China and Capital Flight: From Risk Mitigation to Excessive Control?

No matter which industry you are involved it, you’ve most likely come across more or less frustrating measures in the sphere of capital controls when it comes to the Chinese dimension of the industry in question. From brick and mortar industry limitations to China banning practices pertaining to exotic industries such as cryptocurrency-related ones, the authorities are making it clear that when it comes to limiting excessive capital outflow, they’re determined to be thorough.

But… why?

For a few simple reasons, such as:

1. Because China is more prone to capital flight behavior than countries which enjoy a “safe haven” status such as the United States… at least for now. Let’s assume a global financial crisis would emerge tomorrow and ask ourselves what frightened capital is likely to do. Are scared investors likely to dump their US Treasuries at pennies on the dollar? No. On the contrary, they will most likely do the exact opposite by selling OTHER assets and jumping into safe haven assets such as US Treasuries. Which assets are they likely to sell? Among other things, assets related to China in light of the fact that China hasn’t yet earned the confidence of the financial markets to a significant enough degree to warrant an upgrade to “safe haven” status
2. Because… well, it can or, to put it differently, because Chinese citizens have a far superior tolerance level compared to their Western counterparts. In European Union nations, the United States or let’s say the Western world in general, there would be Earth-shattering backlash in the event that the authorities would impose capital control measures as drastic as the ones China occasionally chooses to implement. While this doesn’t mean Western nations cannot get away with such measures (with the Cyprus banking crisis of 2013 and the subsequent capital controls being relevant in this respect), it simply means it is harder for them to do so than for a nation such as China, where the likelihood of major backlash accompanying capital control measures is multiple orders of magnitude lower
3. Because Chinese investors are less sophisticated than their Western counterparts and therefore more likely to engage in “pump and dump” capital allocation behavior. While everyone loves the “pump” phase of Chinese interest in various assets (from real estate to domain names and cryptocurrencies) and the massive flow of capital it brings about, the effects of the “dump” phase can be just as impressive… but in reverse
4. Because more sophisticated capital flight mitigation or better yet avoidance mechanisms are not yet in place. While tremendous progress has been made when it comes to pretty much all layers of China’s administration, let’s just say China still lags behind as far as the idea of avoiding capital flight in the first place is concerned. Therefore, until better alternatives emerge, capital controls are simply the convenient solution that seems to be always within reach
5. Because measures aimed at protecting domestic companies by limiting external competition can be “branded” as capital flight mitigation measures. In other words, China’s diplomatic talking points can be related to the dangers of capital flight and the importance of proper mitigation, whereas its actual intentions in select instances may pertain to aspects which have little to do with actual capital flight mitigation and everything to do with developing yet another trade-related edge
6. Because they (still) work. At the end of the day, despite being very controversial, capital control measures still work well enough for the authorities to consider that the current pros still outweigh the current as well as potential cons. As or if that balance deteriorates over time, China’s stance on capital flight will most likely change in a more meaningful manner

… the list could go on and on.

Do China’s capital flight mitigation approaches work?

To a certain extent, yes. However, perceiving them as some sort of financial universal panacea would be nothing short of foolish. Instead, they should be seen as nothing more than band-aids: an inevitable solution when few (if any) superior solutions exist but hardly something you can keep doing indefinitely. At the end of the day, there is a significant risk of ultimately falling victim to the very fears you are too afraid to tackle and the capital flight issue in China may very well end up representing a textbook example to this effect if the status quo persists indefinitely.

While drastic capital control measures corroborated with freedom-limiting mechanisms such as the Great Chinese Firewall may seem like an authoritarian dream come true, history proves time and time again that this approach works… until it doesn’t. And when the inevitable “until it doesn’t” moment pops up, the fireworks are frequently nothing short of dramatic.

At the end of the day, it’s only a matter of time until these approaches are attacked on all fronts, from external attacks by trading partners who become sick and tired of countries such as China implementing restrictive capital control measures (restrictive from an international trade perspective, in this case) while they cannot to the average citizen who may be somewhat tolerant of the status quo right now but that tolerance has a limit. As the Chinese authorities know all too well, an eventual transition to a less restrictive framework (even if capital flight risks are here to stay) is not just highly recommended but downright unavoidable.