The massive foreign exchange reserve build-up by East Asia in the past year is a major reason for improving foreign sentiment in the region. China's resolve to tackle economic inefficiency via structural reforms and its upcoming entry to the World Trade Organization (WTO) has further reinforced foreign confidence. The reserve build-up is most noticeable in the Greater China region, where China, Hong Kong and Taiwan's reserves are ranked among the largest five in the world. However, some people suspect that China's illegal capital outflow may have accelerated again. If true, this would not only affect China's future growth adversely, it may also dampen foreign investors' participation in China's economic restructuring and their appetite for Asian assets as a whole.
Forex reserves build up
As Asia slipped into recession during the regional crisis, current account deficits turned into huge surpluses and led to massive accumulation of foreign reserves. The region's central banks intervened to prevent their currencies from rising under positive current account pressure, which augmented the reserve build-up.
The surge in Asia's foreign reserves boosted liquidity sharply, driving up Asian asset prices and unleashing a powerful force for economic recovery. It also allowed the crisis countries to pare foreign liabilities. Some even repaid foreign debts ahead of schedule. Foreign confidence returned, reinforcing the positive forces for economic and asset price growth in Asia.
Doubts over China
Some people question if all is well with China external balances, which have also shown significant rise in foreign reserves. The puzzle comes from the fact that despite a huge trade surplus, growth in China's foreign reserves has been flat recently. This has raised the concern that China's illegal capital outflow, estimated by the errors and omissions item in the balance of payments (BoP), might have accelerated. If true, this will be negative for China, as precious capital is needed to sustain growth and fund economic reform in the face of rising competition after entry to the WTO (expected before the end of this year).
Over-invoicing of export value has been cited as a means of capital flight. Beijing requires Chinese exporters to remit 85% of their export earnings back to the country, only allowing them to retain 15% of the hard currencies they earned as working capital. Hence, by over-invoicing export value, exporters can retain more US dollars and keep them outside the country.
Clarifying the misconception
These and other calculation problems are captured in the errors and omissions item in the BoP. However, these data are only released once a year, which will not help assess the current BoP position in China. It should not be hastily concluded that the flat growth in foreign reserves in the face of a large merchandise trade surplus was due to capital flight. The incentive for illegal capital outflow is much less now than before, due to both the authorities' harsh crackdown on such activity and an improving economic environment in China and around the Asian region.
More importantly, China has a chronic non-merchandise trade (services and income) deficit, averaging over $20 billion a year in recent years. There are no monthly data releases for the non-merchandise trade account, and hence the current account. But it is very likely that the large services account deficit remains, due to continued economic liberalization. This means that China has an average services deficit of about $1 billion a month. That will be big enough to cancel out some of the reported merchandise trade surplus.
On top of this, there is also legal capital outflow (again, nobody knows the amount until the annual BoP numbers are released), including repatriation of foreign capital. China has also been encouraging local firms to invest overseas to both take advantage of the cheap Asian asset prices after the crisis, and establish cheap overseas production bases to ensure Chinese export flows to these overseas subsidiaries (a strategy that the Japanese have used).
Hence, the sluggish growth in China's foreign exchange reserves is not necessarily caused by massive illegal outflow. The fact that monthly foreign reserves are still rising, albeit at a snail's pace, suggests that China overall BoP is still in surplus (since by definition, the change in foreign reserves is equal to the BoP). This situation is expected to last in the coming year, as expected large foreign direct investment inflow will underpin the BoP position.
Capital inflow rising
Western media recently reported that venture capital (VC) business to China was set to rise. Anecdotal evidence shows that $1 billion from US VC funds are set to flow into new Chinese dotcom companies. Data from the Asian Venture Capital Association also show that a total of 181 venture funds had some $6.6 billion invested in all of Greater China, although the proportion for the mainland was not detailed.
Many corporate treasurers in China have similar comments. Many European firms (especially IT related) are considering setting up shop or increase investment in China. Some existing foreign investors are also considering swapping equity for debt with their Chinese partners, instead of demanding repayment of their loans outright. All this bodes well for China's BoP and implies that the renminbi exchange rate would appreciate right to the upper limit of a wider trading band, if it were implemented next year.
Chi Lo is regional head of research and senior economist, the Standard Chartered Bank Treasury, Hong Kong.
