Abstract: The Report examines short-term cross-border capital flows in China based on international payment flows. It also reassesses the actual stock of China's cross-border direct investment and offshore securities assets of various countries from the perspective of the stock of international investment positions. By estimating the offshore securities asset-liability stock that has not been correctly included in the existing statistics, it tries to create a relatively complete and accurate global portfolio asset-liability map.
On June 10, 2023, at the third CF40 Qujiang Forum hosted by the China Finance 40 Forum (CF40) and the Xi'an Municipal People's Government, the Qujiang Report 2023 was officially released, with the theme of Cross-Border Capital Flows in the Process of China's Capital Account Liberalization: Facts, Risks, and Strategies.
Zhang Bin, a senior researcher at CF40 and deputy director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, released the Report. Yu Yongding, a member of the Chinese Academy of Social Sciences and chairman of the Pushan Foundation, along with Zhang Xiaohui, a senior researcher at CF40 and former assistant to the governor of the People's Bank of China, discussed the themes presented in the Report.
The Report is a research result of the CF40 project, jointly responsible by Zhang Bin and Xia Li Sheng, a CF40 youth member and director of the Global Macroeconomic Research Office of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. The project team members include Xu Zitong, Luo Chaoyang, Xu Le, and Chang Shuyu.
The Report examines short-term cross-border capital flows in China based on international payment flows. It also reassesses the actual stock of China's cross-border direct investment and offshore portfolio assets of various countries from the perspective of the stock of international investment positions. By estimating the offshore securities asset-liability stock that has not been correctly included in the statistics, it tries to create a relatively complete and accurate global portfolio asset-liability map.
I. CHINA'S SHORT-TERM CROSS-BORDER CAPITAL FLOWS HAVE UNIQUE CHARACTERISTICS
The Report on China's short-term cross-border capital flows since 2005 has found that our country's short-term capital is cumulatively a net outflow. Among these flows, those categorized as "other investments" have dominated the basic pattern of short-term capital flows, with large capital outflows being the main driving force behind short-term capital net outflows. In co ntrast, the capital flow under the "portfolio investment" category is relatively low, with relatively balanced inflows and outflows.
From an international perspective, there are clear differences in the short-term cross-border capital flow status between China and developed economies, as well as other emerging and developing economies. The Report compared China's short-term capital flows with those of 25 developed economies and 24 emerging and developing economies. The findings are as follows:
(1) Since 2005, China's short-term capital has had a net outflow, while short-term capital in developed economies and other emerging and developing economies during the same period was a net inflow;
(2) The fluctuations of China's short-term cross-border capital are more severe;
(3) The capital inflow and outflow under China's other investment items are more imbalanced;
(4) Short-term capital flows in China and other emerging and developing economies are driven more by other investment items, while developed economies are more driven by portfolio investment items.
It should be noted that the cross-border capital flows discussed in the Report are non-reserve capital flows and do not consider the capital flows brought about by changes in official reserve assets. According to the International Monetary Fund's International Balance of Payments and International Investment Position Manual (Sixth Edition), this part of cross-border capital flows mainly comprises: direct investment, portfolio investment, and other investment. As direct investment is largely based on long-term consideration of the real economy and specific investment projects and is less affected by short-term financial market fluctuations, the Report defines short-term capital flows as the sum of portfolio investment and other investment, excluding direct investment. Portfolio investment includes equity and bond investments, while other investment mainly refers to other financial transactions between residents and non-residents that are not included in direct investment, portfolio investment, financial derivatives, and reserve assets. Other investments have six sub-items: other equities, currency and deposits, loans, insurance and pensions, trade credit, and others.
In China's case, the currency and deposits, loans, and trade credit items have larger capital flow scales under other investments. There are many participants in these three sub-items, mainly from the business sector.
According to Zhang Bin, behind China’s unique pattern of short-term cross-border capital flows are the country’s unique institutional environment, participants, and behavioral motives. “During the gradual reform of the RMB exchange rate formation mechanism, unilateral expectations of RMB exchange rate changes maintain for a long period; in the pipelined capital account opening environment, foreign trade and foreign-invested enterprises play a more prominent role than financial investors in facilitating short-term capital flows. These characteristics make short-term capital flows more volatile in China than in other economies, and capital flows under other investment projects dominate short-term capital flows most of the time.” Zhang Bin said.
With China’s pipelined short-term capital account opening up, the household and the financial sector, under various quota management and capital flow management, have relatively limited direct participation in short-term capital flows; the corporate sector has more channels to participate in short-term capital flows. A large number of foreign trade and foreign-invested enterprises are the most frequent and important participants in the foreign exchange market, and they act as the most significant driving force behind China’s short-term capital flows through capital flows under investment accounts such as deposits, ordinary loans, and trade financing.??
Foreign trade and foreign-invested enterprises have the following characteristics in behavioral motives:
First, they pay substantial attention to changes in RMB exchange rate expectations;
Second, enterprises attach less importance to domestic and foreign interest rate spreads and global risk appetite than a purely financial investment;
Third, the short-term capital flows of enterprises are vulnerable to changes in the domestic economic climate. During the economic boom, domestic capital demand is relatively strong, and enterprises tend to hold local currency, which is manifested by the increase in foreign liabilities and short-term capital inflows and the decrease in foreign assets; during the economic contraction, short-term capital outflows increase.
A “China-oriented” monetary policy and a floating exchange rate system can ensure the stability of both the domestic economy and cross-border capital flows
The above statement can also be verified in the empirical study. The Report establishes a time-varying parametric model that includes factors such as expectations of RMB exchange rate changes, domestic economic fundamentals, global risk appetite, and interest rate spreads and discusses the impacts of these factors on different types of short-term capital flows in different periods.
The findings show that the expectations of RMB exchange rate changes and the domestic economic climate are the two most important factors affecting China’s short-term capital flows; The China-U.S. interest rate spreads and the Cboe Volatility Index (VIX) that measures global risk appetite have rather small overall impacts on China’s short-term capital flows, especially on the lower-frequency quarterly data.
According to Zhang Bin, under the classic framework of “push” and “pull” analysis of cross-border capital flow drivers, it can be described that the “pull” force significantly exceeds the “push” force in China’s short-term capital flows. In other words, domestic economic fundamentals play a more significant role than the changes in the external environment in China’s cross-border capital flows
This finding brings at least two policy implications:
First, the timely elimination of unilateral expectations of RMB exchange rate changes through flexible exchange rate fluctuations will help stabilize short-term capital flows. The reform of the exchange rate formation mechanism should try not to introduce counter-cyclical factors or intervene in the foreign exchange market, and in the future, consider not referring to the basket of currencies in a well-timed manner.
Second, China doesn’t need to reduce capital flow pressure by maintaining interest rate spreads as many emerging market economies do. A combination of China-oriented monetary policy and a floating exchange rate system will better ensure the stability of both the domestic economy and the cross-border capital flows.
Specifically, when facing both the economic downturn and exchange rate depreciation pressures, an interest rate cut is still a choice of monetary policy. This is because, with the guarantee of a flexible exchange rate system, though the interest rate cut will bring capital outflow pressure from the spread level, the pressure is rather small; meanwhile, interest rate cut can play a significant role in supporting short-term capital flows and the RMB exchange rate by improving domestic economic climate.
III. PENETRATING THE “FOG” OF OFFSHORE FINANCIAL CENTERS
The Report estimates the real stock of China’s cross-border direct investment. Portfolio investment is the most important part of cross-border direct investment, accounting for about half of global financial assets. The Report reassesses the portfolio investment of countries’ international investment positions, with the aim to penetrate the “fog” and outline a complete and real picture of the asset-liability relationship of global securities by reckoning the portfolio assets that haven’t been included in the statistics correctly.
First, over 70% of China’s foreign inward direct investment (IFDI) and outward foreign direct investment (OFDI) positions come from or flow to offshore financial centers such as Hong Kong, China, the Cayman Islands, and the Virgin Islands.
Second, the final sources of direct investment funds from offshore financial centers not only include Europe, the United States, Japan and South Korea and other developed economies, but also involve the "return investment" from within China.
As offshore financial centers play an increasingly prominent role in overseas investment, the traditional "residence-based" statistical perspective cannot accurately reflect the real flow of investment.
The Report compares the differences between domestic and foreign direct investment position datasets, employs the IMF's Coordinated Direct Investment Survey (CDIS) macro dataset as a basis, and introduces the Orbis database on micro enterprises as an important supplement to identify the portion of China's IFDI and OFDI that passes through offshore financial centers and the size of return investment from the "final source" perspective It is found that China's stock of IFDI is overestimated because the impact of return investment is ignored and the stock of OFDI is underestimated. Specifically:
After adjustment, IFDI from offshore financial centers such as Hong Kong of China, British Virgin Islands, Singapore, and the Netherland decreases significantly, and most of the adjusted part is the return investment from the Chinese mainland; the investment from countries or regions with a strong foundation of the real economy increases accordingly, and the top five sources of IFDI in the Chinese mainland are Hong Kong of China, Japan, the United States, Germany, and South Korea.
After adjustment, OFDI that flows to offshore financial centers also decreases, and that flows to countries or regions with strong real economic base increases. Among them, the adjusted scale of investment to offshore financial centers like Hong Kong of China and Singapore, as well as the low-tax region Netherlands, falls significantly, and the OFDI positions to the Cayman Islands drop sharply after the adjustment, while the OFDI positions to the British Virgin Islands rise.
"This means that most of the capital transferred for tax avoidance is concentrated in the British Virgin Islands and retained in the form of offshore companies or offshore trusts set up by natural person shareholders," said Zhang Bin.
The Report also uses the maximum entropy method to add the modified portfolio assets and liabilities into the CPIS base matrix, generating a "complete" bilateral position matrix that includes offshore portfolio assets.
The study shows that approximately $17 trillion of global portfolio assets were not included in the international investment position statistics at the end of 2020, and approximately $21 trillion of portfolio assets were held through offshore financial centers. Oil-rich countries such as the UAE, Saudi Arabia, and Russia had a very high proportion of offshore portfolio investments and developed European countries such as the UK, France, Germany, and Italy all had a large proportion of offshore assets with a high degree of homogeneity. Chinese mainland did not have a relatively high proportion of offshore wealth but a high proportion of entrusted wealth.
The Report notes that offshore financial centers pose special challenges to both international financial regulation and research. The IMF statistics on offshore portfolio assets underestimate the offshore assets of countries. The asset management services provided by various offshore financial centers conceal real asset ownership, and a large number of assets are not recorded in the countries of their true owners. Correctly counting and measuring the real stock of China’s offshore assets and liabilities can help clarify issues such as China’s capital outflows and also help re-understand the issues of China’s current account imbalances and inter-temporal optimization.
The estimates and analyses above provide several policy implications:
(1) Large-scale return investment can easily become a cloak for enterprises to conduct short-term capital cross-border arbitrage, which requires further regulation of the declaration of enterprises’ return investment and guidance of the cross-border capital operation of enterprises.
(2) We should strengthen the regulation of new types of capital outflow. Regulatory instruments should keep pace with the times and further standardize equity transfer of domestic enterprises, especially the transfer process for overseas shell companies and institutional investors, as well as profit transfer through variable interest entity (VIE) structure.
It is translated by CF40 and has not been reviewed by the authors. The views expressed herewith are the authors ‘own and do not represent those of CF40 or other organizations.
