Foreign exchange data recently revealed that last month, capital flowed out of China. This has been covered extensively in the media, although it should not come as a surprise, since China’s economy has been slowing since mid 2014. Deficits in the capital and financial accounts in the last quarter of 2014 confirm that funds are moving abroad. Ongoing unofficial capital outflows have worsened China’s liquidity status at potentially 300 billion RMB ($48 billion) since 2010.

China’s economy has suffered from tightened liquidity conditions, and the central bank has sought to loosen monetary policy just enough to prevent another surge in speculative finance from arising. The latest trend in financial speculation has been a surge in margin trading; regulations surrounding this practice were reinforced in January. Recent monetary policy has been limited, operating via an early-February cut to the required reserve ratio (RRR) in anticipation of Chinese New Year, in contrast to use of the RRR and open market operations in previous years.

Tightness in RMB circulation, and strong demand for RMB loans in the domestic economy, contradict pressures on the exchange rate to move out of RMB. These opposing forces present a challenge to China’s monetary and exchange authorities to ensure adequate RMB in the domestic economy while preventing an accumulation of excess RMB supply with respect to foreign exchange markets.

The weakness of the RMB demands increased intervention by the People’s Bank of China to maintain the value of the currency. As a result, the central bank and commercial banks have needed to purchase RMB in December and January, a reverse from their usual purchase of foreign exchange. Bank purchases of RMB in January amounted to 108.3 billion RMB. The lack of optimism surrounding the RMB also occurs in a global environment in which the US Federal Reserve is normalizing interest rates and the European Central Bank is overseeing quantitative easing, which both strengthen the dollar and increase pressure on the RMB to depreciate. In recent weeks, the RMB has often hit close to the 2 percent trading band at the weak end. The offshore RMB has depreciated even further

Ironically, the depreciation trend contrasts with ongoing international pressure in the past two decades on China to allow its currency to appreciate. The RMB exchange rate system changed in 2005 to reflect a basket of currencies within a margin of fluctuation, but in mid-2008 returned in large part to a dollar peg. From 2005 on, the currency appreciated, plateauing between 2008 and 2010, and appreciating once again through recent years. The current depreciation appears small relative to how far the currency has appreciated, but if pressures continue, the RMB may weaken further still.

The State Administration of Foreign Exchange has predicted that cross-border capital flows will remain volatile in 2015. China’s exchange rate is expected to remain relatively tightly controlled in coming months, with some adjustments to rebalance according to the financial environment. Continued control of the capital account, coupled with a large supply of foreign exchange reserves, has tamped down fears of financial crisis and comparisons to the Asian financial crisis of 1997.

Falling expectations about China’s economic outlook underscore the need for Beijing to push through reforms to bolster the services sector and consumer spending. A boost in economic activity would push up demand for the RMB relative to foreign currencies and halt the depreciation squeeze on the RMB. Increasing real economic activity would also permit the central bank to increase the supply of RMB for real-sector (as opposed to financial-sector) loans.

http://thediplomat.com/2015/02/chinas-capital-outflows/