Capital Flight From China: Why Investors Are Taking Their Money Elsewhere

SHANGHAI – Two decades ago, when he first set up his business in China, the European businessman with an interest in design was captivated by seemingly boundless opportunities. His company, which tapped Chinese factories to manufacture high-end garments, quickly boomed – soon his local staff swelled to two dozen. But, on a recent fall morning, the businessman sat in the living room of his house in a suburban residential compound, looking out at a blue sky unusual for this frequently smoggy city, waiting anxiously for the real estate agent to arrive. He was putting his home on the market, as he prepared to shut down what remained of his company and shift his base back to Europe.

“We had some great times here,” he said. “But now it’s time to leave.” The businessman, who spoke on condition he not be named because of sensitivities over de-investing from China, said life had changed: “When I arrived people were kind, life felt straightforward. Now it’s all about money, people are under a lot of pressure. Rents are high, schools are expensive. And the pollution … So I’m tired, I really don’t want to stay anymore. “

Frustration at the slowing economy, and unpredictable shifts in business regulations were factors too, he added – and not just for him. “The real estate company said a lot of people are selling houses – some are afraid about the economy, or about new regulations: in China you never know whether they’ll change the regulations, change the taxes.” Some of those selling were Chinese nationals seeking to move abroad, he added. He recalled what he had heard from a real estate agent back in Europe during a visit earlier this year: “Our best customers now are Chinese, they all come with cash to buy property.”

Official government data bear out the trend of capital flowing out of the country, with growing numbers of investors –foreign and Chinese –shifting assets out of China at an intensifying pace. This year alone, more than $600 billion of assets have been moved from Chinese yuan into foreign currency. In August and September, the pace quickened to more than $100 billion in each month, compared to outflows that had been running at under $5 billion per month previously.

The forces propelling money out of China are many, but a prime factor is alarm over the government’s August decision to suddenly devalue the Chinese currency, the yuan, not long after officials denied such a move would take place. Falling exports and slowing economic growth also played a role, along with the spectacular boom and bust on China’s stock markets, which fell some 30 percent during the summer, unleashing questions about the extent of the authorities’ grip on the economy.

Speculation is rife among certain financial analysts that another currency devaluation is in the works to make Chinese exports cheaper and more attractive on global markets, although the government has denied such rumors.

Andy Xie, the former chief economist for Asia at Morgan Stanley, warned of parallels with the Asian financial crisis of the late 1990s, when speculative bubbles in real estate and stock markets in Southeast Asia, Hong Kong and South Korea eventually led to a crisis of confidence – causing dramatic falls in the value of currencies.

“China’s story is the East Asian story in 1998,” says Xie, who has long held more bearish views on the nation’s economic trajectory. ‘They’d over-invested, there was huge overcapacity due to speculation, and there were no real profitable opportunities – but the money supply kept growing. Then one day the speculation stopped, and there was too much money in the economy – but the government didn’t want to raise interest rates. And then people wanted to leave all at once and then the currency collapsed – and if the money leaves you have chaos.”

In the Asian financial crisis, the run on currencies resulted in a major economic fallout, raising prices of imported goods, adding to inflation, and prompting a mass default on loans with an attendant wave of layoffs. This crippling reversal of economic growth has implications for China today. China's leaders said recently the economy must expand by at least 6.5 percent annually over the next five years to generate moderate prosperity for its citizens. Given the stakes, the prospect of an unruly exit of capital is disturbing.

That said, most economists see substantial differences between China’s predicament and the conditions that produced the Asian crisis nearly two decades ago – not least, the scale of China’s economy and its enormous reserves of foreign exchange, some $3.5 trillion, giving it the wherewithal to shore up the value of its currency.

“Our analysis is that they need around $1.1 trillion to cover six months import needs and short term debt obligations, and resident corporate foreign exchange needs,” says Li-Gang Liu, Chief Economist for Greater China at ANZ Bank. “Any more is excess reserves they can afford to run down.”

Chinese trade, while falling, is still running a surplus - and latest figures suggest a slight rebound in the growth of foreign investment into China.

But the risks are real enough that the government is taking measures to halt the flow of money out of the country. Under long-standing rules, ordinary people are limited to converting no more than $50,000 worth of Chinese yuan into foreign currency per year. In recent months the government has tightened channels that have been widely used to evade those strictures, limiting how much people can withdraw from overseas ATMs, and requiring banks selling foreign exchange to keep more assets in reserve, which Liu says will help “to stem out speculative transactions.” It’s also considering levying a “Tobin tax”, originally devised by economist James Tobin to limit speculative conversion of currency, on foreign exchange transactions.

Xie portrays these as short-term tactics rather than a solution to the problem. “These restrictions just lock up the little people’s money,” he says, “but rich people can still buy overseas assets. And before a currency crashes it’s usually induced by the elite taking the money out. Now we see all these rich Chinese people buying offshore assets, whether they’re buying companies or properties in London. It’s all capital flight.”

Foreign enthusiasm for bringing new money into China – for decades a pronounced driver of growth in the world economy – has given way to anxiety, he adds. “I’ve never seen multi-national companies so bearish about China”, Xie says. “They’re not increasing investment in China, period. There’s no growth and so many problems.”

DEVALUATION IS FINAL STRAW

For the European businessman, the drop in the value of the yuan was especially troubling.

“This devaluation was in the air for many years,” he said, “but suddenly, whoosh, it goes from 6.1 yuan to the dollar to 6.4 in two days – just to improve the exports. And they didn’t explain clearly what was going on,” he added. “No-one does a devaluation like this – but in China you never know.”

It added to his sense of uncertainty about the security of his investments in China. Well-informed Chinese friends were advising him that real estate prices – which have risen again this year, after a three-year stagnation that followed a decade-long boom – could fall back in the next couple of years. “Of course, some Chinese people still say prices won’t go down, only up,” he said, but, “I think the prices are already very high compared to Europe.”

Another factor in his decision to sell was rising costs, both within his business and from suppliers. Hikes in rents, wages and the cost of land, as well as high import taxes, have made it ever more difficult to draw a sizeable profit. “Salaries have got very high, especially in the cities – and every factory in China is very expensive now. And when these factories buy new machines they want to get the money back in one year – in Europe they might wait five or ten years. So some of our products are actually cheaper to make in southern Europe now.”

Suppliers were increasingly frustrating to deal with too, he said, as they'd grown complacent on a constant supply of orders. “Either they said your order was too small, or they take on too many orders, then they delay delivery – it’s very embarrassing because you’re always letting customers down. I’ve been working 25 hours a day to deal with this – now I’ve had enough.” China’s restrictions on moving currency in or out of the country also made business challenging, he added.

The European businessman’s declining confidence is representative of a broader mentality at work as money leaves China.

“Internationally people’s faith in China’s stock markets, our marketization, even our sincerity in reforming and opening and the rule of law has been shaken,” said Liu Shengjun, executive deputy director of the Lujiazui Institute of Finance at the China Europe International Business School (CEIBS) in Shanghai. Liu said a series of errors were made, from official Chinese media being “very irresponsible” in encouraging the boom on the stock market earlier this year, to regulators failing to deal with insider trading properly -- and then intervening to prop up the falling market too early, before it had reached a natural level. Pinning much of the blame for the problems on foreign speculators who were “not the main problem” didn’t help boost investor confidence, he adds.

Joerg Wuttke, President of the European Union Chamber of Commerce in China, agrees the events of the summer came as a shock.

“Everybody’s concerned about this in varying degrees,” he says. “It has taken off the image of invincibility that the Chinese leadership had. This was seen as a very smooth policy machine – hence the surprise was bigger. It doesn’t take away the lure of the market size – but certainly people look at China differently, some are wondering where the next policy mistake is going to come from.”

Wuttke says foreign investors already in China are likely to be there for the long term – but financial industry professionals, like fund managers, are far more more flexible and have been able to move funds out.

“The very big instability in [the market and] policy has had a huge impact on confidence of investors,” agrees the U.S.-based manager of a China-focused investment fund. “It’s made it harder to raise funds to expand here. Some money has moved into commodities, or Singapore’s FTSE A50 China stock index futures market – but most funds are just holding onto their cash and observing from the sidelines.”

A sharp tightening of rules on trading in stock index futures following the market volatility has “effectively closed” this market for investors in China, he adds – and added to investor worries that further financial reforms many had anticipated could be delayed.

Anxieties about the economy, the market, and prospects for reform have also fueled concerns about further devaluation of China’s currency – a significant factor in encouraging capital flight. ANZ Bank’s Li-gang Liu predicts that the Chinese yuan will not devalue further, thanks to government intervention. The problem, he told International Business Times, is that investor clients from the West think the credibility of the government has been damaged.

“This worry [of further devaluation] is still there, and it’s up to the People’s Bank of China [the country’s central bank] to manage this expectation – if it can’t, that could generate larger capital flight.”

EVEN CHINA’S FRIENDS ARE LEAVING

One investor who has sparked controversy this year by pulling assets out of China is Li Ka-shing, the veteran Hong Kong property, logistics and telecommunications tycoon seen as one of the Chinese government’s most loyal supporters. Li’s decision to sell several large developments in China, and pour some $30 billion into companies like telecommunications operator 02 in the U.K., has attracted criticism in China. Media commentators accused him of a lack of loyalty or even patriotism for moving at a time of economic slowdown – saying he had benefited from close ties to government leaders, and his move could encourage others to follow suit.

Li later retorted, saying his moves were normal business dealings – and accusing his critics of “chilling” aggression. Liu Shengjun of CEIBS in Shanghai said Li’s sales were, in part, motivated by his desire to prepare for retirement from business – but he says Li’s move could also be seen as “a sign of a lack of confidence in the current leadership.”

Whatever Li’s motives, questions relating to China’s political leadership – and direction – are certainly a factor for some who are thinking of moving out.

‘Some of the things the leadership has been saying about politics recently are very ‘leftist’, quite old style Communist. I find that quite worrying, so it’s added to my desire to leave China,” a young foreign-educated Chinese professional, who is planning to move abroad in the near future, told IBT.

For all continuing talk of market reforms, and an ongoing crackdown on corruption, China’s leadership under President Xi Jinping is pushing an ideological line, which some say has echoes of the Mao era: a sharp criticism of western values in education and politics, the reassertion of sovereignty and a clamp down on civil society and expression in the media and online. Some wonder whether this emphasis on ideology could ultimately erode not just economic reform, but also protection for individual wealth and assets.

“The government changes its mind so much that you sometimes feel you'd better safeguard your savings before they are locked into the country,” says a western professional who recently relocated part of his China-based business to his home country. “China can feel quite volatile... If you’re wanting flexibility it’s not the place to have all your personal investments."

Worries about politics may not affect everyone – and President Xi remains popular with many Chinese citizens for his anti-corruption campaign. Yet that too is adding to the motivation for some people to move their assets – or indeed themselves and their families - abroad.

“Many who earn money in China are linked to the government – especially if they’re in the real estate sector,” says Gary Kwok, a consultant who advises Chinese citizens on investing in Europe. “And with the crackdown on corruption, some people who have made money with the help of such connections may feel their position could be affected – they don’t feel their assets are secure, so they want to move at least part of them abroad.”

These issues are the latest in a range of factors that are encouraging growing numbers of Chinese people – the middle-class as well as the super-rich – to buy property overseas in recent years – or to move there themselves.

“People generally have two motives – one is to move some of their money abroad, the other is for the sake of their children, in particular to find a better environment,” says Kwok. “They’re worried about air quality, food safety. In Europe there’s not much pollution, no fake alcohol, you can afford to drink milk,” he adds. “And they like the western education system too.”

The bursting of China’s stock market bubble in the past few months has only encouraged wealthy Chinese people to look abroad, Kwok says. “Earlier this year, when the market was flying up, many people were only interested in buying stocks – but then when it burst so fast, lots of them decided the stock market was very unstable. Now they see overseas property as a more stable investment.”

And he says with several of China’s biggest real estate developers – companies like Greenland, Wanda and Vanke – beginning to built property in London and other major European cities, the trend for investing abroad is only likely to gather pace in the coming years. “These are famous companies in China – for people who’ve never invested abroad before, these brands give them confidence,” says Kwok.

Two years ago, Hurun Report, a Shanghai-based research firm that analyzes China’s wealthy, attracted much attention with a report saying that almost two-thirds of rich Chinese citizens had obtained or were thinking of getting a foreign passport. The obsession with getting a foreign passport may have faded a little since, according to Hurun’s founder Rupert Hoogewerf -- many western countries, including the U.S., have now begun to offer Chinese citizens ten year multiple entry visas, giving them an ease of travel previously not possible on a Chinese passport. And Hoogewerf notes that some overseas-based Chinese are still looking to the mainland for new business opportunities. But he says the current economic climate is still encouraging many to move abroad.

“I think if people had questions before about the general quality of life in China -- about pollution, about education, about security, food safety -- the economic slowdown has pushed them to say, ‘perhaps we really should be looking to spend more time in Australia or New Zealand.'"

And while the amounts of money leaving China might not yet be a significant problem for the nation, some believe the country is losing out in other ways from this trend.

“What China is losing is not [only] the wealth, but the entrepreneurship – and this is the most important thing for a country,” says Liu Shengjun of CEIBS. “If Chinese entrepreneurs are emigrating because they lack a sense of security about their assets in China, which means they can’t peacefully get on with running their businesses and with innovating, then it’s a big problem. Only if you have good property protection can entrepreneurs have long term confidence.”

Liu says further opening of China’s stock markets to private companies would reassure investors. ANZ Bank’s Li-Gang Liu, meanwhile, says the government should open up the market to foreign funds, and expand its financial services sector for full foreign participation. Currently, foreign companies have almost no access to sectors such as legal services and insurance, while banking remains restricted. Changing this, he says, would “help attract vast – and more stable - capital inflow into China.”

‘BABY-STEP’ REFORMS

Some in China hope that the Chinese yuan’s predicted entry into the IMF’s Special Drawing Rights basket of reserve currencies later this year may help to boost confidence in the currency, and help slow capital outflows. But in the current climate, such a move, on its own, may not be enough to reassure all China’s nervous investors.

The Chinese government is taking steps to change this: The recently drafted five-year plan promises clearer rules and wider access for foreign investment – and some details may be revealed in December, when the government issues a new list of the sectors foreigners can and can’t invest in. The authorities have also agreed to begin a trial project that will allow Chinese citizens to invest in more financial products overseas – up to now very limited – via the pilot Shanghai Free Trade Zone. According to Li-Gang Liu, it’s an encouraging “sign of confidence … that even when China is under pressure for large capital outflow, the government would still like to see its capital account become more open.”

Last month’s appointment of two new vice chairmen of China’s stock market regulator – Fang Xinghai and Li Chao, both cosmopolitan figures popular with foreign investors – is also seen by some as a sign that the government has realized it needs to take action to shore up investor confidence.

“I think the unexpected media questioning and global onslaught from investors has been a major wake up call for the authorities,” says European Union Chamber of Commerce President Joerg Wuttke. “The fact that Fang Xinghai is in that position indicates they learned something.”

Wuttke says he’s reasonably optimistic about long-term prospects for China’s opening. Nevertheless, he says there is still resistance to reform in the system, and he remains worried about the slow pace of development in economic sectors that the government pledged to liberalize two years ago. He is also concerned about the debilitating effect on business of China’s restrictions on Internet use. Chinese authorities, he says, need to “live up to what they’ve said,” if they are serious about seeking more foreign investment in China than Chinese investment abroad.

“China can’t just do baby-step reforms, [if it wants] to be convincing in its reform efforts … China is not the only story in the world economy. We have choices.”