Excellent Paper on Chinese Capital Flight

Reader Nick responded to one of my last posts and recommended an interesting paper: „High Wealth Concentration, Porous Exchange Control, and Shocks to Relative Return: the Fragile State of China’s Foreign Exchange Reserve“ by Victor Shih from Northwestern University.

The author argues that China, despite high FX reserves, is vulnerable to capital flight due to the fact that a large share of its wealth is concentrated among the top 1 percent. A shift in investment preferences among this group has the potential to dangerously deplete this stockpile despite its huge size. Shih thinks that investment considerations of the Chinese elite are mainly driven by the real interest rate in CNY and at the time of writing (2011) the favourite conduit to escape an erosion in purchasing power was Chinese real estate (this certainly has changed with the housing slowdown since then). Confirming my analysis from a few months back (see here) capital controls are a non-issue for the well-connected and numerous ways exist to circumvent them, most prominently fake trade invoicing.

Interestingly, Shih has an inconvenient message for those who think that the potential for financial repression are unlimited for China’s government,

(…) In a repressed financial system, ordinary households must suffer in silence while inflation erodes both their income and savings. However, the wealthiest households in China, which command a sizeable share of China’s household deposits, will look for ways to beat negative real returns in the banking system (…)

Not so easy to repress the well-connected…

But it is Shih’s account on how the Chinese authorities might respond to capital flight that’s interesting. So interesting, in fact, that I have decided to quote in full with comments in between,

(…) If the FX reserve declines by 50-100 billion a month for a couple of months, the Chinese government will declare victory in their rebalancing efforts and signal the end for yuan revaluation. This moderate amount of net outflows would be an unnoticeable blip in China’s enormous FX reserve. There is some chance that smart money that smart money may see this as a sign of coming trouble and may accelerate their reallocation overseas. If the FX reserve declines by over 100 billion USD a month or if it declines two months in a row, the Chinese government will try to hide it by having China Investment Corporation (CIC) repay some bonds to the PBOC before maturity with US dollars (…)

Currently outflows are coming in at about USD 30 billion/month (see here), we are still away from real worries for the Chinese government. However, I will look out for headlines involving the CIC,

(…)This would force the CIC, which is separate from the State Administration of Foreign Exchange (SAFE), to first sell its equity or bond holding to raise money. Because over half of CIC’s 330 billion dollar holding is tied up with Chinese bank shares, the CIC cannot quickly sell a large portion of these holdings without causing a crash in the shares of Chinese banks, which would intensify a financial panic (China Investment Corporation 2010)(…)

The paper was written in 2011 so AUM are probably much higher now. The market would try to front run CIC which makes bank shares a potential leading indicator of CNY devaluation,

(…)Even this amount of FX depletion would be hardly noticeable and is well within SAFE’s ability to control. If there is net outflows exceeding 250 billion dollars within half a year, SAFE will try to stem the flows. Instead of carrying out inspections on export invoicing, SAFE will carry out inspections on import invoicing (…)

In other words, watch out for headlines about a crackdown on import/export invoicing, it may indicate increasing capital outflows and give you an edge before the official numbers are out. The following is also interesting,

(…)There will be a crackdown on underground money changers also. Indeed, when faced with an unusually high amount of outflows in the second half of 2008, SAFE began to carry out inspections against outflows (Wen and Huo 2009) (…)

Put differently: there is a precedent for what will happen once USD liquidity starts tightening globally. It also indicates that the Chinese malinvestment boom would have deflated much earlier had the Fed not engaged in large-scale QE…

(…) However, just as the prevention of hot money inflows is ineffective today, the attempt to stop capital flight will be challenging. China cannot stop importing large quantities of commodities and food from developing countries, especially if there is inflationary pressure. Chinese import of foreign goods totaled over 1.2 trillion USD in 2010, a 40% increase from 2009 (National Development and Reform Commission 2010). As such, the Chinese government cannot completely stamp out import invoicing as a channel of capital flight (…)

The power of the Chinese authorities to “manage” the economy is way overstated. Once the tide turns, they have only limited options.


It is likely that I have been too early with my CNY short. The political elite who controls most of the wealth in China is likely to get to know first about an impending devaluation and would try to move its assets out of the country as fast as possible. The Chinese authorities know this and hence are probably reluctant to even discuss this as a possible solution. The CNY will be last shoe to drop.

Chinese bank shares are probably the better way to play this (apart from the AUD), as CIC reserves consist to a large part of bank shares. In case of continued outflows there would be selling pressure similar to what occurs when mutual fund holders redeem their shares. Moreover, with the banks you have another lever, since they must have considerable credit risk given their non-existent lending policies (how else, for example, do you explain this). Shorting a basket of Chinese bank shares with long-term put options could be an interesting play.

Disclosure: short CNY and short AUD



  1. Glad you enjoyed! While I hardly blame him, its a shame he went to the private sector because I very much enjoyed reading his work.

    The issue I’ve always had shorting the banks (and I say this having had this trade on off and on forever) is that they will continue to run through the full gamut of accounting fraud to ‘recapitalize’ these banks until the music stops. The Chinese are masters at shuffling bad debts under the rug through the evergreen ‘bad bank’ industry, and we already had a round of this cosmetic nonsense last year, not to mention a highly successful Cinda IPO. I would also expect that with ever less reason to be concerned about inflation, they will have more slack to funnel FX reserves into the banking system. This will have a big signalling effect and SHCOMP will probably go up 100%.

    It’s times like this that I’m tempted to pull a Soros and go long the bubble until the shit really hits the fan.

    1. Hi Nick,
      Just came back from holiday, sorry for the late reply.
      Yes, it is especially fascinating how confident he seems about how this could play out.
      The extent to which you can hide bad debt depends on several factors, liquidty most importantly. Don’t forget that the absolute amount of reserves matters less that the change at the margin.
      When I say shorting the banks, I am thinking about a structured, long term put on a basket of the 4 biggest banks. Depending on the vol. a three year OTM put could be a very interesting play…

      Probalby a good idea, but keep in mind that Soros did not fare well with this strategy in 2000 either…

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