James Nelligan, Currency Research Analyst at RBS, suggests that central to any China and risk discussion is the pace of domestic capital flight and associated drain on FX reserves. Key Quotes “China’s capital account liberalization is gradual. We believe there is significant demand for foreign assets that currently cannot translate itself into a larger IIP (international investment position) because the capital account is not yet sufficiently open. The result is a subdued IIP, at 13% of GDP, relative to demand for foreign assets. Looking at economies that have a more conventional relationship between the current account and the IIP we can begin to gauge how much capital would leave China if the IIP were to move up to international ‘norm’, represented by the trend line in the left hand chart below. We estimate around $1.18tn of capital outflow could occur under that scenario, which could take China’s FX reserves down to $2.04tn and below IMF reserve adequacy levels (assuming PBoC intervention to offset depreciation pressure on the Rmb stemming from the capital outflow). Recently China took another step on the road to further capital account liberalisation by giving overseas financial institutions (including pension funds, sovereign wealth funds, foreign central banks, insurers, securities firms and asset managers) access to the domestic interbank bond market, the third largest bond market in the world. Although this measure is designed to offset capital outflow by encouraging portfolio inflows, it reinforces the idea that China is gradually opening its capital account. PBoC governor Zhou marginally altered the monetary policy language of the central bank to one of a “slight easing bias” this week. We believe more easing can encourage further capital outflow.” For more information, read our latest forex news.