Capital untied from fixed assets, liudong capital in Chinese, is called liquid because it flows. But unlike water, it seeks to flow to higher places, in search of higher appreciation and interest yields.
In January 2008, US$30 billion in "hot money" was added to China’s foreign exchange reserves via unspecified channels. The inflows were equal to increases booked for net export and FDI inflows. Also flowing in was a kind of "warm money" that crossed the border through trade invoicing fraud, captured in the net export figures, but not representing actual exports.
Hot money converted from US dollars to renminbi profited from steady renminbi appreciation against the US dollar and steep gains in investment asset classes, including A-shares and prime real estate.
With the global crisis and domestic policy actions, the source of these attractive gains vanished: the A-share market is down about 70% from its October 2007 peak and high-end property prices began to slide in the second half of 2008. Beijing’s concerted effort to cool the economy gained traction just as the icy winds of declining demand in North America and Europe blasted through China’s export sector.
The renminbi changed direction in July, peaked in September, then sank into its current narrow trading band. Hot money flows reversed.
Size and scope
Understanding the size, impact and response to these flows is key to assessing China’s ability to recover from the current slump and the shape any recovery may take.
In midsummer, published estimates of total potential hot money outflows ranged from US$600 billion to US$1.7 trillion. These were based on historic estimates of inflows plus appreciation. Some of the same analysts now put fourth quarter outflows at US$60 billion-US$100 billion.
Evidence of outflows remains indirect, a calculation of otherwise unexplained gaps in the foreign exchange account. But more and more reports argue that outflows are growing and will do so at least until the second half of 2009.
If correct, the US$100 billion estimate represents about 17% of the total value of China’s US$586 billion main stimulus package, and nearly 28% of stimulus capital that Beijing said must come from outside its own coffers.
Putting outflows in the context of the stimulus plan is highly relevant to seeing their dimensions and impact.
First, the outflows are both a response to declining property values and increasingly a source of strong downward pressure. Residential construction is the top priority for stimulus, so accelerating outflows will exacerbate the problem just as the government prepares to pump in more money. It also aggravates a contradiction already inherent in the stimulus program, whether to shore up the value of prime investment-grade real estate or focus government resources on affordable housing.
Secondly, the many stimulus projects announced will force a redirection of available domestic capital for other needs during a cycle of liquidity decline. It makes sense to direct resources to construction, thereby driving employment, steel, cement, transport and other flagging state-owned sectors. But where will the capital come from to grow China’s robust small- and medium-sized enterprise (SME) sector? These players need capital for growth in high-value markets. If they are deprived of funding then near-term stability could come at the expense of long-term reform of the new economy.
Open the door
If there is a happy answer to this quandary it is that regulators can enable the next great step in China’s opening, and facilitate productive cross-border investment.
Billions are accumulating right outside China’s doors, with frustrated fund managers watching funds grow and deals decline. Much of this money is looking for targets in education, retail, financial services, technology, entertainment and other high employment, wealth creating sectors.
Facilitation means simplifying approvals, currency conversion and cross-border capital account procedures. This is China’s moment to begin these steps, to protect its own recovery interests.
Many forward-looking economists and bankers in China see this and have argued for urgent reform of cross-border investment practices. But when and if top leaders will open the door to more foreign capital, especially from financial investors, remains to be seen. So far, it has been a rather quiet topic as the crisis unfolds.