Weaker Yuan Tests China’s Ability to Prevent Capital Flight

China’s biggest experiment with its currency since a botched devaluation four years ago suggests its leaders believe they can stem a serious flood of money fleeing its borders.

By the end of the week, the yuan somewhat stabilized, offering hope the two countries might not be on the brink of a full-blown currency war.

But allowing the yuan to breach the fiercely defended level against the dollar revived memories of the Chinese currency’s sharp moves in August 2015, when Beijing shocked global financial markets by unveiling a surprise mini-depreciation.

In theory, China keeps a tight grip on money entering or exiting the country, but in practice it had already been grappling with large capital outflows, both legal and illicit, for years. The problem peaked in 2015, when hundreds of billions of dollars fled China.

The money was siphoned out using numerous techniques, often involving Hong Kong or Macau, two Chinese territories which have their own currencies. People turned to money-transfer agents acting as underground banks and bought foreign-currency-denominated insurance products in places including Hong Kong.

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Chinese companies used maneuvers such as getting creative with invoices and inflating the declared value of imports to justify large payments abroad.

Since then, authorities have made it more difficult for individuals and companies to move funds offshore, employing measures such as tightening approval for cross-border acquisitions and monitoring overseas spending using domestic bank cards.

Research from the Mercator Institute for China Studies, a Berlin-based think tank, identified 75 capital-control adjustments that China introduced between June 2016 through January 2018, measures which Beijing can relax or tighten depending on market conditions.

“The willingness of the Chinese authorities to allow the yuan to weaken suggests that they are comfortable with the ability of existing administrative measures to prevent large capital outflows,” said Khoon Goh, head of Asia research at ANZ in Singapore, in a note to clients.

In May, the State Administration of Foreign Exchange publicized 17 cases in which individuals or businesses were punished for violating foreign-exchange rules. The publicity highlights how keen authorities are to discourage this behavior—and the range of tactics they are confronting.

“I think the authorities are very aware of the risk of capital flight.”

—Mansoor Mohi-uddin, senior macro strategist at NatWest Markets

One individual, it said, used 34 people’s bank accounts to transfer $2.5 million abroad. Under Chinese law, each individual can buy up to $50,000 of foreign currency a year. The offender was fined 830,000 yuan ($117,777) and placed on a watch list, the government agency said.

SAFE said it fined another person who bought 13.8 million yuan worth of U.S. dollars via 16 transactions with unregistered money changers, and fined a trading company that fabricated transactions to transfer more than $15 million abroad.

That backdrop, along with reassuring comments from China’s central bank and its official media, helps explain why few forecasters expect a further large depreciation.

Analysts at Bank of America Merrill Lynch, for example, expect the yuan to weaken to 7.3000 per dollar by the end of the year before strengthening slightly in 2020.

Deutsche Bank

’s team foresees 7.1000 by the end of the year, barring an all-out trade war. The yuan was at 7.0598 against the dollar in late Chinese trading Friday.

Any further selloff could also create problems for Chinese property developers and other corporate borrowers who have borrowed heavily overseas, since their earnings are largely in yuan while their international borrowings are mostly in dollars.

Chinese companies had nearly $900 billion of dollar-denominated debt securities outstanding at the end of March, nearly three times the amount five years ago, according to data from the Bank for International Settlements.

Despite Beijing’s strict capital controls, China could experience capital flight if the yuan weakens further, some observers say.

Louis Kuijs, head of Asia economics at Oxford Economics, said policy makers wouldn’t be comfortable with a major weakening of the yuan, given concerns about triggering large outflows.

“People in China tend to take weakening of the currency as a harbinger of more such weakening to come,” he said. “That is a reason for some to shift money abroad.”

Beijing has a range of tools for controlling exchange rates more directly. These include spending some of its more than $3 trillion of foreign-exchange reserves, pulling liquidity from offshore yuan markets or ordering state banks to shore up the currency. The People’s Bank of China also has some discretion in how it sets a daily midpoint for onshore trading in the currency.

“We think authorities will keep enforcing capital controls a lot more stringently than they did in 2015,” said Mansoor Mohi-uddin, senior macro strategist at NatWest Markets. “I think the authorities are very aware of the risk of capital flight.”

Write to Steven Russolillo at steven.russolillo@wsj.com

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