The amount of foreign exchange purchased by the People's Bank of China (PBoC), a key indicator of cross-border capital flows, fell for a second-month in a row in November, dropping by 27.9 billion yuan, pointing to continued capital outflows from the country.

This follows October's decline of 24.9 billion yuan, the first fall since December 2007. The estimated capital outflows, using a broader definition which includes outflow of outward foreign direct investments (FDI), including portfolio investments and hot money, were around $30 billion in November and October, compared with an inflow of $15 billion in September. The consecutive declines are in line with my recent comment that capital outflows will likely persist for a while, amid fears about a hard landing in the Chinese economy and intensified global financial markets uncertainty, which have reinforced yuan depreciation expectations and strong demand for US dollars.

There are two main implications for investors. Firstly, the PBoC will likely cut the required reserve ratio (RRR) by another 50 basis points (bp) within the next month to stabilize liquidity in the domestic market, after which I forecast another three RRR cuts for a total 200bp by end-2012. The negative net forex (foreign exchange) purchases by the PBoC (selling of US dollars) is likely to lead to a contraction in yuan liquidity, further exacerbating the already tight year-end liquidity conditions resulting from minimal PBoC bills and repos (repurchase agreement) maturing.

Secondly, the Chinese currency will face continued depreciation pressures in the coming months. Capital outflows, coupled with a narrower trade surplus ($14.5 billion in November and $17 billion in October, year-to-date (YTD) down 18 percent year-on-year; and I forecast a trade deficit in the first quarter of 2012), and slower FDI ($8.8 billion in November, down 10 percent year-on-year) given a weakening global economy and investor sentiment, which are likely to reduce yuan appreciation expectations and reinforce yuan depreciation hopes instead.

This has been reflected in onshore USD/CNY spot movements: despite the PBoC guiding the USD/CNY daily fixing rate higher (instead of allowing for steady depreciation), the spot rate has consistently traded at the weaker end of the daily trading band (+/-0.5 percent) in the past month.

That said, for now, I maintain the forecast of a modest yuan appreciation of 2-3 percent against the US dollar over the next 12 months.

The author is vice-president and China economist at Barclays Capital Asia. The opinions expressed here are entirely her own.

(HK Edition 12/20/2011 page2)