China’s International Investment Position in 2012

The People’s Bank of China recently released full year 2012 data on the nation’s Balance of Payments (BOP) and International Investment Position (IIP), which shows how the nation’s external balance sheet evolved in the course of the last year.

China’s balance of payments shows a dramatic change in cross-border capital flows in 2012. The financial account as a whole swung from a surplus of $260 billion in 2011 to a deficit of $21 billion in 2012. This was the first financial account deficit since 1998, when the Asian financial crisis triggered capital outflows. This shift was widely seen as evidence of capital flight in reaction to a slowdown in economic activity in the first two quarters of 2012. A dissection of the financial account shows that the reality is less portentous, having mostly to do with changing near-term perceptions about currency appreciation in combination with more freedom for firms and households to hold onto foreign exchange instead of surrendering it immediately to the central bank.

PIIE_Table1

The balance of foreign direct investment (FDI) dropped from $232 billion in 2011 to $191 billion in 2012. The narrowing surplus results from both a rebound in outward FDI, which reached a new record high of $62 billion after a temporary drop in 2011, and a slight drop in inward FDI  from $280 billion in 2011 to $253 billion in 2012. Possible explanations for this drop are a decrease in manufacturing investment in light of rising labor costs; diminished investment capacity due to economic malaise in Europe and other key investor countries; and a drop in the speculative “hot money” portion of FDI in light of a general growth slowdown and property sector tightening. While the gap between direct investment inflows and outflows is narrowing, outward flows are still far from catching up with inward flows.

The portfolio investment surplus more than doubled from $20 billion to $48 billion. Inward flows shot up from $13 billion to $54 billion on the back of new policy initiatives to boost the participation of foreign institutional investors in China’s stock market through the Qualified Foreign Institutional Investor (QFII) scheme and other windows. Attractive valuations for Chinese securities also may have played a role, as the bulk of inflows occurred in Q4 when the Shanghai Composite Index hit a 3-year low. On the outbound side, signs of economic recovery in the US and stability in the Eurozone encouraged Chinese banks and qualified domestic institutional investors to invest in overseas securities in the second half of the year, after a period of downsizing their overseas holdings. Despite this increase in two-way flows, the value of portfolio investment flows remains small compared to the rest of China’s external balance sheet.

The most significant change in China’s financial account occurred in the “other investment” line of the BOP, which includes cross-border loans, trade credit, deposits and “other” flows. The balance here has changed from modest inflows of $9 billion in 2011 to a record $260 billion of outflows in 2012, driven by loans and deposits. These patterns do not represent large-scale capital flight but rather a temporary change in the foreign exchange position of Chinese firms and households. Before 2007, China’s foreign exchange regime forced firms and households to convert all income from current account transactions immediately into renminbi. This “surrender requirement” has been gradually loosened since then, giving firms and households more flexibility to hold FX they earn abroad. In the past, Chinese residents had an interest in immediately converting their FX income in expectation of further appreciation of the RMB. Last year, however, those expectations reversed, motivating a desire to maintain foreign currency deposits.  We saw a similar pattern, briefly, in 2008 when RMB adjustment was put on hold, but the scale is much larger this time. The “loan” position is similarly affected by currency expectations as banks and firms that are in a position to make choices between keeping foreign exchange or trading it in for RMB optimize their FX exposure.

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