Danger of China leaking money to overseas stock

October 6th, 2007

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In our previous article, China considers leaking money to overseas stock, we mentioned that it is possible that by opening the outward investment channels, it may result in disaster. Today, we will talk about how it may happen.

This policy works when China has a lot of foreign currency reserves and a lot of foreign money flowing in through the trade surplus (that is, a lot of RMB is being printed in exchange for these foreign currency inflows?see Why is China printing so much money?). Opening outward investment channels will result in the depletion of China?s foreign currency reserves.

But let?s say an economic crisis hits China. Foreign speculative money that flowed in easily will then flow out just as easily. As foreigners redeemed their RMB for foreign currencies, the Chinese central bank will have to fork out those currencies from their reserves in order to maintain the exchange rates. Hence, the Chinese foreign currency reserves will dwindle in supply.

Devaluing the RMB will exacerbate the problem. By devaluing the RMB, the Chinese central bank is in effect exchanging less foreign currency for every unit of RMB. In that case, foreigners? holdings of assets denominated in RMB will decrease in value in terms of their foreign currencies. This will prompt foreigners to withdraw their money from China to cut their losses. When foreigners withdraw their money, this means they have to sell assets, which will worsen the asset price deflation in China (e.g. stock market crash), which in turn will give them a stronger reason to cut loss and withdraw more money from China.

Therefore, when capital flight (from China) happens, China?s foreign currency reserves will be drained out. Of course, the Chinese authorities would probably implement capital controls to prevent capital flight to preserve their reserves. But that is akin to a bank preventing cash withdrawals in order to protect its cash reserves. Either way, if the situation should come to such a stage, serious loss of confidence in the Chinese economy and financial system will result in an ugly state of affairs.

If China should open the way for outward investments, then we will expect their foreign currency reserves to be reduced, which will result in their reduced ability to deal with a capital flight in future (assuming that the RMB is still not freely floating).