Feeling the heat

Zhu Baoling, deputy chief of the State Information Center’s economic forecasting department, sent ripples through China’s financial world in April when he announced that hot money inflows had reached US$80 billion in the first quarter of the year. This compared to hot money inflows of around US$120 billion for the whole of 2007, he said.

Speculators may be setting their sights on China because of the seemingly unstoppable rise of the renminbi. The yuan gained more than 4.2% against the dollar in the first quarter alone, and analysts expect the currency to keep rising this year. This gives speculators more incentives to pump hot money into the country.

“In reality, what’s encouraging hot money flows is the expectation of further yuan appreciation,” said Logan Wright, an analyst with economics research firm Stone & McCarthy in Beijing.

Wright said his own estimates put the amount of hot money at around US$100-120 billion in the first quarter, a figure he calls “unprecedented.”

Economic implications
The boom in these speculative inflows of foreign capital – which may go into real estate, the equity markets or currencies – signals a looming crisis for Beijing’s economic planners and may have dire consequences for the economy as a whole.

Because China controls its exchange rate, it must purchase every dollar that is brought into the country either by printing more yuan or by issuing central bank notes. Strong inflows of foreign capital can therefore lead to inflation, risky lending, excessive debt and asset bubbles.

The worst-case scenario is a meltdown along the lines of the Asian financial crisis, in which speculators withdraw their hot money suddenly and en masse, causing the yuan to collapse. Similar problems in the property and stock market would compound the damage, lowering domestic consumption, which in turn hits enterprises’ bottom lines. The result could be a new round of non-performing loans in the banking system, Wright said.

However, any solution to the current problem is likely to cause pain in some parts of the economy.

“All the risks we were worried about, plus some we weren’t expecting, seem to have hit us at the same time,” said Michael Pettis, a former managing director at Bear Stearns, who now teaches finance at Peking University.

 The inflows of hot money signal that China’s attempts to tighten monetary policy have been largely ineffective, said Tan Yaling, a senior economist with the Bank of China’s institute of global finance in Beijing. According to Tan, one reason is the widening spread between American and Chinese interest rates: US rates have been lowered to fight the credit meltdown, while Chinese rates are rising.

“By the end of last year, China began to adopt a tighter monetary policy to curb over-liquidity and to fight against international speculative capital,” she said. “In truth, this policy has had little effect on reining in hot money inflows.”

Staying cool
China’s massive foreign exchange reserves – which reached US$1.68 trillion by the end of March, according to the State Administration of Foreign Exchange (SAFE) – will enable it to defend against large capital outflows for some time.

But dipping into forex reserves is far from ideal. Blocking the inflows is better, although doing so is far from easy. One possibility is a one-off revaluation of the yuan. Investment bank JPMorgan said in a recent research note that it believes there is growing debate in Chinese policymaking circles about another revaluation on the order of 10-15%, a development the bank called “very surprising.”

“Although we still believe the odds of such a move are small (less than 50%), it is much higher than the 10-20% odds we had before,” JPMorgan said.

The negative effect such a move would have on Chinese exporters, who drive a significant part of the country’s economy, will make a big revaluation unpalatable for policymakers.

“There’s still a consensus that they’re not going to do a maxi-revaluation. It would be difficult politically,” Pettis said.

Another possibility, Tan says, is a series of “mini devaluations” of the renminbi in the near term. She said she couldn’t give a specific figure for such a devaluation.

Beijing could also widen the yuan’s trading band – which currently stands at 0.5% on either side of the central parity rate – and boost inter-agency cooperation, said Zhang Ming, a researcher at the Research Center of International Finance at the Chinese Academy of Social Sciences.

“SAFE and Chinese Customs should strengthen their cooperation in terms of data sharing, so that the two can better identify artificial trade activity,” he said.

Regardless of the method China adopts, curbing inflows of hot money is likely to be a painful process.

“There are no cheap or easy options,” Wright said. “You’re only living with the least-bad options at this point.”