Capital Flight from China?

By Ichiro Suzuki According to the Bank of Japan, the Japanese yen is most undervalued against the U.S. dollar since 1973, in terms of real effective exchange rate (REER). 1973 was the year the JPY went free-float against the USD, following President Nixon‘s August 1971 announcement that shocked the world by halting conversion of gold into the dollar, bringing the Brettonwoods system to its end. So the JPY is more undervalued against the USD than at any time in its history as a free-float currency. REER takes inflation effects into consideration. Japan has always run lower inflation (and hence interest rates) than the United States. This makes it natural for the JPY to rise against the USD in nominal terms, since higher inflation erodes the currency’s real (inflation-adjusted) value. Other things equal, the JPY should be rising against the USD over the long-term. However, since the final quarter of 2012, the JPY has been on a steady depreciation trend. Former PM Abe’s economic policy, Abenomics, called for fiscal expansion and aggressive injection of liquidity into the economy. They consist of a recipe of a weak currency, to which the yen is duly responding.

While initial effects of Abenomics petered out in the middle of the 2010s, the JPY never got back onto a rising trend that it always did in the past. It broke the 100 barrier to the south only for a moment in July 2016, in response to the shock wave caused by the Brexit referendum. It is said that the weakness of the yen in real terms can be attributed to two factors. One is Corporate Japan’s new behavior on their profits on exports. In the past, foreign subsidiaries of a Japanese companies always brought back overseas income into the headquarters at home. Repatriation of those funds exerted upward pressure on the yen, as they converted the USD or the EUR into the JPY. Today, what Toyota America earns stays in the U.S., to be reinvested into expansion of businesses in North America. Since not much capital investment takes place in Japan, profits overseas don’t have to come back. The other reason is Japanese retail investors’ newly found love of U.S. equity. The Japanese household sector has been long known for its notorious risk aversion, always so scared of losing money, holding onto principal-guaranteed bank deposits. There has been an obsessive fear of foreign exchange losses, because the JPY was almost always rising against the USD since the 1971 Nixon Shock. However, a small segment of the household sector is showing different preference for risks in recent years. On top of effectively zero interest rates on deposits, Japan’s equity market has a distinction of still trading 25% below its peak value that was witnessed as far back as the end of 1989. Enough is enough. So some investors are taking risks on U.S. equity that has been roaring for the last dozen years, after the 2007-09 Global Financial Crisis. So money flows out of Japan, little by little but steadily, underpinning the greenback against the yen. This is a new trend that was not witnessed before. On the other hand, the Chinese household faces even tougher situation than Japanese, in their pursuit of wealth. They are essentially trapped in China, not being able to invest in overseas assets, in sharp contrast to Japanese counterparts that are allowed to do so but don’t. China’s monetary authority imposes tight capital controls on the renminbi, not allowing households to invest in overseas assets. Even worse, return opportunities are severely limited in the domestic Chinese financial markets. In spite of one of the word’s highest economic growth rates, interest rates in China are set artificially low to favor the industrial sector, making households victims of ‘financial repression’. Deposit rates in China are higher than Japan’s zero but it doesn’t give much consolation to Chinese households. Japanese counterparts enjoyed much higher rates when their per capita income was at the level of China today, at $10,000, at the outset of the 1980s. Japan’s stock market was strong. Interest rates were high enough. The JPY was free-float, with minimum FX restrictions. Chinese stock markets are simply horrible, having been utterly decoupled from the country’s high economic growth. Long before the Communist Party’s tech sector crackdown and advocation of ‘common prosperity’, Chinese companies have hardly been run for shareholders, especially if they are state-owned enterprises (SOEs). The raging bull market in China in 2003-07 has proved to be an exception rather than a norm though images of those years got stuck in some minds as what China always offers. Amid low interest rates and lackluster equity markets, Chinese households jumped onto wealth management products offered by asset management companies. Though such products offer higher yields to investors, some of them are known to be not managed properly. It is still a fresh memory that a few months ago stories were reported on China Evergrande employees who invested in wealth management products offered by their employer, only to face an uncertainty if they can get their money back. Chinese retail investors, with their higher risk tolerance and savvy instincts would be more than willing to allocate their money to assets in countries that not only offers higher returns but also protects the rights of shareholders. However, the Communist Party does not allow them to do so, with tight capital controls. It has been five years since the RMB was admitted into the IMF’s special drawing rights (SDR), a basket of currencies that the IMF offers to its member countries. This is a blatant violation of conditions attached to SDR component currencies. Legitimacy of the CCP’s rule has been based on providing jobs and higher pay to hundreds of millions of people, many of whom once lived in dire poverty. In return, they have been placed in severe financial repression that has deprived them of a chance to become richer other than in real estate speculation. Having been deprived of a chance to grow their wealth, they could show greater anger as their salaries and wages grow more slowly, in response to the growth rates of the economy. If and when Beijing was driven to a point to ease capital controls, a floodgate would be wide open, with ensuing mass exodus of household sector money out of China.

About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.