China macro:What drove capital outflows in 2016?

China’s capital outflows topped global macro risks 12 months ago, but much lessso recently. Is the risk gone, or is this just the calm before storm? Recently thePBoC has released the detailed Balance of Payment data for 2016. Using thesame framework in a note we published one year ago (Dissecting China’s capitaloutflows in 2015, April 2016), this report focuses on the drivers behind China’scapital outflows in 2016. The main conclusions are:

Carry trade (“foreigners withdrawing money from China” or “Chinese payingdown foreign debt”) has completely reversed, turning from outflows to inflows.

In other words, outflows in 2016 were mostly driven by domestic residentsand the most important driver was “Chinese increasing foreign assets”.

2016 was a year of a vicious cycle of outflows and depreciation. Theweakening RMB led to domestic money outflows, which further weakened theRMB. The US$640bn capital outflows in 2016 were similar to those in 2015.

In response, the government substantially tightened capital controls from2H16, which has largely worked. Meanwhile, foreign money has beenreturning from 4Q16 via FDI and bond investments. As such, we expect theheadline FX reserves to fall by US$150bn in 2017 and for these to start risingagain in 2018.

In our 2017 outlook, we made the out-of-consensus call that the USDCNYwould end this year at 6.9, i.e. no depreciation from end-2016. With theupdated knowledge on capital outflows, we are comfortable with the forecast.

The situation last year was very different from that in 2015. According to ourprevious study, half of the capital outflows in 2015 were due to carry tradeunwinding. That said, close to 60% of the carry trade inflows in 1Q09-2Q14 hadgone by end-2015. That’s why carry trade unwinding was a non-issue in 2016.

Looking ahead, capital controls at the current level are not a stable regime. Withthe stabilized RMB outlook and returning foreign inflows, the government shouldease the current capital controls in months ahead. But outflows would rise againif the dollar strengthens. That said, we believe that the risk of reserve losses andcapital outflows is manageable. A harder task is how to restart the RMBinternationalization, which was disrupted by capital outflows three years ago.