* FX deposits in China hit record high every month since last October
* FX holdings partly shift from PBOC, state banks to non-state sectors
* Comparative study of data shows fund inflows/outflows largely balanced
* QE3-driven yuan/dollar stability set to further check capital outflows
By Lu Jianxin and Pete Sweeney
SHANGHAI, Oct 3 (Reuters) - Foreign exchange deposits in Chinese banks have hit record highs every month since last October, suggesting that fears of destabilising outbound capital flows may be unwarranted.
The structure of the deposits also shows that the non-state sector is taking an increasingly large share of China's forex deposits, allowing Chinese businesses to gradually wear away at the government's control over dollar supply and demand.
Chinese firms began keeping dollars on hand in the fourth quarter of 2011, when a slowdown in growth of the world's second-largest economy began dimming the prospect for further yuan appreciation, once considered a safe one-way bet.
During the same period, the People's Bank of China (PBOC) and state-controlled banks began selling off dollars from time to time, reversing a decade-old tradition of only participating in the market as a buyer of forex and prompting speculation that a wave of capital flight from China was imminent.
Market observers read reports of slowing inbound foreign investment and a corresponding reduction of inward forex flows and concluded, not illogically, that the next step would be a reversal of flows out of China.
But in fact, while the ownership structure of foreign currency in China has changed, overall capital flows are roughly balanced.
Data on China's forex deposits, when compared with data on forex purchases by the PBOC and Chinese banks, points to a movement of foreign currency holdings from the state to non-state entities, not capital outflow to other countries.
This does not support the thesis that China is facing a large-scale outflow of funds that could destabilise the economy, but does suggest a coming shift in the way forex is channelled.
"An increasing amount of foreign exchange in the country has moved into the hands of non-state sectors, reducing the state's control of foreign currencies," said Liu Dongliang, an analyst at China Merchant's Bank in Shenzhen.
"Foreign exchange in China will from now on see a trend of two-way movements, sometimes flowing from the state to non-state sectors and other times vice versa, depending on how the market sees the future trend for the yuan's value. Over time, it will end the status quo that only the state absorbs and reverses the bulk of foreign exchange in the country." <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
GRAPHICS: FX deposits Banks' FX purchase PBOC FX assets Balance of Payment ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
Now the yuan has begun appreciating again, following the U.S. Federal Reserve's decision to begin injecting $40 billion a month into its economy until unemployment improves.
Flooding the market with dollars has put downward pressure on the dollar index , freeing the yuan to begin rising again after months of decline. Thus a flood of Chinese hot money washing out of the country is even less likely in this context, currency analysts say.
The yuan rose against the dollar on Friday, and posted its biggest monthly gain this year in September, in response to global dollar weakness driven by the third round of U.S. quantitative easing (QE3).
Foreign-currency denominated funds on deposit in Chinese banks hit $415.1 billion by the end of August, rising a staggering 62 percent from a year earlier, PBOC data shows.
While residents' forex deposits remained largely flat during the period, corporate savings rose to a record high of $324.6 billion, comprising 78 percent of total deposits.
Total forex deposits in banks are now equivalent to 13 percent of the $3.2 trillion worth of foreign currency held by the central bank and other institutions. Just a few years ago, the state monopolized almost all of the forex in the country.
Capital inflows into China have slowed down since late 2011, and some signs of outflows through certain channels have indeed appeared, as shrinking external demand weighs on export growth and foreign direct investment (FDI) drops.
FDI inflows fell 3.4 percent in the first eight months of this year versus a year earlier, although they still stood at a decent $75 billion. August inflows fell a year-on-year 1.43 percent to $8.3 billion.
Included in the FDI figures is $1.79 billion in foreign equity investment put into Chinese banks and other financial institutions in the second quarter of 2012, according to data released by the State Administration of Foreign Exchange.
These institutions in turn made a total of $375 million in net outbound equity investments over the same period, the regulator said.
Another set of PBOC data showed that the central bank and Chinese banks sold a net $2.76 billion worth of forex in August, indicating the third month of such sales recorded this year.
Since such forex transactions are mainly used to adjust the balance of the dollar supply, net sales usually imply signs of capital outflows both from the state sector and the country as a whole.
But in August, forex deposits rose $2.64 billion, about the same amount as the PBOC and banks' sales, meaning their dollar purchases and sales were roughly balanced.
Average net monthly PBOC and banks' forex purchases in the first seven months of this year were about $8 billion, down significantly from the average of about $50 billion per month the institutions snapped up in the same period of last year.
But forex deposits in non-state hands rose by $21.7 billion per month in the first seven months of this year, compensating for a large part of the drop in PBOC and bank purchases.
"This year's situation is that domestic institutions have increased their holdings of foreign exchange assets instead of the central bank and other state-owned banks," said a trader at a Chinese state-owned bank in Beijing.
"Taking the data into considerations, you'll see a rough balance of capital inflows and outflows this year. Inflows could even gain the upper hand for the rest of this year, thanks in part to QE3."
Regulators have also encouraged a partial shift of forex reserves in the country to the non-state sector.
In a statement in July, a spokesman for the forex regulator, the SAFE, said: "There has recently been a trend that foreign exchange holdings have been shifting from the central bank to domestic institutions and individuals."
"That is a trend that suits to the state's long-standing policy target to let nongovernmental entities to reserve foreign exchange."
(Editing by Kim Coghill)
Keywords: MARKETS CHINA/DEBT