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“the Curious Case of China’s Capital Outflows” – Goldman Sachs 21 July 2015

The note reads:

“China’s balance of payments has been undergoing important changes in recent quarters. The trade surplus has grown far above previous norms, running around $260bn in the first half of this year, compared with about $100bn during the same period last year and roughly $75bn on average during the previous seven years. Ordinarily, these kinds of numbers would see very rapid reserve accumulation, but this is not the case. Partly that is because China’s services balance has swung into meaningful deficit, so that the current account is quite a bit lower than the headline numbers from trade in goods would suggest.But the more important reason is that capital outflows have become very sizeable and now eclipse anything seen in the recent past.

Headline FX reserves in the second quarter fell $36bn, from $3,730bn at end-March to $3,694bn at end-June. While we estimate that there was a large negative valuation effect in Q1 (due to the drop in EUR/$ on the ECB’s QE announcement), there was likely a positive valuation effect in Q2, which we put around $48bn. That means that our proxy for reserve accumulation in the second quarter is around -$85bn, i.e. the actual “flow” drop in reserves was bigger than the headline numbers suggest because of a flattering valuation effect. If we put that number together with the trade surplus in Q2 of $140bn, net capital outflows could be around -$224bn in the quarter, meaningfully up from the first quarter.There are caveats to this calculation, of course. There is obviously the services deficit that we mention above, which will tend to make this estimate less dramatic. It is also possible that our estimate for valuation effects is wrong. Indeed, there is some indication that valuation-related losses in Q1 were not nearly as large as implied by our calculations. But even if we adjust for these factors, net capital outflows might conceivably have run around -$200bn, an acceleration from Q1 and beyond anything seen historically.

The big question is obviously what is driving these flows and how long they are likely to continue. We continue to take the view that a stock adjustment is at work, although it is clear that the turning point is yet to come. We will look at this in one of our next FX Views. In the interim, we think an easier question is what this means for G10 FX. This is because this shift in China’s balance of payments is sure to depress reserve accumulation across EM as a whole, such that reserve recycling – a factor associated with Euro strength in the past – is unlikely to be sizeable for quite some time.”

So the recent “problems” in Chinese markets and the deprecation of the Renminbi appear to be the results of other problems, which are not understood outside the Chinese Communist Party and its institutions. For China to see a capital outflow of around $200 bn in a three month period (including a trade surplus of $140 bn) is currently inexplicable.

Something very strange indeed is happening in China and foreigners dealing with Chinese markets will need to be extremely careful, even after stock markets appear to quieten down. This needs to be read with Michael Pettis’ article on “Interpreting information in China’s Stock markets” and Ambrose Evans-Pritchard’s 22 July 2015 article “Capital exodus from China reaches $800bn as crisis deepens”.

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