A stronger renminbi and the brighter economic picture at home have not dented Chinese household appetite for foreign exchange, according to FTCR’s latest survey of bank officials. This demand means the government will want to maintain a tight grip on the capital account, even as some of the controls introduced over the past two years are quietly relaxed. 

More than two-thirds of the 53 bank officials surveyed said they were selling more foreign exchange than six months ago (see chart), while a similar number reported an increase in customer inquiries. When we last conducted this survey in March 2017, inquiries were up 40 per cent. 

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The increase partially reflects the resetting of foreign exchange quotas at the start of the calendar year, as well as rising demand ahead of the lunar new year holiday. However, Chinese consumer demand for forex is also increasing on a fundamental basis; our monthly gauge of consumer sentiment found the number of households saying they would hold at least 10 per cent of their savings in foreign exchange has steadily increased (see chart), even as domestic financial conditions have stabilised and the renminbi has hit two-year highs against the dollar. 

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More confident consumers

The government began tightening capital controls in late 2015 following a stock market crash and botched renminbi devaluation. Ignoring criticism that they were backtracking on reform commitments, the authorities succeeded in stabilising capital flows and ending the drawdown of China’s foreign exchange reserves (a weaker dollar has also helped). Far fewer bank officials cited concerns among clients about economic or exchange rate risk as drivers of demand for foreign exchange in our latest survey than in March last year or August 2016, when the authorities were still battling to shore up the financial system (see chart). 

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Capital is still pouring out of China, if at a less furious pace than two years ago. The Institute of International Finance, a Washington-based financial industry association, says the intensity of outflows via households and companies has lessened, estimating them at $55bn in the final quarter of last year compared with $198bn in the same quarter of 2016 (see chart). China’s most recent errors and omissions data — a line item in the balance of payments accounts that reconciles unidentified cross-border flows — also suggest outflows have stabilised, as has the travel services deficit, which is thought to hide capital outflows

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Household savings leaving China do not automatically equate to capital flight. Our survey showed that consumer demand is being driven by more prosaic needs, with education most frequently cited as the main reason for clients buying foreign exchange. By the end of last year, more than 1.5m Chinese students were studying abroad, up from 1.2m in 2015, according to the Center for China and Globalization, a government-affiliated think-tank. Based on average out-of-state tuition fees and room and board costs at US public colleges, that equates to an annual bill of at least $55bn. 

Households are also looking to diversify their investments. Demand for foreign currency-denominated wealth management products has been rising, even though they yield less than renminbi equivalents (see chart). Though technically banned, Chinese consumer demand for overseas real estate is also a key driver, as is the demand for more stable investment returns. 

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Consumers are still bumping up against the government’s $50,000 annual forex conversion quota, while the proliferation of red tape in the past two years has made finding foreign currency, even for legitimate purposes, more complicated. Some bank officials said a shortage of forex means they are turning down applications, even when accompanied by validating paperwork such as plane tickets or university admissions letters. 

Despite a relatively strong economy at home, 64.1 per cent of bank officials surveyed said demand for foreign exchange will grow in the coming six months, but capital controls will remain a nuisance; 73.6 per cent said converting funds above the $50,000 cap will still be possible, but more than half said they expect it to become more difficult. 

Holes in the dam

Increased regulation has created opportunities for those able to bypass the capital controls regime. Underground bankers surveyed in Chongqing, Shanghai and Xiamen reported that business has increased by as much as a third in the past year. 

However, the State Administration of Foreign Exchange has launched a crackdown on these lenders. More than 100 were arrested last year, and the agency has vowed to deliver another “deep blow” in 2018.

FTCR spoke to a money changer in Chengdu who has stopped handling single orders of more than $500,000, while another, who operates in Xiamen, is considering getting out altogether.

“All I would need to do is switch my phone off and move away — either that or I get arrested when one of my partners informs on me,” he said.

Back to 2015

With stability restored, the government should begin loosening capital controls. There is some evidence this is under way; SAFE head Pan Gongsheng recently said flows are balanced once again and that the policy stance has “returned to neutral”. A small channel for portfolio outflows has reportedly been reopened, while overseas direct investment grew for a third straight month in January (see chart). 

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However, we do not expect a wholesale dismantling of barriers because of the threat of financial instability. Instead, the authorities may quietly roll back some of the impositions introduced over the past two years. The economy is expected to slow, in part because the government is clamping down on risky loan structures by tackling the “known unknowns” in the financial system. At the same time, global market turbulence earlier this month is a reminder of the impermanence of some capital flows.

Although the dollar has weakened as US rates have been raised, the Federal Reserve will continue tightening this year and, in response, the Chinese government will err on the side of caution and maintain its tight grip

— Sun Yu, Director of Network Research, FT Confidential Research

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.

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