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By Hu Yuanyuan (China Daily)
Updated: 2008-07-07 14:11

Getting in

But how does speculative money get past the Chinese government's strict capital controls? A survey by Deutsche Bank found enterprises bring hot money into China by the following means: 52 percent of such funds come in the form of FDI; 21 percent, evenly split, come from under-invoicing imports or over-invoicing exports; 8 percent is foreign donations; 5 percent comes through money exchange by underground money changers; and the rest comes from various other means, including paying local employees or service providers in foreign currency and borrowing in foreign currency.

A strange thing with hot money in China is that given its nature, one would think it would leave the Chinese market the moment stock and property sectors began to plunge at the end of last year. But in reality, China seems to be pulling in more hot money these past months. So, where exactly is this money going?

The sluggish stock market can safely be ruled out as a destination. According to Zhang of the Chinese Academy of Social Sciences, much of the hot money may be parked in the form of ordinary bank deposits. An interest rate of over 4 percent on yuan deposits compared with 2 percent on dollar deposits, combined with expected renminbi appreciation, offers these deposits at least 12 percent annual returns, a figure particularly attractive in the backdrop of a stagnant global economy.

Another option, Zhang adds, is the private lending market along the coastal areas. Since the government started to tighten credit controls, companies have been looking to borrow on the international market. Low interest rates globally have created an abundant capital supply for Chinese borrowers. To dodge regulatory supervision, this type of money comes in the guise of a short-term stake acquisition deal with local enterprises, which buy back the stake a few months later at a higher price.

Massive hot-money inflows present two major threats to China's economy. One is that capital can suddenly flow out, as it did from other East Asian countries during the financial crisis in 1997, and Vietnam this year.

"Their decision on whether or not to keep their money in China will hinge on other factors - mainly the opportunity cost of holding money abroad relative to the expected returns of holding money in China," says Ma Jun, chief economist of Deutsche Bank (Greater China).

Michael Pettis, a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets, says if the yuan's trading in the 5.50-6 (to a US dollar) range coincides with a financial market collapse or a sharp economic downturn, China might witness a sudden and massive capital outflow. "But the key thing here is the condition of the market, not just the level of the renminbi," Pettis says.

Because of China's vast foreign exchange reserves and trade balance, hot money outflow by itself is not the prime concern. It is the tight money supply that would inevitably follow such an outflow that makes experts like Zhang worry.

A more immediate concern is that capital influx through irregular channels will fuel inflation. Since the central bank must monetize these inflows - either by issuing currency or by issuing central bank bills - hot money ends up adding to the country's monetary base and makes the monetary policy more difficult. If the central bank raises the interest rates, higher rates would attract yet more hot money. If not, there will be more inflationary pressure. So the central bank has instead tried to curb inflation by allowing the yuan to rise at a faster pace against the dollar - by an annualized rate of 18 percent in the first quarter of this year. But this, in turn, has bolstered expectations of further yuan appreciation, bringing in even more hot money.

To combat this growing menace, the government is now increasing the supervision over capital flows. The State Administration of Foreign Exchange (SAFE) is watching yuan bank accounts held by non-resident individuals or organizations more closely. Banks in eight provinces have been asked to submit data on yuan accounts opened by non-residents to the SAFE. Moreover, banks in these regions are required to submit monthly statistics showing outstanding deposits and loans.

Because of these efforts, the growth of China's foreign exchange reserves did slow in May. It increased by $40.3 billion that month, around half of the rise in April, according to media reports.

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