In recent years, the big question for China watchers was whether the authorities can pull off a smooth rebalancing of GDP growth away from a heavy reliance on investment-led growth. In 2017, the focus has shifted to the rising tide of capital outflows from China that re-emerged toward the end of 2016.
Importantly, previous spikes in outflows were mostly driven by investor perceptions of domestic factors, including growth sustainability, gradual portfolio rebalancing by onshore residents, and confusion about China's exchange rate regime. This time around, external pressures are playing a lead role in a strong dollar environment, driven by expectations of higher US growth and interest rates.
Chinese policymakers are clearly concerned. They have three unpleasant policy options to counter the outflow pressure: (1) let the currency depreciate at a (much) faster pace, (2) deplete the country's foreign exchange reserves further, or (3) intensify capital controls.
Each of these options comes at a cost.
Let the currency go
A potentially rapid deprecation of the renminbi runs counter to the authorities' much-vaunted preference for stability. This would also complicate the People's Bank of China (PBOC)'s objective of keeping the renminbi stable against a basket of trading-partner currencies, since the yuan will have to appreciate against some currency. Letting the yuan depreciate would also likely spook global markets, feeding further market expectations for depreciation.
Use reserve drawdowns to finance more outflows
The PBOC's soft peg exchange rate solution (to a basket of trading partner currencies) works until depreciation pressures pick up and more reserve drawdown is needed. Markets are forward-looking and if they smell blood then the pressures for the yuan to depreciate will intensify. Even a stockpile of US$3 trillion in foreign exchange reserves may not be able to withstand sustained pressures.
Intensify capital controls
A third strategy is to stem the outflow through stricter access to foreign exchange. This is already happening, particularly for outbound direct investment, which has recently been subject to new restrictions and scrutiny. Anecdotal evidence of soft controls on access to US dollars abounds as well. The problem is that such controls impede the liberalisation of the capital account and lessen the attractiveness of the yuan as a reserve currency.
Pick Your Poison
None of these three options are likely to generate long-term confidence in the currency and China's policy predictability, which could pose a setback to the authorities’ long-term objectives, including China's goal of having the yuan become a true global reserve currency.
Faced with these imperfect choices, authorities appear to be doing a little bit of everything at the moment. But as outflow pressures are likely to intensify in early 2017, the markets will be closely watching authorities' response.
If the trade-offs are not considered wisely and the policy adjustments not communicated clearly and convincingly to the markets, then we could begin to see spillovers into the real economy. Should that happen, then we would have to worry about GDP growth after all.
The article is authored by S&P Global’s Asia-Pacific economists Vincent Conti and Paul Gruenwald