Renminbi fears still fuelling Chinese forex demand

April 23, 2017

by: FT Confidential Research

• Despite the renminbi exchange rate stabilising, concerns about depreciation continue to drive strong Chinese household demand for foreign exchange.
• Tighter capital controls have strangled foreign exchange sales as banks demand more paperwork and turn away customers in the glare of nervous regulators. Business is booming for unlicensed foreign exchange sellers, but their capacity is insufficient to meet demand.
• Despite a recent relaxation, most capital controls will remain in place, in the near term at least, as the authorities continue to shield the domestic financial system.

Concerns about the weakness of the renminbi are continuing to support demand for foreign exchange, despite recent exchange rate stability, according to the latest FTCR survey of capital flows at the household level.

Fears about renminbi depreciation again topped the list of reasons given for requesting foreign exchange, according to our survey of 70 bank officials and 1,000 urban households (see chart). The renminbi is up nearly 1 per cent against the dollar so far this year, after falling 6.6 per cent in 2016, but respondents to an earlier FTCR survey said they expected the currency to fall another 5.5 per cent in 2017.

Underlying demand for foreign exchange remains strong among Chinese households. In our banker survey, 64.3 per cent of respondents said demand for foreign exchange is strong, up from 38.8 per cent last August. This backs up the findings of a monthly FTCR survey, which has found strong and growing appetite among consumers to diversify out of renminbi as the currency has weakened. This is particularly true in first-tier cities, where respondents tend to be more affluent and have greater access to financial services (see chart).

Capital controls strangling forex sales

But this demand is going unfulfilled. The government significantly tightened capital controls at the end of last year in order to staunch outflows that were draining foreign exchange reserves and threatening domestic financial stability. Although the authorities have unwound at least one of the more draconian controls, the broader regime remains in place and bankers said this has caused a sharp drop in foreign exchange sales.

The percentage of bankers surveyed saying foreign exchange sales had decreased from six months ago rose to 42.2 per cent, up from 26.9 per cent last August (see chart). The decline was most pronounced in smaller cities: 52 per cent of respondents in second and third-tier cities reported a decrease in foreign exchange sales, compared with 36.4 per cent in first-tier ones.

Potential customers have absorbed the government’s message about tighter controls — the proportion of bankers reporting falling inquiry volumes has doubled since our last survey (see chart). In Nanjing, an official with the Bank of China said sales of foreign exchange fell 10 per cent after the China Banking Regulatory Commission fined two banks for helping clients circumvent capital controls. “Tighter regulations are keeping customers away,” the official said.

Staunching the flow

At the turn of the year, Chinese lenders, acting on instructions from regulators, imposed more red tape on foreign exchange purchases. Among the bankers we surveyed, 77.1 per cent said they were using disclosure restrictions on the intended use of foreign exchange to limit sales (see chart). Applicants are being asked to produce more paperwork — ranging from university admission letters to overseas corporate licences — to prove funds are being used for legitimate purposes.

In Changzhou, in eastern China, a Bank of China official said a local firm’s application for $2.5m was declined because the company was less than a year old and reported registered capital of just Rmb1m. “If the company can’t explain how it raised so much money so quickly then we aren’t going to make the money available,” the bank official said.

The strength of the central government’s clampdown has resulted in some city authorities ordering banks to simply reduce the supply of foreign exchange outright. In Hangzhou and Chengdu, local lenders were told to cut net sales of foreign exchange by 5 per cent a month in January and February, resulting in a large backlog of (mostly legal) applications that may take months to clear.

Where there’s a will

But China’s capital account remains porous. Just 18.3 per cent of households surveyed think it is impossible to get funds greater than the $50,000 annual quota out of the country. Among bankers, 88.6 per cent said such transactions were still possible, down from the 94 per cent who said so in our previous survey.

Despite a vaunted crackdown by managers of China’s current account, 53.1 per cent of respondents to our household survey who had circumvented the quota said they had been able to use falsified trade import and export invoices (see chart).

The underground banking system, which operates largely beyond the grip of regulators, has also picked up business dropped by the banks. In Shenzhen, the owner of one of the countless money shops in the southern city — which act as unlicensed bureaux de change and have long been holes in China’s capital account regime — said business is up 20 per cent in the past six months, strong enough that they have raised commission rates to 6 per cent from 3 per cent at the end of last year.

Zhou Li, the shop’s owner, said clients include corporate executives, business owners and government officials. He takes renminbi from mainland clients and transfers dollars, obtained from partners such as overseas subsidiaries of state firms, to the offshore accounts of his clients. “We are not worried about a lack of business, we are worried our overseas partners don’t have enough capital to meet demand,” he said.

Controls to remain in place

We expect the bulk of China’s capital control regime to remain in place for now, although the authorities may remove more of the toughest measures introduced in recent months. In our banker survey, 91.4 per cent of respondents said they expect individuals to face more problems transferring funds abroad in the coming six months.

A weaker outlook for the dollar may strengthen the renminbi, but the vulnerabilities in China’s financial system necessitate continuing to expand institutional channels for inflows while restricting outflows. 

Our surveys, which highlight significant demand for foreign exchange among Chinese households, suggest that net outflows would be far greater without the current controls in place.

The economy’s performance in the first quarter points to recovery, but growth remains overly reliant on housing market and credit excesses that the authorities are struggling to contain. We expect more market ructions, and that means the capital account stability of the past few months may not last. 

Although the government continues to talk up renminbi internationalisation and has committed to making the renminbi convertible on the capital account by the end of this decade, the past 18 months demonstrate that these goals will remain subordinate to financial stability.