Will the Return of Trillions to China Spark a Surge in A-shares?

The global stock markets are often characterized by uncertainty and volatility during the months of September through November. Investors worldwide have learned to closely watch the actions of American politicians and the Federal Reserve, especially amid the first interest rate cut in recent years.

For Chinese investors, the focus often centers around how the Federal Reserve's decisions might impact the A-share market. With the likelihood of a U.S. interest rate cut becoming increasingly apparent in September, discussions around the potential benefits for A-shares have intensified, leading to claims that such a cut could spark a trillion-dollar capital inflow back to China, favoring the A-share market.

The narrative suggesting that a reduction in U.S. interest rates would mean foreign capital returning, more liquidity being pumped into the A-share market, and a potential surge in stock prices seems appealing. This aligns well with investors' wishes as A-shares are in dire need of fresh, risk-seeking capital. If foreign investment actually returns to the A-shares, a significant market rally appears plausible, perfectly reflecting the optimistic outlook maintained by many investors. Hence, this reasoning has gained considerable traction without much scrutiny.

Advertisement

However, the reality may not be as rosy. The phrase "the East rises while the West falls" has been repeated numerous times over the last few years as interest rate cuts have been linked to the performance of different stock markets, yet results have often contradicted this narrative. This article aims to unravel the reasoning behind the skepticism towards the idea of massive capital inflows and elucidate the limited impacts on the domestic market, including the stock market and other sectors.

Recently, Stephen Jen, the creator of the "Dollar Smile Theory," stated in an interview with Bloomberg that Chinese companies could have accumulated vast amounts of U.S. dollars overseas in recent years, investing in high-yield dollar-denominated assets. As the Federal Reserve begins to lower interest rates, the appeal of these previously high-yielding dollar assets may diminish, potentially catalyzing at least one trillion dollars in capital to flow back into China.

This logic underpins the narrative of "trillions returning and benefiting A-shares."

First, let’s examine whether Chinese enterprises have genuinely accumulated substantial foreign exchange overseas.

In fact, the proportion of foreign exchange earned by domestic companies from exports that gets converted into local currency has been declining over the past two years. Chinese enterprises have indeed accumulated significant assets abroad. The domestic economy has largely relied on exports for growth, with traditional exports like clothing and household appliances witnessing a resurgence, and new export categories such as electric vehicles and renewable energy products shining in international markets. However, rising trade tensions have led to many countries imposing high import tariffs or anti-subsidy and anti-dumping duties on Chinese goods. The boom in exports has allowed domestic companies to earn considerable foreign exchange. In the past, regulations mandated companies to convert export earnings into RMB. Since January 1, 2011, businesses can now hold their foreign exchange offshore without bringing it back home. This change allows firms to choose how to utilize their foreign earnings based on exchange rate movements and their needs, whether converting to RMB or investing abroad.

With the continuous depreciation of the RMB in recent years, the willingness of export firms to convert their dollars back to RMB has markedly declined. The ratio of foreign exchange earned from trade to the overall trade revenue reflects this trend, indicating that many exporters are choosing to hold their foreign currency instead of converting it, keeping a notable amount of dollars abroad.

Evidence shows that since 2020, this conversion ratio has fluctuated and has steeply declined since 2022.

The rationale behind this trend is not complicated: firstly, the RMB has depreciated, leading to a perceived loss in value when converting to RMB. Secondly, due to high-interest U.S. dollar assets with annual deposit rates surpassing 5%, the yield compared to RMB denominated assets naturally makes the dollar more attractive. Lastly, firms have increasingly pressing needs for overseas investment, making dollar holdings more convenient.

Consequently, more companies are opting not to convert their dollar earnings into RMB. Data suggests that since 2022, unconverted revenue (approx. one trillion dollars) has built up outside of China. For instance, estimates by China International Capital Corporation reveal that the ratio of currency conversion for trade has dropped by approximately 10 percentage points compared to historical averages. Between January 2022 and July 2024, the total amount of funds not converted could be around $933.2 billion.

If the Fed does cut rates in the future and the RMB gains strength, the prior logic of "holding dollars due to RMB weakness" could reverse, prompting these dollar-holding companies to accelerate conversions back to RMB—especially at year-end when conversions are required for paying upstream suppliers, bank repayments, and year-end bonuses for employees.

This phenomenon is one of the key reasons behind the claim that "one trillion dollars will flow back to China." However, different institutions predict this figure with notable discrepancies. For instance, Macquarie Group estimates over $500 billion; ANZ Bank estimates $430 billion; Goldman Sachs suggests that even when including individual holdings, Chinese enterprises and citizens won't stockpile over $600 billion by mid-2022 to 2024. Consequently, calculable dollar assets are likely less. Even Wang Ju from BNP Paribas has noted in an interview that this figure may be far from the one trillion mark.

This indicates that while the market generally agrees on the potential for dollar yields flowing back, opinions diverge greatly on the projected scale of such inflows.

The feasibility of dollar-to-RMB capital inflow depends heavily on the reasons enterprises hold dollar assets, which include foreign exchange gains from dollar appreciation, higher dollar asset yields, and personal investment needs.

Analyzing exchange rates, for exporters, RMB depreciation equates to increased revenue and improved profit margins. Conversely, if enterprises expect future appreciation of the RMB, they are likely to convert dollars to mitigate exchange rate losses. The future trajectory of the RMB's exchange rate is complex, and while it won't be elaborated on extensively here, a guiding statement from regulatory authorities provides insight:

"On August 9, we must monitor cross-border capital flows, maintain a baseline mentality, adopt a comprehensive strategy to stabilize expectations, and avoid unilateral expectations that self-validate. It is imperative to guard against excessive fluctuations in exchange rates and keep the RMB steady around reasonable levels." Earlier, on July 30, the Political Bureau also mentioned, "We must maintain the RMB at a reasonable equilibrium."

It is notable that the emphasis is on stability, whether appreciating or depreciating is not in line with the wishes of regulatory authorities—excessive appreciation could severely hamper exports, which would be unbearable for an economy heavily reliant on them. Thus, when there are significant fluctuations in either direction, the central bank would intervene to stabilize the currency. Therefore, setting high expectations for substantial RMB strength in the future may be unrealistic, and it is even possible we have reached a relative equilibrium.

Next, with the high yield on U.S. dollar holdings, many businesses opt for a strategy of "holding high-yield dollar deposits while borrowing low-interest RMB loans" to enhance profits.

For example, in one of its 2023 financial reports, a publicly listed company revealed that nearly 90% of its monetary funds were kept in dollar deposits.

In contrast, this same company relied heavily on short to medium-term RMB loans to meet its operational and liquidity needs.

Using this "borrow RMB to maintain operations while holding high-yield dollar assets" model, the company's interest income soared to 291 million yuan, a 169% increase year-on-year. Although relying on domestic loans does incur some interest expenses, the overall income generated vastly outweighs the interest costs incurred.

This illustrates how the interest differential between the U.S. and China influences companies’ currency conversion choices. Should this interest differential shrink or flip, it would incentivize companies to reverse the trend and increasingly hold RMB.

However, realistically, over an extended period, a notable interest differential between the two currencies is likely to persist. Until this gap closes completely, many firms are expected to continue the strategy of "borrowing low-interest RMB while holding high-yield dollar deposits."

Finally, considering the investment needs of export firms and their operational requirements, a significant portion of offshore assets is likely to become fixed assets, reinforcing the concept of overseas investments as part of these companies' broader investment strategies, which may continue to proliferate.

Reflecting on the scale of overseas expansion, in 2023, the number of non-financial overseas enterprises directly invested in by Chinese firms reached 7,913, marking a remarkable increase from the previous year. Non-financial outward direct investment amounted to 130.13 billion yuan; the figures are second only to another wave of investments seen in 2016. The past several years have witnessed a surge in investments towards regions like Southeast Asia and Latin America, where a substantial portion of foreign exchange has been transformed into local fixed assets, funds that are unlikely to return.

This situation mirrors Japan's experience, where many studies suggest that although the nation saw little GDP growth during its "lost two decades," it successfully cultivated overseas assets via globalization, effectively creating a 'new Japan' abroad. The validity of this conclusion is debated, but one cannot deny that overseas assets constitute a vital segment of a nation’s wealth. The current tide of Chinese enterprises going overseas reflects this dynamic.

In summary, while the aspiration for "one trillion dollars returning" is appealing, the reality may not be as bright as simplistic deductions suggest. The concept of capital inflow into A-shares can become an elusive notion. High hopes without substantive backing introduce risks of underperformance against expectations.

That said, this does not dampen my optimism regarding the A-share market. The market often oscillates between extremes, and currently, A-shares are mired in overwhelming pessimism. Positive policy indicators and improving fundamentals are obscured by negative sentiment. Just as excessive optimism carries risk, so does overzealous pessimism.

Timing the market when it's bustling is challenging, just as it is to buy when nobody seems interested. Yet, oftentimes, such moments may represent the more prudent choice.

[Note: Markets carry risks, and investment should be approached cautiously. This does not constitute investment advice for anyone.]