Is China at risk of instability?

In a chapter contributed to my recent edited volume on country and political risk, Michel-Henry Bouchet of the Skema Business School makes the case for a new indicator of political risk: capital flight.

He writes: “when attempting to understand the complexities of country and political risk, it is perhaps the most useful to turn to those who are embedded in the country’s matrix of social, political and economic forces, and hence understand these forces best – that is, a country’s residents.”

To be sure, there are also more direct indicators of political behavior that one might wish to use to track political risk. Protests, for instance. Or even – as has lately become popular in the era of big data – natural language analysis of postings to blogs and social media.

But, as Bouchet points out, capital flight has much to recommend it as an indicator, because capital flight involves putting one’s money on the line: “there are costs and risks associated with transferring one’s money abroad. When citizens do so consistently over time and en masse, it is meaningful.”

(To this, I would add, somewhat cynically: in contrast to protests or social media posts, capital flight has the advantage of being, in the main, an indicator of the behavior of a nation’s wealthy elite, who are perhaps more likely to be in the know in regard to the true state of their country’s politics and economy.)

Of course, where money is involved, one must also consider financial motivations. Bouchet and a co-author have constructed a model explaining capital flight in 43 countries. An overvalued currency and negative real interest rates tend to be strongly associated with capital flight. In that case, moving one’s money overseas is a smart investment decision.

Corruption and generalized weak governance also correlate with capital flight. A lack of opportunities for profitable investment and the risk that money will be expropriated can lead to efforts to shelter or invest funds overseas (which may explain Russia’s consistently high level of capital flight).

The model also finds that capital flight is indeed a useful event-risk indicator: rising capital flight tends to correlate with the onset of political and economic turmoil.

In Thailand, for instance, there was a surge in capital flight in 1995, not long before the 1997 Asian financial crisis (and indeed since then capital flight from Thailand has continued, along with ongoing political instability). In Tunisia, capital flight rose to high levels – and largely remained there – from 2007 up to the onset of the Arab Spring.

This year one country has dominated the news in regard to rising capital flight, and that is China. Massive capital outflows from China started in the middle of 2014, reaching a record high of more than $100 billion in December 2015.

Over the course of 2015, outflows were more than $800 billion in total (a level that would have provoked a foreign-exchange crisis in many lesser economies – but China, which still maintains over $3 trillion in foreign exchange reserves, can handle it).

Some of these outflows seem like capital flight. In 2015, for instance, one out of every 14 homes in the US that sold for over $1 million was sold to a buyer from China.

To be sure, even this behavior may be driven in large part by economic causes. There are good financial reasons for Chinese people to pay the costs, and take the risks, of sending their money overseas.

One such reason is simply that, in its effort to internationalize the currency, China has recently liberalized restrictions on international transfers. At last, Chinese companies are allowed to move their money; and so they are doing so. Another reason is that Chinese investors may expect that the country’s currency will depreciate.

Indeed, Oxford Economics estimates that in February, capital outflows fell from their previous rate of about $100 billion per month to less than half that – suggesting China’s recent efforts to prop up its exchange rate, and to crack down on capital flight, may be becoming increasingly effective.

That said, it is too early to write off these outflows as signifying nothing. The large and consistent capital outflows are unique in the country’s recent history (large capital outflows have occurred in the past, but always reversed within a few months, rather than continuing for over a year).

Moreover, China has come to a very interesting point, politically speaking.

There have been some countries that have been both authoritarian and richer than China. But these countries have been either resource-rich and/or swung back and forth between democracy and authoritarianism several times.

To my knowledge, Singapore is the only non-resource rich country to have remained steadily authoritarian while joining the world’s rich nations. By contrast, there have been many countries that have preceded China in authoritarian development – specifically, Portugal, Spain, Hungary, Greece, Taiwan, South Korea and Cyprus.

All of these countries were authoritarian during much of their periods of rapid economic growth, but became democratic once they hit the “democratization window” of between roughly $12,000 and $15,000 in per capita income (at purchasing power parity).

Portugal and Taiwan Transition

Taiwan, Korea, and Portugal experienced the transition to democracy at about $12,000 in income per person; Greece, Hungary, and Spain at about $15,000. (See the graph above, plotting level of democracy against income per person for Portugal and Taiwan – reproduced from a paper on this subject by Jack Goldstone and Adriana Kocornik-Mina.*)

China, at a purchasing power parity income per capita of $13,000, is now well within the “democratization window.”

Is there a big transition coming for China?

Of course, even if China’s citizens are “embedded” in their country’s political and economic systems in a way that foreign analysts can never be, it is unrealistic to expect that Chinese citizens will have a crystal ball tuned to future developments.

But they might have a general sense of an impending transition. For instance, even if they did not know precisely what was coming, a few years before the dramatic transitions in Thailand and Tunisia, those country’s wealthiest citizens started sending their money offshore.

Do China’s rich elite know, or at least suspect, something that we do not? Most analysts worry about an impending economic crisis. But perhaps China’s politics are due for some type of transition as well.

It appears that China’s wealthiest citizens have indeed begun to transfer capital overseas, “consistently over time and en masse.” It is an indicator that will bear watching.


* The original figures in the paper are at 1996 USD PPP from the Penn World Tables. I have crudely adjusted these figures to current PPP dollars.