Geoff Dyer

China risks a scorching as hot money flows in at record level
 
On the face of it, China might not seem the obvious place to invest at the moment. The local stock market has collapsed, property markets are weak and the interest rate on bank deposits is about half the rate of inflation.

Yet that has not prevented a record flood of capital inflows even higher than China’s huge accumulation of reserves in recent years. In the first quarter, foreign exchange reserves rose by $154bn (€98bn, £78bn). On top of that, according to usually reliable figures leaked to Reuters, reserves jumped by $75bn in April and $40bn in May to a total of $1,800bn.

Given that the inflows far outstrip trade and direct foreign investment, China appears to be receiving vast amounts of speculative “hot money”.

China has two big attractions for foreign investors – interest rates are higher than in the US and the currency is expected to appreciate. “China’s FX reserves seem to have turned into some kind of massive black hole for the world’s liquidity,” says Stephen Green, economist at Standard Chartered.

The huge armoury of reserves was actually designed to withstand the volatile capital flows that helped cause the 1997 Asian financial crisis. However, ever-mounting reserves bring their own economic risks – inflation could be aggravated if the inflows cannot be managed and the financial system could suffer whiplash if investors decide to withdraw funds all at once.

Just how big a problem they present depends on how much of the reserve accumulation is the result of hot money, however that requires a lot of guesswork because the official numbers are not transparent.

Some of the big increase in headline reserves could be explained by accounting issues, such as the inclusion in reserves of reinvested profits from bond holdings or an increase in the recorded market value of the overseas assets in which Chinese reserves are invested.

Yet some economists believe the official numbers might actually understate the hot money inflows.

As part of the creation of China Investment Corporation, a $75bn-$100bn chunk of reserves was transferred to the new sovereign wealth fund. If most of that transfer took place in the first quarter of this year – as some analysts believe – then the surge in hot money inflows has been even higher.

Logan Wright at Stone & McCarthy analysts in Beijing estimates that hot money entering in the first five months could be as high as $150bn-$170bn.

There are plenty of legal routes to bring capital into China. Foreign residents can deposit up to $50,000 a year and Hong Kong residents have a much higher quota.

But government officials also believe that illegal transfers are taking place – through foreign companies declaring that funds are for direct investment and then putting the money in the bank and exporters exaggerating the value of overseas revenues in order to bring in extra funds. (As an aside, economists point out that if fraudulent export receipts really are widely used to bring in hot money, China’s politically troublesome trade surplus would actually be much lower than thought.)

The authorities announced a new crackdown on this trade route on Wednesday, saying that exporters would not actually receive payment until they could prove to their bank that revenues were the result of real trade transactions recorded by Chinese customs.

However companies and analysts were sceptical that the new capital controls would limit illegal capital flows. One exporter in Beijing said that simply checking documents given to the customs would not expose exaggerated invoices: inspectors would need to examine the actual value of the cargo itself to prove fraud. Moreover if this new process is rigorously applied, the risk is that it will increase the burden on genuine trade.

China’s central bank has faced huge capital inflows for several years and has so far managed to limit the impact on the domestic economy by draining the excess liquidity in the financial system through bonds issues and obliging commercial banks to deposit more money in reserves.

However, there are some signs that the system for sterilising inflows is reaching its limit. The higher reserve requirements are putting heavy pressure on some cash-poor, smaller banks.

Minggao Shen at Citigroup says that the only countries in the world with higher reserve ratios are Zambia, Croatia and Tajikistan and that Chinese levels cannot go much higher.

Moreover, the difference between Chinese and US interest rates means that the central bank is making a loss on its bond issues, which have been rare in recent months.

If the system of sterilising inflows is becoming hard to operate, then the Chinese authorities could find themselves in a trap. Facing inflation at home, the obvious response is to appreciate the currency or raise interest rates. But both those options attract more hot money that will feed inflation.

There are plenty of legal routes to bring capital into China. Foreign residents can deposit up to $50,000 a year and Hong Kong residents have a much higher quota.

But government officials also believe that illegal transfers are taking place – through foreign companies declaring that funds are for direct investment and then putting the money in the bank and exporters exaggerating the value of overseas revenues in order to bring in extra funds. (As an aside, economists point out that if fraudulent export receipts really are widely used to bring in hot money, China’s politically troublesome trade surplus would actually be much lower than thought.)

The authorities announced a new crackdown on this trade route on Wednesday, saying that exporters would not actually receive payment until they could prove to their bank that revenues were the result of real trade transactions recorded by Chinese customs.

However companies and analysts were sceptical that the new capital controls would limit illegal capital flows. One exporter in Beijing said that simply checking documents given to the customs would not expose exaggerated invoices: inspectors would need to examine the actual value of the cargo itself to prove fraud. Moreover if this new process is rigorously applied, the risk is that it will increase the burden on genuine trade.

China’s central bank has faced huge capital inflows for several years and has so far managed to limit the impact on the domestic economy by draining the excess liquidity in the financial system through bonds issues and obliging commercial banks to deposit more money in reserves.

However, there are some signs that the system for sterilising inflows is reaching its limit. The higher reserve requirements are putting heavy pressure on some cash-poor, smaller banks.

Minggao Shen at Citigroup says that the only countries in the world with higher reserve ratios are Zambia, Croatia and Tajikistan and that Chinese levels cannot go much higher.

Moreover, the difference between Chinese and US interest rates means that the central bank is making a loss on its bond issues, which have been rare in recent months.

If the system of sterilising inflows is becoming hard to operate, then the Chinese authorities could find themselves in a trap. Facing inflation at home, the obvious response is to appreciate the currency or raise interest rates. But both those options attract more hot money that will feed inflation.

“We are passed the point when there were easy solutions,” says Michael Pettis, a finance professor at Beijing University.

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