China’s capital flight and US monetary policy

Yin-Wong Cheung , Sven Steinkamp, Frank Westermann 27 January 2016



In a largely closed capital market like China, illicit capital flows are inherently difficult to measure as no official data is recorded and the true volume is unobservable. However, standard proxies in the literature suggest that it is economically sizable, amounting to up to 2% of GDP in recent years. Figure 1 displays three common measures of capital flight. Although these proxies appear to follow different dynamics, they have in common that they are large and on the same order of magnitude when compared to official flows.

Figure 1. Capital flight and official flows

Data sources: National Bureau of Statistics of China, China State Administration of Foreign Exchange, Directions of Trade Statistics (IMF), International Financial Statistics (IMF), own calculations.

Measures of capital flight

The World Bank residual measure of capital flight is based on the balance of payments statistics. It compares the sources to the uses of funds – that is, it takes net foreign investment and the change in foreign debt and deducts from it the current account balance as well as the change in reserves. The remainder is a series that has widely been used as a proxy of capital flight in the literature, an unexplained component in the balance of payments.

The trade mis-invoicing measure is based on the fact that different statistical agencies record the same export/import activities, but often report different numbers. For instance, an export out of China worth $1,000 may enter the US statistics with a value of $1,000, but enter the Chinese statistics with a value of only $500. When abstracting from transportation costs this ‘under-invoicing’ of exports may be a sign of capital flight, as the remaining $500 is placed in a US bank account rather than being sent to China.

A new pattern

An interesting new pattern is the decline of total illicit flows in recent years. In particular, capital flight as measured by trade mis-invoicing has declined since the beginning of the Crisis in 2007/8. In a new paper, we explain this new finding and interpret the results in the context of China’s trend towards a gradual liberalisation of its capital account (Cheung et al. 2016).

Earlier empirical studies have shown that illicit flows, just like official flows, respond to interest differentials between countries. As capital controls exist, covered interest differentials can occur and attract portfolio rebalancing by investors on both sides. The covered interest differential has been documented to be a relevant empirical factor explaining China’s capital flight. In our extensive empirical analysis, we show that this empirical link has remarkably diminished in recent years. Using an interaction dummy variable, we show that the post-2007 response to the covered interest differential has been significantly smaller – and is hardly different from zero.

The impact of US monetary policy and other factors

A new factor that started to play a role in the post-2007 period is the relative money supply between China and the US. While China’s money supply has been rapidly increasing for many years, the US has been following an expansionary monetary policy only since the onset of the Global Crisis. Empirically, we find that this change in the relative monetary stance of the two countries has had an impact on investors’ decisions to reallocate their portfolio between the two countries. The US expansion has significantly reduced capital flight out of China, in both the trade mis-invoicing as well as a combined measure of capital flight.

This empirical result helps to explain the reduced impact of covered interest differentials. The fit of the regression, measured for instance by the adjusted R2, improves when relative money supply and a dummy variable for the post-2007 period are added to the regression. This finding is also robust when controlling for other factors in a multivariate regression setup, including relative growth rates, exchange rate regimes dummy variables, and so on.

Another new factor that becomes increasingly important is China’s gradual process of capital account liberalisation. Using the new index of capital controls by Chen and Qian (2015), we control for this process. We find that it also starts being significant in the post-2007 period. Investors appear to appreciate China’s new policies by investing their financial resources domestically. Nevertheless, we also find that the ex post realised exchange rate volatility is a negative factor for capital flight (i.e. an increase in intra-day volatility of the renminbi has a significant positive impact on capital flight out of China).

A caveat: Transportation cost and insurance

In the absence of official data, all measures of capital flight are proxies and must be interpreted with caution in general. This is particularly the case for the trade mis-invoicing measure, as exports are commonly reported without transportation cost and insurance while data on imports include these items. The IMF and other researchers typically assume a constant 10% of the net trade value for transportation and insurance when computing trade mis-invoicing proxies.

But certainly trade costs can vary both across countries and over time. The statistical significance of tariff revenues in our regressions suggests that this is indeed a potential shortcoming of the analysis. To address this issue, we construct a modified version of the trade mis-invoicing measure that uses country-specific and time-varying trade cost estimates that were computed by the CEPII institute from a standard trade-gravity equation. The main results in the empirical analysis are unaffected by this change.

Economic and policy implications

Our empirical results highlight the challenges of managing China’s capital flight. First, different measures of capital flight seem to have different empirical determinants. Second, these determinants have been changing over time. From the Chinese perspective, it is thus important to take a disaggregated analysis into account when designing further steps of financial opening.

Our regression analysis extends only to the end of 2014 and does not include the events of the past year. Our findings imply, however, that the increased volatility in the summer of 2015 and in particular the recent raise in US interest rates, which were associated with expectations of a more general reversal of US monetary policy, may be the cause of a resurgence in capital flight. This reversal has already been visible in the World Bank residual measure, as well as the combined measure, in the first three quarters of 2015.


Cheung, Y-W, S Steinkamp and F Westermann (2016) “China's capital flight: Pre- and post-crisis experiences”, Journal of International Money and Finance, doi:10.1016/j.jimonfin.2015.12.009.

Chen, J and X Qian (2015) “Measuring the ongoing changes in China’s capital flow management: A de jure and a hybrid index data set”, HKIMR Working Paper No.11/2015.



Topics:  Global economy International trade Monetary policy

Tags:  capital flight, monetary policy, globalisation, international trade, Fed, expansion, capital account liberalisation, money supply, illicit capital flows, trade

Hung Hing Ying Chair Professor of International Economics, City University of Hong Kong

Assistant Professor at the Institute of Empirical Economic Research, Osnabrück University

Professor of International Economic Policy at the Institute of Empirical Economic Research, University Osnabrueck

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