China’s Cold Eye on Hot Money

BEIJING – With China feeling the pressure from large-scale inflows of short-term capital, the State Administration of Foreign Exchange (SAFE) issued a notice in early May outlining a set of measures aimed at controlling “hot money” and reducing external risks. Indeed, the new regulations are essential to managing the renminbi’s rapid appreciation and ensuring the accuracy of trade data. But will they be enough?

A variety of data indicates the massive scale of the inflows. In the first quarter of this year, Chinese banks’ foreign-exchange purchases skyrocketed to a record ¥1.2 trillion ($195 billion) – more than double last year’s total. Such purchases increased by some ¥294.3 billion from March to April, which was the fifth consecutive month of growth.

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Over the same period, China’s foreign-exchange reserves swelled by $128 billion, to $3.4 trillion – the largest quarterly increase since 2011 and equal to the total rise in 2012. Given China’s $43 billion trade surplus and $30 billion in foreign investments during this period, capital inflows must have been a contributing factor.

Furthermore, since the beginning of this year, Chinese banks’ valet foreign-exchange settlement (foreign-exchange purchases that designated banks make for their clients and themselves) has outstripped corresponding sales, resulting in a consistently large surplus – also an indication of increased capital inflows. The difference, which banks offset through transactions in the inter-bank currency market, has a significant impact on China’s foreign-exchange reserves, but is not equivalent to the net change in foreign-exchange reserves during the same period.

According to SAFE, individuals and institutions exchanged $152.2 billion in foreign currency for renminbi through Chinese banks in March, and purchased $107.6 billion in foreign currency from financial institutions. As a result, the banks’ foreign-exchange surplus reached $44.6 billion, rising 38% from February and marking the seventh consecutive month in which bank-to-client transactions created a surplus.

The consequences of abnormal capital flows into China are becoming increasingly apparent, particularly in foreign-exchange markets. Despite slowing GDP growth – currently only 7.7% annually – the renminbi has appreciated rapidly, reaching a record-high central parity of 6.2082 against the US dollar at the beginning of May.

With no sign of improved economic fundamentals, the renminbi’s rapid rise must be related to substantial foreign-currency inflows. Since China’s current benchmark interest rate is higher than the comparable rate in the United States, individuals and institutions have an incentive to keep renminbi as assets and dollars as debt. The current round of monetary easing underway in many advanced countries, together with strong expectations of renminbi appreciation, are also fueling currency speculation, placing further upward pressure on the exchange rate.

The new SAFE regulations will attempt to curb this trend by imposing, for the first time, limits on net open positions held by Chinese banks with foreign-currency loan/deposit ratios (LDRs) exceeding 75% and by foreign banks with LDRs above 100%. A higher foreign-currency LDR will mean tighter restrictions on long renminbi positions. By providing an incentive for banks to hold more foreign-exchange deposits against their loans, the new rules will drive up the price of foreign-currency loans, thereby deterring firms from using dollar loans to speculate on renminbi gains.

Although the regulations did not take effect until June 1, their impact was felt immediately. The renminbi ended its upward trend against the US dollar on May 6, closing at 6.1667, down 112 basis points from the previous trading day – the steepest decline since last December. On the same day, stricter controls on capital inflows caused the offshore renminbi to close at 6.1790 against the US dollar, down 0.4% – the largest drop since January 2012. This suggests that the measures will succeed in stemming upward pressure on the renminbi.

At the same time, the new regulations aim to end many firms’ practice of channeling capital into China disguised as trade bills. By inflating export deals in order to move foreign currency – mostly US dollars – into China, firms have evaded capital controls and distorted trade data. In order to transform the funds into renminbi outflows, the firms then increase the scale of renminbi settlements in cross-border trades. In March and April, cross-border renminbi trade settlement increased by ¥412.8 billion, up 57.6% year on year.

The growing discrepancies between foreign-trade data and port data have cast doubt on the reliability of the former. Last year, China’s exports grew by roughly 6.2%, and container throughput completed at China’s above-scale ports increased by 6.8% year on year.

By contrast, in the first quarter of this year, Chinese foreign trade increased to $974.6 billion, reflecting a higher growth rate than in 2012, while Chinese ports completed 800 million tons of cargo throughput, representing a growth rate that was 4.2 percentage points lower than in the same period last year. In March, container traffic at China’s above-scale ports was 15.29 million TEUs (twenty-foot equivalent units), with month-on-month growth 1.7 percentage points slower than in the previous two months.

Clearly, trade data are being inflated as companies carry out fake transactions to bring capital into the country. Firms know that as long as the hot money can reach mainland banks through Hong Kong, they can expect risk-free yields of more than 2%. Considering the renminbi’s recent appreciation, the rate of return could reach 3-4%.

According to the new regulations, SAFE will issue a warning ten days after finding that a firm’s capital flows do not match its physical shipments. Such firms will be more closely monitored for at least three months, until the relevant figures return to normal.

One can only hope that these measures will be sufficient to bring China’s export data gradually back to reality. At a minimum, the new measures are an important step toward improved management of cross-border capital flows, which is bound to benefit China’s economic transformation and restructuring significantly.