China faces more challenges in attracting securities investment

Since the pandemic, China has experienced a rapid increase in the trade surplus and foreign investment, bringing its net forex receipts to a record high of $356 billion in 2021. However, the trend ended in February 2022, which is the first net outflow after 22 months of inflow. In this report, we analyze the net forex receipts of China's current and financial accounts to explore what might be the sources of capital outflows and what to expect in the coming months.

Net exports contributed positively to China's forex receipts regarding the current account. The strong global demand for electronics and healthcare products is a crucial factor. The vanished outbound tourists from China also reduced the capital outflow by slashing imports of services (9% of total imports and 50% of services imports in 2019). Still, it is uncertain if China can keep the large trade surplus this year, given the rapid slowdown in external demand and high commodity prices.

Foreign direct investment (FDI) is also not the origin of outflows. Global firms have continued to expand operations in China faster than Chinese firms investing overseas. Indeed, securities investment is the primary source of capital outflow. China saw net capital outflows of $32 billion in February 2022, which is the largest outflow since March 2020. The average monthly capital inflow was $9 billion in 2021.

There are potential reasons for this sudden reversal of capital flow. First, the Ukraine-Russia war is an important risk-off event. Investors generally saw China as a safe haven in previous risk-off events. The perception means China could have attracted capital redirecting from emerging economies. However, this was not the case. Second, there are rumors that Russian investors – whose holdings of Chinese bonds hover around $140 billion – may have sold their assets for cash. Beyond the Russia factor, the sovereign yield differential between China and the US narrowed from 127 bps in end-2021 to 32 bps in March 2022 due to a hawkish FED and a dovish PBoC. It is just a matter of time before the US overtakes China in yields. Third, the new wave of lockdowns in China may have added another layer of uncertainties.

High-frequency indicators also show that the capital outflow in securities investment has continued in March 2022, which has spread from bonds to equities. For the first time since 2020, there is a net outflow through the Northbound Stock Connect, meaning foreign investors are offloading their equities through Hong Kong.

Overall, given the narrow yield differential and the still uncertain outlook of Chinese bonds and equities after Vice-premier Liu He's recent speech, we may continue to see net capital outflows in China's securities investment in the short run. Together with the waning external demand and higher import prices, the narrowed trade surplus will create depreciation pressure on the RMB if exports are not support enough.

Full report is available for Natixis clients.