Chinese firms cross-border and their net debt within China.
In a parallel to the offshore borrowing in renminbi, the BIS is also seeing an increase in borrowing in euros outside the euro area, with the volume rising by 15 percent a year.
Euro-denominated bonds issued by U.S. non-financial companies is now so prominent that it has been given its own name – the reverse yankee.
In contrast to the rise in euro-denominated credit outside the euro area, lending to borrowers within the euro zone has only been growing at a rate of 2.1 percent despite the efforts of the European Central Bank (ECB) to stimulate lending.
Click to read the BIS March 2016 quarterly review.