Super-loose monetary policies resulted in the combined net outflow of portfolio capital from the Eurozone, Japan and China – disguised or hidden in China’s case – surging to a record in 2016. With monetary stimulus likely to be wound down, the outflow may slow in 2017, casting doubt on forecasts of US dollar strength / US asset price outperformance.
The Eurozone, Japan and China must, by definition, run capital account deficits by virtue of their current account surpluses – ignoring errors and omissions, credits and debits must sum to zero in the balance of payments accounts. The current account surpluses in the year to the third quarter of 2016 amounted to 3.2%, 3.6% and 2.4% of GDP respectively. The Eurozone and Japanese surpluses were up from 3.1% and 2.7% of GDP in the prior 12 months, while the Chinese surplus was down from 3.0%.
The net outflow of portfolio and other investment was, however, much larger than these surpluses. The Eurozone portfolio deficit surged to a record 5.1% of GDP in the year to the third quarter. Japan’s deficit was 6.2% of GDP, following 6.4% in the year to the second quarter, a level exceeded only after the financial crisis – see first chart.
Chinese controls on portfolio flows have diverted most of the capital exodus into the “other investment” account and errors and omissions. The combined portfolio, other investment and errors and omissions deficit was 5.4% of GDP in the year to the third quarter. This was, however, down from a peak of 6.7% in the year to the fourth quarter of 2015 – first chart.
According to monetary theory, the balance of payments “basic balance” – the sum of the current account and the direct and portfolio investment accounts – is determined by the difference between domestic credit expansion (i.e. the growth of bank lending to the domestic public and private sectors) and growth in domestic residents’ demand to hold bank liabilities (i.e. broad money plus non-monetary liabilities such as bank bonds). Faster expansion of domestic credit than demand to hold bank liabilities creates “excess” liquidity that is, in effect, exported by running a basic balance deficit.
Domestic credit expansion has been boosted in the Eurozone and Japan by QE, and by state borrowing from the banking system in China. The demand to hold bank liabilities, by contrast, has been suppressed by low interest rates and inflation. A blow-out in basic balance deficits has been necessary to restore monetary equilibrium. The current account positions are strong in all three cases, reflecting competitive currencies and domestic saving-investment surpluses. Portfolio and other financial investment flows, therefore, have borne the main burden of adjusting the basic balance to compensate for “excess” domestic credit expansion.
In the Eurozone’s case, for example, QE has contributed to annual growth of domestic credit extended by monetary financial institutions (MFIs) rising to 4.2% in November 2016, the fastest since 2009. Domestic holdings of MFI liabilities, however, increased by only 1.7% in the year to November, with broad money M3 growth of 4.8% offset by a withdrawal of funds from longer-term bank bonds and time deposits – second chart.
In value terms, therefore, the 12-month sum of the gap between domestic credit expansion and growth of domestic liabilities was €338 billion in November, having reached a record €389 billion in October. This compares with a basic balance deficit of €370 billion in the year to November – third chart.
The ECB has announced a reduction in the pace of QE from €80 billion per month to €60 billion from April, while inflation is likely to exceed its forecast in 2017, suggesting further tapering (announced or actual) later in the year. The PBoC, similarly, has started to wind down stimulus, this week increasing a key interest rate amid solid economic data and surging producer prices. The BoJ remains committed to its zero target for the 10-year JGB yield for now but this may be achievable with a slower pace of QE against a backdrop of stable US Treasury yields and a firmer yen.
Unless private credit demand and / or supply pick up to offset reduced policy stimulus, therefore, domestic credit expansion may slow in all three economies. The demand to hold broad money and other bank liabilities, meanwhile, may strengthen in line with faster nominal GDP expansion. The domestic credit / liabilities growth gap, therefore, may narrow, implying an improvement in basic balances, probably driven by a reduced net outflow of portfolio and other financial investment. Such a slowdown could be associated with upward pressure on the euro, yen and renminbi against the US dollar as well as stronger relative asset price performance.