China's Capital Outflow: Much Ado About Nothing

by: Wall Street Daily

By Tim Maverick

In January 2016, the international market was uneasy about the capital outflows from China. Looking back, all that panic over China reminds me of Shakespeare's famous line from Macbeth:

It is a tale told by an idiot, full of sound and fury, signifying nothing.

Or, to once again borrow from William Shakespeare, it was Much Ado About Nothing.

The BIS on China's Reserves

All that chaos was cooked up around one data point made by the chronic China doomsayers who've been predicting China's economic Armageddon since the 1990s. Then, in March, in a story that went scarcely reported, the Bank for International Settlements (BIS) shed light on the reasons for Chinese capital outflows.

The BIS, where central bankers, like the Federal Reserve, do all their business, announced that the majority of the decline in China's foreign exchange reserves could be attributed to two causes: Chinese companies paying off dollar-denominated debt, and the unwinding of the renminbi carry trade. It was not, as reported, due to rich mainlanders desperate to get their money out of China before the economy imploded. This rumor, however, spread like wildfire and exacerbated the situation.

The Reality Sets In

Between 2005 and 2013, the strength of China's currency, the renminbi, grew exponentially. This caused many companies, rich individuals, and even some hedge funds, to borrow in dollars and hold on to renminbi. Beyond its skyrocketing value, another attraction of the renminbi was that its deposits paid more in interest than U.S. dollar deposits.

But when China allowed its currency to see even the slightest bit of decline, this carry trade became too risky. The subsequent frenzy is still being unwound today.

And it was because the U.S. dollar had, at one point, become so strong, many Chinese firms scrambled to pay back their dollar-denominated debt before the dollar grew even more - and with it, the size of their debt. On this point, JPMorgan Chase & Co. (NYSE:JPM) is largely in agreement with the BIS.

It estimated that capital outflows from China totaled $870 billion in the 18 months prior to the end of 2015. The largest component of the outflow was $620 billion due to corporate balance sheet adjustments.

In other words, over 70% of the capital that left China during those months went to paying off dollar-denominated debt, for fear that the weakening renminbi and the strength of the dollar would add to that debt.

That shocking capital outflow corresponded almost exactly with a sharp rise in borrowings by companies in renminbi, as reported by China's central bank, the People's Bank of China. These loans were clearly being made in order to pay back those same debts - cause and effect.

Chinese M&A Soaring

Last month, Chinese capital outflows finally ceased. China's foreign exchange reserves rose for the first time in five months, edging up by $10.3 billion to reach $3.2 trillion.

Despite this momentary pause in the cycle, I do expect the outflows from corporate China to continue. Not only are Chinese companies continuing to pay down their dollar-based debts, but also Chinese firms have gone on a worldwide shopping spree.

Of the $682 billion in global merger and acquisition (M&A) activity in the first quarter in 2016, Chinese companies were involved in $101 billion of that M&A action. That's about 15% of all international business efforts. The previous record for China's global involvement was $109 billion, set just last year. Clearly, a pattern is forming.

Of course, the China doomsayers continue to twist these statistics to argue that Chinese companies aren't simply expanding, they're fleeing China altogether. Or perhaps they'll even attempt to draw similarities to Japan's attempt at going international before its economy plummeted.

Either way, both arguments are nonsense. Large private companies in China are simply going down the same path that American multinationals followed decades ago. Like their American counterparts, Chinese firms will have to worry about taking on too much debt, regardless of whether or not that debt is dollar-denominated.

Nevertheless, most deals that are pulled off by firms not owned by the state are sound. As Roy Kabla of Nomura told the Financial Times:

"Many Chinese buyers continue to enjoy relatively attractive cost of capital versus western players, and can leverage these assets against the growing consumer class [in China]."

We'll certainly be seeing the mainstream financial media head into a whirlwind about Chinese capital outflows, as this pattern of spending and lending continues. Just don't let it carry you away in its gust! Sit down, take a breath, and read a book - maybe even some Shakespeare.

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