Tuesday, 28 April 2015

China's Capital Outflow: The Hong Kong Connection

A squeeze on lending to Chinese banks by Hong Kong’s banking system has been a primary, and perhaps even dominant factor in the capital outflow which has eroded China’s foreign reserves over the last six months.  Net foreign currency lending to China by Hong Kong’s banks contracted by HK$555bn (US$71.5bn) in the four months to January 2015 - a fall of 21% over those four months. So far, though, there has been no reciprocal significant withdrawal of Chinese bank liquidity from the Hong Kong dollar market.

The core fact needing explanation are these:  between the end of August 2014 and the end of March 2015, China’s fx reserves dropped by US$238.8bn, despite having recorded a US$67.021 bn current account surplus in 4Q, and a US$123.8bn trade surplus in 1Q15.  In 4Q14 China recorded a capital and financial account deficit of US$30.5bn, and the deficit was certainly much larger than this in 1Q15.

How was Hong Kong involved in those outflows? Was it a beneficiary of deposits moving from China to Hong Kong, or was it a protagonist, clawing back credit previously extended to China? More, has the decrease in China’s foreign exchange reserves meant any alteration in the extent to Chinese banks’ involvement in Hong Kong’s money markets?

We can find the answers in the changes in the net external position of Hong Kong’s banking system, and specifically the net position with China, both in Hong Kong dollar markets and in foreign currency markets. Within this, it is the foreign currency position which matters most,since the Hong Kong dollar position accounts for only about 22% of Chinese entities deposits in Hong Kong’s financial system.

Looking at the foreign currency position (which includes the Rmb position),  liabilities to Chinese banks rose by HK$138.6bn and to non-banks by HK$36.5bn in the four months to September, whilst foreign currency claims on Chinese banks fell by HK$379bn, and by HK$2.5bn to non-banks.  Overall, this means that Hong Kong banks’ net claims on Chinese entities diminished by no less than HK$554.8bn (US$71.5bn) in the four months to January. That’s a fall of 21% in the net position in four months!

Crucially, HK$515.8bn of that withdrawal from Chinese positions was attributable to closing positions with Chinese banks, with loans to Chinese banks being withdrawn far faster than Chinese banks raised their deposits: foreign currency claims on Chinese banks fell by HK$379bn, whilst liabilities to those banks rose by HK$136.6bn.  What is more, it is plain that the withdrawal of net foreign currency loans by Hong Kong banks has (so far) been specific to Chinese banks: to net lending to foreign banks (including China) fell by HK$99bn only in those four months, whilst net loans to foreign non-banks rose by HK$44.3bn.
Why have Hong Kong’s bankers cut their China loans? There are at least two ways to look at this. Most obviously, Hong Kong’s banks may have cut their risk profile with Chinese banks in response to concerns about China’s economic slowdown and the deteriorating credit quality.  

(One interesting question is: do China’s banks themselves share this perception of increased risk, and if so, will (are?) Chinese bankers taking a similar view of their customers’ prospects?  Given the concerted efforts made by banks to improve their abilities to assess risk and price for it, one would expect so.

For example, this week the results of a survey of 200 bank branches in 12 cities by Rong360 found no banks were offering first-time buyers the 30% discount on mortgage rates recently allowed by the government, or were giving discounts on second home loans, despite policy relaxations by central bank.  Rather, a majority of the banks were charging rates above the benchmark rate.  There were a couple of bankers’ quotes accompanying the report which bear repeating: 'It's difficult because our margins are already squeezed, there isn't much differentiation in the market, so our focus is on how much our capital costs are.'  Another: 'Banks look for good investment return, so they'd rather invest in the stockmarket.')

But there is a second reason: Hong Kong’s economy is no longer producing savings surpluses which need to be re-invested in foreign assets.  Historically, the massive build-up of net foreign assets of Hong Kong’s banking system have been a result of a massive sustained private sector savings surplus. Between 1990 and 1994 this averaged 6.6% of GDP, but in the  pre-handover boom years before 1997 this deteriorated into a private sector savings deficit of around 5% of GDP. That deficit was swiftly and dramatically rectified: from 1999 to 2009 the savings surplus was back, averaging onwards 8.4% of GDP. 

However, over the last three years, there has been a further reversal, with minor savings deficits emerging: there were deficits of 1.1% of GDP in both 2012 and 2013, followed by a surplus of 0.8% in 2014 which has probably dipped back into a deficit of around 1.4% in the 12m to 1Q2105. (Caveat - the 1Q15 result in the chart below is an estimate only.)

A sufficiently sophisticated financial system will, of course, find ways to finesse these underlying cashflow dynamics in the short to medium term. However, the erosion and disappearance of Hong Kong’s private sector savings surplus has capped the overall amount of net foreign assets Hong Kong’s banking system carries. The current US$288bn in net foreign assets is, for example, lower than the amount carried in 2007. 

Moreover, the dramatic concentration into China assets which mushroomed so dramatically after 2010 means that if cashflow concerns dictate that asset holdings have to be cut, then unavoidably it will be Chinese assets which are offloaded.

So far, Chinese banks have not really responded to the withdrawal of foreign currency lines from Hong Kong’s financial system by scaling back their own position in Hong Kong.  Indeed, so far this has had made almost no impact on Hong Kong’s HK$ banking liquidity, to which China is a major supplier. Taking the position in Hong Kong dollars,  between Sept 2014 and Jan 2015, HK$ liabilities to mainland banks fell by HK$9.3bn to HK$112.7bn, whilst HK$ liabilities to Chinese non-banks rose by HK$10.5bn to HK$205.4bn. However, HK$ claims on Chinese banks rose by HK$768bn and Chinese non-banks they rose by HK$9.32bn.  On a net basis, the total net HK$ exposure of Hong Kong banks to the mainland went from a net liability (deposit) of HK$73.1bn in Sept 2014 to HK$64.1bn in January 2015.  In the scheme of things this is a relatively minor change drop in China’s provision of HK$ liquidity to the system. 

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