The Economist on Hot Money and the Dramatic Growth in China’s FX Reserves

I had grumbled recently that the financial press had not paid any attention to the simply stunning rise in China’s foreign exchange reserves, which were estimated to have increased by $75 billion in April alone. Brad Setser and Michael Pettis have been reporting regularly on this beat, but it has gone undernoticed in the wider world.

That’s beginning to change. Brad Setser pointed approvingly to an article in the Economist, “Hot and bothered,” which gives an overview of the issue and explains why it poses a problem to China.

From the Economist:

[Although China’s trade surplus has started to shrink this year, its foreign-exchange reserves are growing at an ever faster pace. The bulk of its net foreign-currency receipts now comes from capital inflows, not the current-account surplus.

According to leaked official figures, China’s foreign-exchange reserves jumped by $115 billion during April and May, to $1.8 trillion. In the five months to May, reported reserves swelled by $269 billion, 20% more than in the same period of last year. But even this understates the true rate at which the People’s Bank of China (PBOC) has been piling up foreign exchange….

Mr [Logan]Wright [a Beijing-based analyst at Stone & McCarthy, an economic-research firm] reckons that total foreign-exchange assets rose by an astonishing $393 billion in the first five months of 2008 (see chart), more than double the increase in the same period last year.

China’s trade surplus and foreign direct investment (FDI) explain only 30% of this. Deducting investment income and the increase in the value of non-dollar reserves as the dollar has fallen still leaves an unexplained residual of $214 billion, equivalent to over $500 billion at an annual rate. Some economists use this as a proxy for hot-money inflows. But some of it may reflect non-speculative transactions, such as foreign borrowing by Chinese firms. Mr Wright therefore estimates that China received up to $170 billion in hot money in the first five months of 2008. This far exceeds anything previously experienced by any emerging economy.

Michael Pettis, an economist at Peking University’s Guanghua School of Management, reckons that speculative inflows during that period were perhaps well over $200 billion, because hot money also comes into China through companies overstating FDI and over-invoicing exports….

Massive hot-money inflows present two dangers to China’s economy. One is that capital could suddenly flow out, as it did from other East Asian countries during the financial crisis a decade ago and Vietnam this year. China’s economy is protected by its current-account surplus and vast reserves, but its banking system would be hurt by an abrupt withdrawal.

A more immediate concern is that capital inflows will fuel inflation. The more foreign capital that flows in, the more dollars the central bank must buy to hold down the yuan, which, in effect, means printing money. It then mops up this excess liquidity by issuing bills (as “sterilisation”) or by lifting banks’ reserve requirements. But all this complicates monetary policy. China’s interest rates are below the inflation rate, but the PBOC fears that higher rates would attract yet more hot money and so end up adding to inflationary pressures. The central bank has instead tried to curb inflation by allowing the yuan to rise at a faster pace against the dollar—by an annual rate of 18% in the first quarter of this year. But this encouraged investors to bet on future appreciation, exacerbating capital inflows. Since April the pace of appreciation has been much reduced, in a vain effort to discourage speculators.

Some economists argue that the problems caused by hot money have been exaggerated. After all, the PBOC has so far succeeded in sterilising most of the increase in reserves. Inflation…

The snag is that money-supply growth would explode without sterilisation, which is now close to its limit. It is becoming very costly for the central bank to mop up liquidity by selling bills, so it is now relying more heavily on raising banks’ reserve requirements…But it cannot climb much higher without hurting banks’ profits…

One solution would be a large one-off appreciation of the yuan so that investors no longer see it as a one-way bet. This, in turn, would give the PBOC room to raise interest rates. The snag is that the yuan would probably have to be wrenched perhaps 20% higher to alter investors’ expectations, and this is unacceptable to Chinese leaders, especially when global demand has slowed and some exporters are already being squeezed.

This is weirldly looking like the reverse of a run on a currency, the prototype of which was Soros’ famed raid on the pound. Speculators start selling a currency that has bad fundamentals, which generally means a big current account deficit and little in the way of foreign exchange reserves. The central bank attempts to defend the currency by purchasing it, but that game is limited by how much in FX reserves the country has. The currency traders know they can outlast the central bank and force a devaluation.

Here we have the mirror image of that situation, although there are two big differences. The first is that while China still has a large current account surplus, it is declining. The big driver of this dynamic is the hot money itself. So the question becomes can China stand inflation long enough for some of these hot money traders to become discouraged and withdraw. or will delay merely convince them that the eventual revaluation will be even greater, thus encouraging even more money to flood in?