What is the Cause of China’s Capital Flight?
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By Wen Xin Lim

What is the Cause of China’s Capital Flight?

Jan. 17, 2017  |     |  0 comments

While the Chinese government successfully kept its foreign reserves slightly above USD 3 trillion at the end of 2016, capital flight remains a precarious problem for China’s economy. As the Chinese government continues to battle with the massive capital outflow by issuing strict controls on overseas investments, how did China “encourage” capital flight in the first place?

In 2015, China’s capital outflow rose to nearly USD 1 trillion. The exodus of China’s capital continued to surge in 2016, which prompted the government’s efforts in "imposing new restrictions on yuan movements — including prohibitions on using credit and debit cards to pay for insurance products in Hong Kong", and limitations on individuals to move out only USD 50,000 per year. However, these efforts failed to reverse the phenomenon. Last year, Cao Dewang, a leading Chinese glass maker, unveiled his plan to move his factory operation to the United States due to rising transportation and labor costs in China.

Due to capital’s nature to chase profits, in recent years amidst China’s economic slowdown, foreign investors have been retreating from China, and substantial domestic capital has also been leaving. According to Figure 1, domestic investors are the main contributing factor to the enormous capital outflows from China. Also, there has been a surge in outflows of foreign capital since 2015, when China’s economic prospects were bleak as the annual GDP growth went below 7 percent with decreasing wage growth.

Figure 1.

Historically, capital flight is more commonly found in developing countries due to serious corruption and a lack of monetary autonomy. China’s capital flight is nevertheless quite different from the other large industrialized and emerging economies including “the US in the Great Depression and Japan in the 1990s, which both saw relatively little capital leave the country” as reported by Bloomberg. Instead of channelling their money elsewhere, investors in these countries were inclined to keep their wealth in cash or safe assets during times of economic uncertainty.

This prompts us to ponder about the reasons for the extensive capital flight from China. Capital flight and the openness of an economy is negatively correlated. Paradoxically, the most open economies are the least susceptible to capital flight, as investors’ expectations and confidence, and the long-term prospects for such economies increase with higher market transparency and openness.

Many have opined that great political uncertainties under China’s current leadership has spread insurmountable fear among businessmen and foreign investors. President Xi Jinping who has increasingly consolidated power within Chinese politics has bothered many investors and even the Chinese population. Capitalists are channelling out their capital assets to get away from the control and influence of the Chinese government. Such political culture could be paralyzing to China’s economy as it is inclined to become less open and transparent, contributing to the massive capital flight.

The Hong Kong tycoon Li Ka-shing was among the first few to sell off assets in both mainland China and Hong Kong, eventually relocating his business to the Cayman Islands. Besides higher business risks and gloomy economic prospects, there were also rumours that the 2015 Occupy Central event and China’s increasing ideological struggles were deterring capitalists and investors like Li. This is however not something new in Chinese history. Li’s family had fled to Hong Kong during the Cultural Revolution to escape the political violence. Having gone through that period when ideology overturned conventional aspects of politics, society, and economy, it was natural for Li to be leery of the Chinese government amidst the rising tension between Hong Kong and the mainland China. Li's withdrawal was driven not solely by economic factors but also the public manifestation of political changes going on behind the scenes in Beijing.

China under Xi’s leadership is pushing an ideological line, and investors have started to feel the emergence of left-wing thinking echoing Mao’s era. The clampdown on civil society, media expression, and the freedom of speech have sent threatening signals to many, making some wonder if the over-assertion on ideology could eventually erode Xi’s reform plans, including the promised establishment of the rule of law and economic reforms that protect personal wealth. Without an effective rule of law system, and with higher government intervention, there is a possibility that attempts to prevent capital from running will just make it run faster through various illegal means.

In these times of globalization, China’s economy is however not a genuine laissez-faire economic system, but remains very much subject to government intervention. China expert Pei Minxin argues that China’s gradual economic reform after Deng’s opening up policy “has allowed the state to use its political strength to protect its own power, by maintaining a patronage system that keeps economic and political elites loyal.” In this way, economic and political factors have converged to help perpetuate the dominance of the ruling party. It is therefore appropriate to study China’s economy by employing the concept of political economy to see how the crucial role of China’s politics determines its economic outcomes.

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