China capital outflows surge on geopolitical risks and Covid lockdowns

Local currency bonds accounted for most of the outflows in the first quarter, IIF says

Near-empty roads during a Covid-19 lockdown due to Covid-19 in Shanghai, China. The financial centre's experience is a cautionary tale for Beijing officials seeking to maintain China’s zero-Covid strategy, an approach that leaves the country increasingly isolated as the rest of the world opens up. BloombergShow less

China recorded the largest quarterly capital outflows on record in the first quarter on the back of Covid-19 lockdowns, depreciation and the perceived risk of investing in countries whose relationships with the West are complicated, according to the Institute of International Finance (IIF).

Investors sold equities and bonds, with local currency bonds accounting for most of the outflows, the institute said in a report on Wednesday. Outflows from government and development bank bonds started in February and picked up in March.

Russia selling part of its estimated $70 billion in reserves allocated to China was also partly responsible for the huge outflow.

“Portfolio outflows from China reached unprecedented proportions in the first quarter. In the big picture, they are unlikely to cause noticeable external funding issues,” the IIF said, without providing an exact figure.

“Reserve sales by Russia may explain some of the outflows at the beginning of the [Ukraine] war, but we are unconvinced they are driving this episode."

Investors have been pulling out of China, the world’s second largest economy, owing to geopolitical tensions caused by the Russia-Ukraine war, leading to business risks. The Asian country recorded $17.5bn worth of portfolio outflows in March, an all-time high, according to IIF estimates revealed last month. The outflows included $11.2bn in bonds, while the rest were equities.

China recorded large inflows in 2020-2021, when investors increased their exposure to Chinese bonds by 30 per cent to 40 per cent each year. However, flows to China have been unusually weak since Russia’s military offensive in Ukraine began in February.

“Russia may have used RMB [renminbi] assets in the second half of February, when total reserves declined and access to dollar and euro assets became complicated," the IIF said.

“It is less clear that in March sales by Russia were large as reserves were stable. If anything, part of the current account surplus may have ended in Chinese bonds, which are free of sanctions."

However, with China’s trade surplus expected to remain high after exceeding $200bn in the first quarter on a seasonally adjusted basis, "strong non-resident capital flows are not an imperative for external stability”, the report said.

“We take outflows from China as a sign that investors are growing more cautious about geopolitics, a development that may favour flows to EMs [emerging markets] with uncomplicated relationships with the G7 [Group of Seven],” the IIF said.

The effect of the Ukraine war on EM portfolio flows has “not been catastrophic so far”, the report said. While outflows from EM excluding China were registered in the first quarter, the episode “does not come close to the most severe in the last decade”, the IIF said.