China capital curbs reflect buyer’s remorse over market reforms

Posted on November 30, 2016

Last year the reformist head of China’s central bank convinced his Communist party bosses to give market forces a bigger say in setting the renminbi’s daily “reference rate” against the US dollar.

In return, Zhou Xiaochuan assured his more conservative party colleagues that the redback would finally secure coveted recognition as an official reserve currency by the International Monetary Fund. Some people familiar with Mr Zhou’s sales pitch described it as a “Trojan horse” strategy because it wrapped difficult reforms in an alluring package. 

The State Council, China’s cabinet, now appears to have buyer’s remorse over its new gift horse. In recent days, draft proposals to tighten investment outflows from China have been widely leaked. 

This has led executives, bankers and lawyers to fear that many of the overseas mergers and acquisitions they are working on will be delayed if not derailed by the restrictions. The curbs focus on transactions worth more than $10bn but also much smaller ones if they fall outside the scope of the buyer’s normal business activities or involve real estate. 

“The People’s Bank of China is reluctant to impose such restrictions,” says Fred Hu, chairman of Primavera Capital Group. “They have worked very hard over the past couple of years to spur financial reform in general and capital account reform in particular. This is clearly a setback for these reforms.” 

One of the PBoC’s biggest financial reforms was announced in August 2015. The central bank said the renminbi’s dollar reference rate, around which it is to allowed to rise or fall no more than 2 per cent, would be set in accordance with the previous day’s trading and overnight market moves in Europe and the US. 

Under the earlier system, the PBoC had been free to set the reference rate wherever it wanted. When market pressures are driving the renminbi downwards, China’s central bank can now stem its fall only by selling dollars from its foreign exchange reserves. 

Such interventions have helped drive China’s forex stockpile from almost $4tn in early 2014 to $3.12tn at the end of October and also raised concern about another outflow — this year’s unprecedented surge in overseas M&A activity by Chinese companies. Non-financial outbound investments by China Inc reached almost $150bn over the first 10 months of this year, after a $121bn outflow in all of 2015. 

This has given ammunition to critics of another of the PBoC’s main reform initiatives of recent years — a more open capital account. 

“The PBoC has been very keen to open up the capital account and downplayed the risk that poses for the financial system,” said Louis Kuijs, Asia economist for Oxford Economics. “It’s the State Council, finance ministry and everyone else who are less keen in making capital account progress.” 

Yu Yongding, a former central bank adviser, argues that outflows are dangerous and that the PBoC’s use of forex reserves to counteract them has been a waste of money. Even with steady intervention to support the renminbi, the currency has depreciated more than 5 per cent against the dollar this year and last week fell through the 6.9 level. 

“Better late than never,” Mr Yu told the Financial Times this week. “The policy of increasing capital controls and stemming outflows is completely correct.” 

The PBoC is not, however, completely comfortable with this year’s M&A outflows. According to people close to the central bank, Mr Zhou has been a strong advocate of the need to reduce China Inc’s high debt levels and much of this year’s surge in overseas direct investment has been driven by highly leveraged companies venturing into areas far beyond their expertise.

Recent deals with doubtful synergies include an iron ore producer’s purchase of a UK video game developer and a copper smelter’s bid for the Hollywood production company behind Oscar-winning film The Hurt Locker. 

“So much money has been spent by Chinese companies on overseas hotels, football teams and properties,” says Huang Weiping, an economics professor at Renmin University in Beijing. “It is what Japanese companies did in the 1980s. These kind of outflows are not rational.” 

But many people doubt Chinese bureaucrats will be able to tell the difference between good acquisitions and bad ones. 

“In reality it’s very hard to differentiate the good guys from the bad guys,” Mr Hu argues. He suspects that the “the good guys will pay a heavy price and the bad guys will still find ways to move their money offshore”. 

Additional reporting by Wan Li

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