News Analysis: Capital outflows not severe concern in China as U.S. expected to slow rate hikes

Capital outflows from China will not pose a severe concern to the world's second-largest economy and are likely to slow down in the next few months as the U.S. Federal Reserve is expected to slow the pace of future interest rate hikes, experts said.

Since the People's Bank of China (PBOC), the central bank, announced on Aug. 11 to revamp the foreign exchange mechanism to make the rate more market-based, the currency renminbi (RMB), or the yuan, has faced downward pressures and concerns about capital outflows from China have been on the rise.

China's foreign exchange reserves dropped by 99.5 billion U.S. dollars to 3.23 trillion dollars in January, after a record fall of 107.9 billion dollars in December, signaling capital outflow pressures in recent months, according to the PBOC.

"Capital outflows originated in part from market expectations that the Fed would increase interest rates and the PBOC would cut rates, resulting in narrower interest rate spreads between the U.S. and China," Zhou Hao, a professor at Tsinghua University's PBC School of Finance, told Xinhua in a recent interview.

The Fed raised its benchmark interest rates to a range of 0.25 percent to 0.5 percent on Dec. 16, the first rate hike in nearly a decade, making the U.S. dollar more attractive to yield-seeking investors and driving investment flows into the United States. At that time Fed policymakers estimated that there would be four more rate hikes in 2016, with the earliest to come in March.

But the global economic and financial turbulence since the start of this year has raised concerns about the strength of the U.S. economy, throwing the Fed's rate hike plan into doubt.

William Dudley, president of Federal Reserve Bank of New York and a close ally of Fed Chair Janet Yellen, said Monday that the balance of risks to his U.S. economic outlook may be "starting to tilt slightly to the downside," an assessment that could signal a pause for the central bank's rate hikes.

Only 9 percent of the business and academic economists predicted the Fed would raise interest rates in March, while roughly 60 percent of economists said the central bank would wait until June to hike interest rates, the latest survey conducted by the Wall Street Journal indicated.

Zhou, a former Fed senior economist, said the U.S. central bank would be cautious to probably raise interest rates only twice this year because of "the moderate recovery of the U.S. economy and uncertainties in the global financial markets."

As the impact of Fed tightening on the U.S. dollar looks largely priced in, Zhou believed the expected slower pace of Fed rate hikes this year would limit further dollar appreciation, ease the RMB's depreciation pressure and slow capital outflows from China.

Zhou said the PBOC preferred to use open market operations and lending facilities rather than interest rate cuts to provide liquidity and support China's economy in recent months, which would also help stabilize market expectations of the RMB's value.

"The worst period of concerns about sharp depreciation of the RMB and dramatic capital outflows from China may be over," he said.

Zhou also noted that capital outflows from China were "not necessarily bad," citing the appropriate diversification of assets by Chinese households and companies from home to overseas as a healthy development. Given generally higher returns in China than abroad, he believed Chinese households and companies would finally "make mart investment choices."

The Institute of International Finance (IIF), a global association representing about 500 financial intuitions, estimated that a large part of capital outflows from China last year were repayments of dollar-denominated debts by Chinese companies, in order to mitigate the impact of the dollar appreciation. Once Chinese companies repay most of their offshore debt, outflow pressure could ease.

Zhou's view on capital flows was echoed by officials at China's central bank. Yi Gang, vice governor of the PBOC, said Sunday that the recent drop in China's foreign exchange reserves was mainly due to a rise of foreign exchange assets in residential accounts and a reduction of foreign exchange liabilities, which are not likely to last for long.

"This process has a limit and the capital outflows will gradually slow down," Yi said, adding that China still enjoys high trade surplus and direct foreign investment, resulting in still-fast capital inflows.

Yi recognized some volatility on the RMB exchange rate, but said markets should not overreact, as the RMB's fluctuation range is still smaller than many other currencies. He was confident that the currency's fundamentals rather than short-term speculation will drive the exchange rate in the long term.

Despite of downward pressure, the RMB exchange rate remained generally stable against a basket of currencies in February, China Foreign Exchange Trading System (CFETS) said Thursday in a note.

The RMB exchange rate index based on the CFETS basket and the BIS (Bank for International Settlements) basket depreciated 0.52 percent and 0.35 percent respectively last month, while the index based on the SDR (Special Drawing Rights) basket appreciated 0.14 percent, according to the CFETS.

Charles Collyns, managing director and chief economist of the IIF, said the attention will now focus on the outcome of the upcoming annual sessions of China's top legislative and national advisory body starting on Saturday, which will set the growth target and the key fiscal and reform priorities for 2016.

"The hope seems to be that the announcement of further initiatives to strengthen confidence in growth and reform will reduce exchange rate pressures and allow calm to be restored," Collyns said Monday in a research note.

"I will be looking for measures that support the growth of consumption such as hukou (household registration system) reform or more fiscal spending on health and education," David Dollar, an expert on Chinese economy and senior fellow at the Brookings Institution, said of China's annual parliamentary session.

"China could also help the economy by opening up more of the service sectors to foreign investment and competition," Dollar told Xinhua. Endit