In a bid to curb outflows and better manage its currency, China plans to impose its strictest capital controls yet since it began regulating in September 2015. Among other things, it proposes to scrutinize foreign acquisitions worth $10 billion or more, or just $1 billion if the target company is in an unrelated business; and raise monitoring of capital outflows including those via the Shanghai free trade zone.

The regulations – still far from watertight – will in the near term reduce capital outflows and curb volatility of the renminbi, but also raise doubts about China’s determination to fully back the Shanghai experiment, Morgan Stanley said in a research note Nov. 29.

Domain Names Hot As Chinese Avoid Capital Controls

Capital Controls China Capital Controls
Capital Controls

“The newly imposed strict restrictions on ODI (outbound direct investment) and RMB cross-border flows could mitigate the pressure of outflows and help to avoid high volatility in the CNY in the near term, albeit at the cost of delaying or canceling Chinese firms’ overseas investment deals, and slowing the pace of financial liberalization and RMB internationalization,” Morgan said.

Still, over a longer period economic fundamentals, rather than controls, will determine capital flows and the yuan’s valuation, it added.

“The fundamental factors behind the outflow pressures – decline in investment return and lower real rates in China while the U.S. enters the rate hike cycle – will likely keep capital outflow pressures alive in the medium term and drive continued CNY deprecation,” the bank said.

China Capital Controls

China Capital Controls

The Wall Street Journal first reported the proposed capital controls on Nov. 26. Among others, property investments by state-owned firms above $1 billion will be scrutinized. Also, the Peoples Bank of China has asked banks to ensure a balance between inflow and outflow of capital via the FTZ accounts, and additionally plans to monitor cross-border flows to make sure banks “do more incoming yuan business, and less yuan outflow activities.”

Capital Controls – China’s international assets unattractive

Morgan believes China’s international assets are still low relative to comparable Asian countries – Japan, Korea, and Taiwan, all major Asian trading economies that moved to the higher end of production chain and established a strong investment presence abroad.

“As of 2015, China’s holding of net international assets is 14% of GDP, much lower than the weighted average of 74% in Japan, Korea and Taiwan,” it said.

“This suggests room for capital outflows if China were to follow the path of these three economies,” the bank said.

China Capital Controls

In gross terms, China’s international assets constitute 56% of GDP – still lower than the three economies’ 182%. Also, gross international assets excluding official reserves (i.e., private sector holding of foreign assets) in China are only 25% of GDP vs. 146% in these economies, Morgan said.

On the other hand, China has more near-term options should the current round of regulation prove insufficient to check outflows, or curb the volatility of the yuan. It could further tighten overseas direct investments, curb individuals’ overseas spending and purchases of foreign currency; or even bring back the mandatory trade exchange settlement system, which requires exporters to sell all trade proceeds in foreign currencies to domestic banks in exchange for the local currency, Morgan said.