The regulators watching the official launch of Shanghai’s free trade zone (FTZ) on Sunday are surely anticipating a headache brought on by a quick exit of cash from the country.
Officials have promised to liberalize interest rates and allow for a freely convertible yuan within the zone. They say foreign banks will be able to establish wholly owned branches without hassle. Business will prosper on preferential tax treatment and reduced red tape.
That’s not all that would flourish in such an environment. Arbitrage, or cashing in on the price differences between two markets, is expected to be a major problem. So is the hot cash outflow from investors looking for better markets in which to put their money given the paltry returns at home.
As the rules for the FTZ are still unknown, it’s unclear the extent to which the zone will allow arbitrage, which has lead to large inflows of cash into China in the past year. It is not known if special rules formulated for operations inside the zone will be allowed to spill into the rest of China. But lugging suitcases of cash into the 30 square-kilometer area seems highly unlikely at present.
If banks can open a representative office in the FTZ but offer deregulated services to the outside world, this would be akin to liberalizing the yuan across the country. At least at first, activities will be heavily restricted to avoid, among many things, a rush of hot inflows and outflows of cash.
“Proposals to loosen capital controls, for example, would open massive arbitrage opportunities for any firms able to shift money in and out of the zone,” London-based Capital Economics said in a note.
Trade arbitrage is easy, and it’s already prevalent in China. Traders in southern provinces roiled the country’s trade data in the first half of the year when they brought hundreds of millions of hot dollars into the country and cashed in on differing exchange rates.
Here’s one way to arbitrage exchange rates, according to Bank of America Merrill Lynch: First, a trader on the mainland borrows US$1 million and converts that into yuan. Then he imports something with low logistics costs, such as gold, from a business partner in Hong Kong. There the money becomes offshore yuan, which in May is worth more than mainland yuan. The partner then converts the offshore yuan to US dollars. Finally, the trader exports the product, bringing the dollars back to the mainland.
In May, the deal could have yielded more than US$8,000 on the difference in value between onshore and offshore yuan.
In the past year, since exchange rates have become profitable, the practice inflated China’s export data. Last May, exports grew year-on-year by 17.3%. Yet economists said real growth was probably about 5%. A crackdown by the authorities on arbitrage that month caused June exports to contract by 3.1%, demonstrating just how much the numbers earlier in the year had been twisted by arbitrage.
Perhaps more threatening than hot inflows is a quick flush of money out of the country, something that could drain liquidity from the market and push a country heavily dependent on easy access to credit toward a crisis.
Hot outflows are already common in China but strict limits on convertibility have prevented a wave of cash heading outward.
Regulators are surely tracking the rate at which the zone opens up compared to sluggish domestic financial reform. Investment opportunities in the stock market are abysmal and real estate and coal mining investments are still speculative and risky. The prospects for freely converting yuan and investing it abroad will be highly sought out should the zone offer such opportunities.
One way to prevent large, unregulated movements of money via the FTZ would be to require all cash moving in and out be matched to a government-approved contract, said a Shanghai-based lawyer who spoke on condition of anonymity. If a bank loans money from inside the zone to a company on the outside, the contract would be a record of that movement and potentially prevent hot flows.
Yet with each step the government takes to regulate cash flows, it dampens the prospects for investment in the zone. Beijing will need to take on a high level of risk if it’s going to entice investors to turn its pet project into a functioning reality. Full realization of what the government has promised for the zone will likely lead to massive arbitrage as well as an outpouring of hot cash.
The investment world is waiting for details on the zone. So are arbitragers and investors sitting on piles of cash. When announced, Beijing will show just how much capital it’s willing to let pass through that door.