China likely to be a magnet for capital flows next year

Capital flows have captured various headlines over the past several months, for varying reasons. In China, several months of capital outflow sparked discussion about investor confidence in the economy, the valuation of the yuan and the seeming halt in the accumulation of foreign-exchange reserves.

Central banks of major developed economies appear set to inject huge quantities of liquidity next year, the first big moves that may open the floodgates of liquidity worldwide. With potentially limitless quantities of asset purchasing by the US Federal Reserve and the European Central Bank approaching, and near-zero interest rates in major developed economies for the coming year or beyond, not to mention the potential for further monetary policy loosening from other central banks worldwide, an abundance of liquidity in the international system can be expected, creating potential for high levels of capital flow next year.

Following the high uncertainty that has plagued the global economy this year with a likely flood of liquidity coming in, where will the capital flow to next year?

China is likely to adopt a more relaxed monetary policy and join global central banks in injecting liquidity over the next year. With the domestic economy still weak, it can be expected that the People's Bank of China, the central bank, will act to support growth. China has injected liquidity in the form of two reserve requirement ratio cuts twice this year, in February and May, and there were two interest rate cuts, in June and July.

Furthermore, China rapidly ramped up its open-market operations in the form of reverse repo operations to inject liquidity in July, though the liquidity injected via this method was short term in nature, mostly composed of seven- and 14-day agreements, with some 28-day reverse repos starting in mid-September.

China is likely to enter another cycle of reserve requirement ratio cuts going into 2013, as the ratio is still very high, not only compared with international levels, but with historical domestic levels, as the current reserve requirement ratio is only 1.5 percentage points lower than the peak last year. Interest rate cuts are also possible, but given the likely prospect of escalating inflation globally and domestically next year, we believe the Chinese central bank is likely to continue to be cautious in this respect.

With an abundance of liquidity globally, the question next turns to where it will flow. Traditionally during times of high uncertainty capital has flowed to safe havens as investors seek to limit risk, while in times of low uncertainty they have a greater risk appetite and seek higher returns. This has been a year of great uncertainty, with concerns over the slowing global economy, the European debt crisis, the approaching US fiscal cliff and regional political risks affecting investor sentiment.

Uncertainty has created a flight to safety, with many investors repatriating dollars and investing in safe havens. We believe that while uncertainty will remain, conditions next year will lead to more capital flowing to emerging economies.

Safe-haven developed economies remain a target for risk-averse investors. The state of the global economy at large is still far from an upbeat sustained recovery, and consequently, there will still be demand for investors seeking safe-haven assets. With the European debt crisis seemingly still far from its resolution, the eurozone is not the most attractive location for safe-haven investors. Consequently, we expect the US and Japan to be the primary beneficiaries.

The US economy appears to be on a gradual and stable path to recovery, making it the big draw for safe-haven investors. In recent months the housing market has shown signs of recovery, unemployment rates have fallen, and consumption appears to be steadily recovering as well. The implementation of the third-round of quantitative easing should also serve to support asset prices. While the fiscal cliff remains a risk, and the US is projected to fall into recession if that is not avoided, we believe that this scenario is unlikely. In times of uncertainty there is typically a high level of dollar repatriation and general investment in the US.

Capital seeking higher returns will flow to emerging economies. We expect that next year will prove to be relatively less uncertain than this year, though the global economy remains gloomy. While still a pressing concern with no true resolution in sight, measures such as the European Stability Mechanism and Outright Monetary Transactions have been erected to soften the impact of the European debt crisis. Barring a further move of "kicking the can down the road", the US fiscal cliff situation should be settled, for better or worse. Furthermore, major leadership transitions in key global economies should be settled by the end of this year or early next year. Finally, prospects for growth still remain relatively weak in developed economies, particularly in Europe. In this environment, we should see more capital flowing to emerging economies seeking higher returns.

China will be an important destination for capital flows next year. Amid the slowing of growth from the second quarter to the third, China experienced several months of capital outflow, before reversing the trend in September following the announcement of the third round of quantitative easing. This is likely to be reversed next year.

Firstly, this is because China's economic fundamentals remain strong, attracting capital flow. China has significantly higher growth rates than the other major economies, despite the recent slowdown. This comparatively higher growth has attracted foreign investment; a United Nations Conference on Trade and Development report issued last month showed China overtaking the US in FDI inflows in the first half of this year, marking the first time since 2003 the US has not been ranked first; this is despite China registering a year-on-year decline in FDI growth because of a strong 2011.

China's growth will pick up next year, benefiting from a greater degree of certainty that will allow for policymakers to push for more ambitious supportive policies if necessary. Currently, the primary supportive policies have all been in infrastructure, and while this is likely to continue, supportive policies for boosting consumption are also possible next year. China is also likely to adopt a more accommodative monetary policy, which should bolster growth. Traditionally investment has risen rapidly following each generation of Chinese leadership entering office. These factors combined lead to this forecast: GDP growth will improve to 8.1 percent next year.

Secondly, foreign investors are increasingly provided with opportunities to invest in China. Programs such as Qualified Foreign Institutional Investors and RMB Qualified Foreign Institutional Investors are increasingly expanding in scale and scope, opening up China's capital markets gradually to foreign investment. In September approved Qualified Foreign Institutional Investors funds stood at $30.8 billion (24.1 billion euros). This will provide another method for capital inflow to China, beyond FDI.

The author is managing director, chief economist & head of research, Haitong International Securities. The views do not necessarily reflect those of China Daily.

(China Daily 12/07/2012 page11)