Signs of China (5): Tightening the Screws on China’s Foreign Reserves

Jeff Wang, November 8, 2018

The Chinese government has been gradually tightening its foreign exchange controls to the great detriment of enterprises and citizens, as well as the country’s economic vitality. What are the reasons for this heavy regulation, and what does it tells us about the economic and political state of China?

Over the last two years, members of the Chinese middle class have found it increasingly challenging to access foreign exchanges or make international remittances.

Ms. Zhang (张女士), a Chinese woman who had immigrated to the United States and who declined to disclose her full name, returned to Beijing this October to sell her apartment. However, the process of sending the money to the U. S. has proved a daunting experience.

“I’m still stuck here waiting,” she said. “I see exchange rates for the dollar get higher every day, and I think about how much I’m losing.”

The obstacles that Ms. Zhang faces have been commonplace in China after the authorities started tightening up on foreign exchanges in the second half of 2016.

In January 2017, the China Foreign Exchange Administration announced new rules that, in addition to maintaining the $50,000 per person limit on foreign exchanges, required purchasers to fill out a form, the “Application for Foreign Exchange Purchase” (个人购汇申请书). Additionally, purchases of foreign exchanges could not be used for buying real estate or making investments in securities overseas.

This January, the Foreign Exchange Administration also stipulated in its “Notice on Regulating Large-Scale Cash Withdrawal Using Bank Cards While Abroad” (《 关于规范银行卡境外大额提取现金交易的通知 》) a 100,000-yuan limit on overseas withdrawals when using a Chinese-issued bank card.

In June, the daily limit for Chinese citizens to withdraw foreign cash deposit from bank was reduced to $5,000 from $10,000. Many banks decline transaction requests by saying they lack sufficient foreign cash.

On October 10, the government issued its trial version of the “Anti-Money Laundering and Anti-Terrorism Financial Management Measures for Internet Financial Institutions” ( 《互联网金融从业机构反洗钱和反恐怖融资管理办法（试行）》 ). Per the Measures, customers who make trades with online financial institutions in excess of 50,000 yuan or foreign money worth more than $10,000 must have their transactions reported to the government.

As Beijing tightens the financial screws, Ms. Zhang has found herself being given the short end of the stick. “A lot of people, including me, are looking for relatives and friends we can give our renminbi (yuan) to, asking them to use their quota to exchange as many dollars as we can. But after making the exchanges, we run into a huge problem: how to remit the money overseas?”

She said that in order to bypass foreign exchange controls, ordinary Chinese use the “ant move” method to incrementally transfer their exchanges.

In addition to controlling foreign exchange transactions by individual citizens, the authorities also aim to limit capital movement on the part of private enterprises. Hu Liren (胡力任), a private entrepreneur living in the United States, said: “At present, China’s [private enterprises] foreign investment has basically stopped. Although there’s no law banning it, it has in fact stopped, because foreign investment requires a process, which in turn depends on government approval.”

Such policies started in 2017. In the first half of last year, China’s foreign direct investment fell by 40 percent, the first time since 2015 that it has decreased so sharply.

An extreme example is that in 2017, the Chinese government obstructed Wanda Group in the process of making a large-scale overseas merger and acquisition. The China Banking Regulatory Commission prohibited large state-owned banks from granting loans to Wanda for overseas M&A projects. At the same time, the authorities, making reference to private enterprise groups such as Wanda and Anbang, and forced them to sell their overseas assets and transfer the funds back to China.

The Chinese government has also used administrative measures to delay the withdrawal of foreign capital. In 2016, Deutsche Bank sold more than 3 billion euros of shares in China’s Huaxia Bank in China, but it took nearly a year before the money could be moved out of the country. In September of that year, when a large Japanese economic delegation visited China, its members made direct complaints about the procedural obstacles that Japanese companies faced when trying to withdraw capital.

The impetus for the rapidly tightening bureaucratic measures comes from the serious loss of foreign exchange capital in China in the past few years. According to the Chinese Academy of Social Sciences, during the two-year period from 2015 to 2016 — when losses of foreign exchanges reached a peak — capital outflows recorded in China’s international balance sheet reached $1.28 trillion.

It is a market truism that private enterprises and individuals convert their renminbi assets into U.S. dollars and transfer them abroad. This is the main reason for China’s capital loss. Ye Zhao (叶昭), a former finance journalist who lives in the United States, described four grades of capital outflows:

“Once a family makes a few million, it first sends its children abroad; if they make tens of millions, the whole family will emigrate. The ones with hundreds of millions will set up business overseas. If billionaires are leaving China, that means their decisions have are political, and it has become too difficult for them to do business in China.”

It can be said that entrepreneurs and common people have concocted brilliant schemes to transfers their assets abroad. In addition to the aforementioned “ant move” adopted by members of the middle class, private enterprises have funneled large amounts of funds out of China chiefly by means of foreign investment and “underground money houses.” The two giants, Anbang and Wanda, took out loans from Chinese banks and used the money to buy up large amounts of overseas assets.

Ye Zhao said: “I have been in touch with these entrepreneurs. Speaking directly, they told me that one of their motivations is to explore business opportunities that might be available overseas, and the other is to have an escape route in case they are implicated during the investigation of some corrupt official.”

Ye Zhao’s words point to a fundamental dilemma among private enterprises operating in China. Since the marketization of the economy, China’s private enterprises have been carrying a so-called “original sin,” namely, that in order to flourish, they have no choice but to resort to illegal means including tax evasion and illicit collusion with officialdom. These illegal acts and their potential legal consequences have become the “Sword of Damocles” hanging over the heads of many entrepreneurs.

Recent changes in China’s political and economic situation have squeezed the private sector. Since 2011, China’s economy has been in a downward spiral, with domestic consumption sluggish and the market running out of space for expansion. Private enterprises face many obstacles such as high tax burdens and difficulty in acquiring loans.

Meanwhile, the trend of “the state advances, the private sector retreats” (国进民退) has become increasingly prominent, and the living space of private enterprises has been gradually eroded by state-owned enterprises. Earlier this year, someone even opined that private enterprises should be eradicated. The difficult environment has forced private companies to seek overseas investment.

The Chinese middle class is feeling likewise constrained. Kai Wen (凯文), who has long been engaged in business between China and the United States, believes that “whether in terms of education, clean air and clean water, and food safety, China cannot meet the demands of its emerging middle class, who want more security in their lives. So they have taken matters into their own hands.”

As companies and individuals flock to transfer their assets overseas, the PoBC intervened in the foreign exchange market in order to hedge capital outflows and maintain the exchange rate, which caused China’s foreign exchange reserves to fall from their peak of nearly $4 trillion in June 2014 to less than $3 trillion in January 2017. The sharp drop in foreign exchange reserves has set off alarms bells in the Chinese government.

Foreign exchange reserves are seen in China as a financial buffer for turbulent times. Although Beijing’s foreign reserves dropping below $3 trillion has little real impact on the Chinese economy, Cheng Xiaonong (程晓农), a U.S.-based commentator, believes that it will cause the government a host of other problems. “Part of China’s economic security is the demand for foreign imports. If China loses the reserves it needs to import goods, oil and food prices will present a massive dilemma. Therefore, retention of these three trillions is something the Chinese government keeps a close watch on.”

The loss of foreign exchange reserves would also lead to an accelerated depreciation of the renminbi and an increase in the chances of triggering a financial crisis.

Xia Ming (夏明), a professor of political science at the City University of New York, believes that, “the Chinese government is very worried that if there are insufficient foreign exchange reserves to serve as a protective firewall, the national currency might come under attack, the economy may experience turbulence, and that this could even lead to regime collapse.”

The decline in China’s foreign exchange reserves has directed public attention to their real composition. According to the China Administration of Foreign Exchange, as of March 2018, China’s foreign exchange reserves were worth $3.11 trillion US dollars, while China’s balance of foreign debt was $1.84 trillion. This means that more than half of China’s foreign exchange reserves must be reserved for repaying foreign debts, and are not true assets.

At the same time, about half of China’s foreign exchange reserves exist in the form of US dollar bonds, which are not easily realized at any time. This kind of bad composition has added to public concerns about Chinese foreign reserves.

Along with the decline of foreign exchanges, there is also the risk of brain drain, said Hu Liren. “China has reached a period of great risk in terms of human resources, and many people have emigrated. There are still many [talented] people in the country, but their children have emigrated. The Chinese government does not want these thoughtful and intelligent people to leave, but it is difficult to change the current political status in China.”

The Chinese government’s moves to exercise stricter control over its foreign reserves have greatly slowed the momentum of capital loss. According to a report released this February by the Washington-based International Finance Association, the net outflow of China’s capital in 2017 was 60 billion US dollars, just a tenth of the $640 in outflows recorded in 2016.

Chinese financial scholar He Jiangbing (贺江兵) has applied the Mundellian impossible trinity, of Nobel Prize fame, to explain China’s foreign exchange controls:

“Among the three ‘impossibles,’ the first is the independence of monetary policy, the second is the relative stability of the currency exchange rate, and the third is the free flow of capital. Of these, you can only choose two.”

In other words, China has no choice but to impose strong controls on foreign exchange if it wants to maintain independent monetary policy and a relatively stable currency exchange rate.

This kind of foreign exchange control is useful for settling financial balances, as well as keeping the exchange rate and domestic prices stable. But at the same time, the burden it places on some classes is considerable. “Who is to bear the consequences?,” said a rather emotional Ms. Zhang. “I feel it’s us members of the middle class who are being hit hardest by these strict foreign exchange controls.”

Foreign exchange control not only puts unreasonable pressures on enterprises and citizens: the Chinese government’s restrictions on foreign companies remitting profits to their parent firms have done tremendous damage to the country’s credit.

Jacob Parker, vice president and head of China Operations at the US-China Business Council, said last year that as the United States lowered its corporate tax rates, some members of the Council expressed their desire to quickly bring back the profits they received in China, so as to minimize the risk of capital controls.

The serious loss of foreign exchange reserves and the urgency of foreign exchange control reflect a tandem battle between the Chinese government and civil society being fought in the context of economic downturn and political totalitarianism. When the people lack trust in the government and want to avoid political and economic crisis, they vote with their feet. At the same time, the stubbornness of the political system manifests itself in high-pressure policies that grab civil liberties by the throat in order to maintain control.

Beijing’s foreign exchange controls give us but a glimpse of the reality in China, where political and economic pressures have been compounded by the U.S.-China trade war. Whispers of the “China collapse theory” are getting louder as the struggle between the Chinese state and the people heats up in different arenas and on different levels.

Jeff Wang is a journalist with Radio Free Asia’s Mandarin Service. The article was first published in Chinese on October 31, 2018. Follow him on Twitter @NeverlandWang0

Related:

Signs of China (1), September 16, 2018.

Signs of China (2), September 22, 2018.

Signs of China (3), September 30, 2018.

Signs of China (4), October 8, 2018.

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