RaboResearch - Economic Research

China: turbulence on financial markets accompanied by fall of FX reserves

Country Report


Flag China

Turbulence on financial markets has been accompanied by a strong fall of China’s still sizable stock of foreign exchange reserves. Growth in industry and construction took a hit in 2015, but service sector growth appears to have remained stable. China’s economic challenges are big.

Strengths (+) and weaknesses (-)

(+) Exceptionally strong external position

China’s vast (though declining) stock of FX reserves, amounting to USD 3.33trn in December 2015, a positive NIIP and low external debt give it a strong external position. Capital controls also reduce external vulnerability, though growing outflows suggest that controls have become more leaky.

(+) Large economy with growth potential

China has a large and growing economic market. In PPP terms, China is now the world’s biggest economy. Meanwhile, growth potential still seems present, as China’s GDP per capita is still relatively low and the country has so far successfully moved up gradually on the technological ladder, though policy reforms are crucial to sustain growth in the medium term.

(-) Existing growth model is unsustainable

China has to change its growth model to reduce inefficiencies and ensure sustainable growth in the future. However, many crucial reforms still have to be implemented & are becoming more urgent.

(-) Weak accountability of the government

High levels of corruption, weak protection of human rights, strong influence of the Chinese Communist Party on the judiciary and lack of democracy implies that the Chinese population cannot hold the government accountable for its actions, which increases the risk of public unrest. 

Key developments

1. New bout of market turbulence accompanied by large-scale capital outflows

China’s stock and currency markets got off to a turbulent start in 2016, as both the currency and share price face strong downward pressure. Following heavy-handed government interventions some stability seems to have returned. The fall of share prices has stopped, but probably only after renewed large scale (indirect) government purchases. The government also intervened heavily on currency markets, even on the offshore renminbi market, after the offshore renminbi had become substantially cheaper than the onshore renminbi. The government seems to have recognized that its poor communication and frequent policy U-turns had boosted instability, as it has created a new cabinet office to co-ordinate financial and economic policy. However, the fundamental tensions between more market forces and maintaining government control remain unresolved.

The turmoil has been accompanied by a sharp fall of China’s foreign exchange (FX) reserves from USD 3.69 trn in June 2015 (and 3.99tn in June 2014) to USD 3.33trn in December 2015. The decrease of FX reserves by a record USD 108bn in December implies net capital outflows of about USD 150bn. Capital outflows are probably driven primarily by expectations of further currency depreciation, though the ungoing anti-corruption campaign and sentiment on stock and property markets might also contribute. The scale of the flows suggest that China’s capital controls are now quite leaky, which could increase financial stability risks. While the pace of decline has been fast, the buffers left are still sizeable, even after taking into account that FX debt is estimated to be close to USD 1 trn. A sizeable part of the fall in FX reserves thereby appears to be caused by a Chinese companies and banks reducing their FX debt. Furthermore, China has a positive net international investment position (17% of GDP in 2014) and a sizeable current account surplus (of slightly more than 3% of GDP in 2015). If outflows continued at the current pace, the government would attempt to tighten capital controls and could also allow greater depreciation.

Figure 1: Equity rout
Figure 1: Equity routeSource: Macrobond
Figure 2: FX rate and reserves are falling
Figure 2: FX rate and reserves are fallingSource: Macrobond

2. Impact of turbulence on real economy seems limited, but challenges remain present

So far, the impact of the turmoil on the real economy seems to have been limited. According to the official first estimate, economic growth fell to 6.9% in 2015, down from 7.3% in 2014, but other economic indicators suggest a more pronounced slowdown, with growth falling to slightly below 5% in early 2015 and remaining at that level afterwards. This big slowdown thus took place in 2015Q1, when the stock market was still booming, and was driven by much weaker growth of the industrial and construction sectors. In particular heavy industry has taken a hit, with steel production declining for the first time in recent history. According to most indicators growth in the service sector, which is the biggest and also the most labour intensive economic sector, has remained high. Even excluding the high growth of the financial sector in 2015 (likely linked to the high trading levels on stock exchanges), service sector growth has remained relatively high. While there are no reliable unemployment data, most indicators suggest that the labour market has remained rather tight (though unemployment may be an issue in regions with a lot of heavy industry).

Macroeconomically much more important than the stock market is the real estate market. Construction grew extremely rapidly until early 2014, when both house prices and transaction numbers started to go down. Thanks to easing of lending, a recovery has taken place in the biggest (especially in so called tier I) cities, but much less in the tier-III cities and cities in the industrial north. Given the scale of construction in recent years, the real estate sector continues to pose risks.

Meanwhile, credit growth has continued to grow at a much higher pace than nominal GDP, which means that leverage has continued to increase. Despite relatively high consumption growth, the (household) saving rate remains high, which implies that high levels of investment continue to be needed to support growth. While the control of the government over the financial sector and (though apparently increasingly leaky) capital controls mitigate risk, increasing leverage coupled with high levels of wasteful investment pose financial stability risks and are likely to result in a further slowdown of growth further in the future.

3. Impact of end of one child policy likely to be limited

In November the government abolished China’s one child policy. As China’s labour population has started to fall in recent years and will continue to do so as the population will start to age, a higher birth rate could help to raise long-term growth perspectives. However, the impact is likely to remain small. An earlier easing of the one child policy for some groups did not result in a much higher birth rate, and birth rates in neighbouring countries such as Japan, South Korea and Taiwan are also very low. Furthermore, the costs of having children are high, especially in the big cities, and having just one child migh have become culturally ingrained.

Factsheet China
Factsheet ChinaSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

China is the second-largest economy in the world in nominal GDP terms (estimated at USD 10.9 trillion in 2015) and the largest economy in PPP terms (estimated at USD 19.8 trillion in 2015). At the heart of China’s economic success has been its successful export- and investment-led growth model. However, after 2008 growth relied to a great extent on rapid credit and (real estate and infrastructure) investment growth. Meanwhile, adverse side effects, such as a rapid rise in income inequality and major environmental problems have become too big to ignore. China’s growth model will have to be changed and become more consumption-driven instead of investment-driven. Innovation will have to be nurtured, while environmental responsibility will have to gain in importance. The late-2013 Third Plenum addresses these issues, but implementing the plans correctly and timely will be a key challenge for Chinese authorities while major downside risks, such as a sharp economic slowdown or public unrest are present.

The People’s Republic of China, established in 1949, is a socialist one-party state ruled by the Chinese Communist Party (CCP). Power is centralized in the CCP whilst the support of the People’s Liberation Army and a well-developed internal security system safeguard political stability. The availability of information is heavily controlled by the government. Press freedom and freedom of speech are heavily restricted, while the judiciary is not independent. Due to lack of transparency, developments in China, especially political ones, remain clouded and difficult to gauge. In recent years, President Xi Jinping has launched a far reaching anti-corruption campaign, which has helped him to increase his personal power.

Economic indicators of China
Economic indicators of China Source: EIU, Rabobank

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