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.
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.
The $270 billion swing in the financial account and record high errors and omissions of $80 billion are responsible for another major change in China’s external patterns: a sharp drop in the accumulation of new official reserves. Despite a current account surplus rebound from $136 billion in 2011 to $193 billion in 2012, China’s State Administration of Foreign Exchange only added $97 billion to its existing $3.26 trillion in reserves, the lowest annual addition since 2002 (Figure 1). As explained above, this mostly represented a shift of foreign exchange from the central bank to the balance sheets of domestic banks.
A second factor changing the profile of China’s international investment position (IIP) is fluctuation in the valuation of existing assets – as summarized in Table 2. On the asset side, China’s IIP booked gains on almost every position except “other investment”, resulting from exchange rate effects and changes in market valuation. Foreign assets in China also profited from mark-to-market adjustments, with the exception of foreign direct investment assets which were unchanged.
Accounting for those valuation changes, China’s international assets grew by $441 billion or 9% in the course of 2012, resulting in a year-end position of $5.2 trillion. China’s international liabilities – foreigners’ claims on assets in China — grew by $393 billion to $3.4 trillion at year-end 2012, an increase of 13% over the previous year. China’s net foreign assets (NFA) — international assets minus liabilities – therefore grew from $1.69 trillion in 2011 to $1.74 trillion in 2012, a year-on-year increase of 3%. The pace of net foreign asset growth has slowed to an annual average of 4% in 2009-2012, compared to more than 50% in the pre-crisis years (2004-2008). China’s year-end 2012 IIP position is summarized in Figure 2.