The facts end there û and the debate about whether China is suffering from speculative capital inflows begins. Many in Beijing and Shanghai are convinced that that æhotÆ money has got around ChinaÆs border controls and that a chunk of the current appreciation pressures on the renminbi have come from these speculative flows. As a result, opposition to RMB appreciation has strengthened in some quarters in recent months. On the other hand, some market analysts dismiss the æhotÆ money story, arguing that all the current pressure is real and fundamental and that appreciation is really the only sensible way to solve the current imbalances. Hot money is an unhelpful digression.
Which leaves us with some questions. Has hot money really been flooding into China over the past few years? And if yes, then what should Beijing be doing about it? We at Standard Chartered have spent the last few months marshalling evidence that suggests that hot flows have indeed been occurring. Here are our main reasons.
Look at Chart 1, which shows the money coming into China that is not generated by the trade surplus, by foreign direct investment (FDI) or by the interest payments made on ChinaÆs FX reserve investments overseas each month. As is clear, a lot of æotherÆ money was coming in during 2003-05. Now, of course, some of this money was entirely legitimate, including things like the money that foreign banks were bringing in from offshore to lend their customers onshore. But we suspect that a chunk of it was not, that it was æhotÆ money, hot in that it was entering China in the hope of a quick profit and would leave whenever that profit was made.
But of course, the authorities soon became aware of these flows, and the potential that these various types of transaction had to facilitate æhotÆ inflows. So they clamped down. During 2004-05, the SAFE issued various edicts which made it harder to borrow from offshore, etc. As a result, we believe that this concentrated the minds of those wanting to import funds into China, and they ramped up their use of trade transactions to achieve this end.
China is a massive trading nation û some $1.6trn worth of trade will be done this year, 65% of GDP. Much of this trade is done by foreign-invested entities (FIEs), trading with connected parties offshore. All it needs is for a relatively small number of these firms to start boosting their export invoices, and they can bring in extra dollars and exchange them legally at the local bank for renminbi. Invoice massaging was suspected in the 1990s as a means of taking money out of China. We (as well as many in Beijing now) suspect that it is happening the other way now.
In April we published provided evidence of these flows. We looked at the difference between ChinaÆs export numbers and the import numbers provided by its trade partners, and found that since 2002 the gap had been steadily declining, as Chart 2 shows. The declining trade gap said to us that Chinese firms were exaggerating their exports. This was about the same time that the offshore non-deliverable forwards (NDF) market was signalling that the market was moving to the view that the RMB was not going to devalue but instead appreciate.
We also looked at the trade balance that FIEs run in China û and discovered that while this sector was running roughly a balanced trade account with the outside world until 2004, that it suddenly moved into sharp surplus starting in 2004, shown in Chart 3. Which suggested to us that many FIEs were boosting their export numbers.
There is other evidence of æhotÆ flows too. We had a look at the line on the balance of payments account which records income on investments made overseas. This skied in 2004-05, far more than might be expected from increasing official FX reserves. We suspect that firms were bringing in funds from overseas, claiming they were returns. At the same time, we looked at the amount of profits that FIEs in China were remitting offshore û and the returns simply stopped growing in 2003. We think that a lot of this internally-generated æhotÆ money was kept onshore because of RMB appreciation expectations.
If this was not enough, we also looked closely at the errors and omissions (E&O) line on the balance of payments (BoP). This is the line which makes everything balance. On one side, the BoP counts all the flows of FX in and out of China through trade, direct and portfolio investments, plus a bunch of other stuff like trade credit, bank loans, returns on investments and the like. All these flows are reported and known. On the other side is the increase in the countryÆs FX reserves. In any given period, the net inflow in the first should equal the increase in the second. When they do not, E&O makes everything balance.
In 2005, two International Monetary Fund (IMF) economists, Eswar Prasad and Wei Shang-jin showed that E&O, at least in recent years, was explained by ævaluation effectsÆ. In other words, since the dollar value of ChinaÆs FX reserve investments in euro, yen etc. assets changes with exchange rates so the E&O was simply adjusting for this effect. We decided to take another look at the E&O and found something very interesting. We estimated what the effect of the valuation changes should have been, and discovered that in H2 2004 and H1 2005, the E&O is bigger than what one would expect from valuation effects. In other words, unexplained money was coming into China. Then in H1 2006 the opposite thing occurred û the E&O was much lower than the valuation effect, suggesting that hot money had begun to flow out of China. Chart 4 shows the difference between the valuation effect and the E&O; positive numbers suggest hot inflows, negative hot outflows.
We are not claiming that either all or even the majority of flows into China have been æhotÆ in recent years, as one or two analysts seem to have suggested we are saying. We agree that the large majority of the trade surplus has been real. And we also admit that putting a number on these flows is very hard. But looking across our charts, we find it almost impossible to believe that hot money has not been coming into China through any route it can. The head of SAFE recently announced that they were investigating some 5,300 firms which they suspect of exchanging more funds into RMB than their real trade needs warrant, a remark that suggests to us that SAFE believes the æhot money through the trade accountÆ story as well.
Why would hot money have come into China? And why would it be leaving now? Certainly, there was the RMB û and back in 2003-04 the possibility of a big one-off revaluation existed and was widely rumoured. Since then, Beijing has proved itself more than able to stand up to WashingtonÆs rhetorical posturing û and the extent of internal opposition to a significant or fast appreciation has been recognised. The expectation of RMB appreciation is now 3-4% against the dollar over a 12-month period. The loss elimination of big win has perhaps persuaded some money to go elsewhere, but we remain doubtful that RMB appreciation was the main attraction for fund inflows.
We are more sympathetic to the view that the rumours and then actual crackdown on residential real estate price growth in Q1-2 2006 played an important role. Asset prices growing at 20%+ is a big enough motive for people to import funds, with the assumption that the exchange rate can only go one way. This does not have to be foreign money û many PRC individuals would have thought that this was a good time to bring back money stashed overseas. As property price growth has slowed (albeit not stopped û although with all the taxes et al. the profitability of the play has been seriously undermined), the easy money has been made, thus causing flows to slow and perhaps reverse.
This is the story that Charts 1 and 4 tell; hot money inflows and then outflows. What are the policy consequences? In contrast to the ôWe should defend the RMB against all this foreign speculationö school, we think that hot inflows strengthened the case for a more rapid appreciation, 5% over the course of, say three months, for instance. This would delivered lots of bang for oneÆs buck. Now the opposite seems to be occurring; hot outflows. And if this is indeed what is happening (we would like to see more evidence), then the current course of slow appreciation seems to make sense.
To add to that hot outflow story, cold money also seems be leaving China û and we think more will go over the next two years. Start with ChinaÆs insurance companies, who had a total of Rmb1,757.8 billion ($220 billion) in investible assets sitting on its collective books by end June 2006. If they were to take 20% offshore to escape their exposure to low/falling onshore yields, then that would be $44 billion worth of outflow, about two months worth of FX inflow at present.
Second, there is the National Social Security Fund (NSSF) which had investible assets worth Rmb255 billion ($32 billion) by the end of 3Q 2006. The NSSF is thought to be well run and it has only just appointed two banks as its custodians for its first offshore investments (which the media reports are earmarked at $5-10 billion). The NSSF is also likely to be given management of at least some of the provincial pension funds, which might add another $10-12 billion to its offshore investments).
Then there is the Qualified Domestic Institutional Investor (QDII) scheme, where total quotas worth $12.6 billion had been issued by November 3rd. The initial response has not been huge, one general explanation being RMB appreciation expectations. However, the potential is still there, particularly as USD-RMB moves lower and a wider variety of products are launched.
This is all shown in Table 1. Adding up the insurance ($44 billion), NSSF ($5-$10 billion, plus $12 billion from the provincial pools) and QDII ($12 billion) gets us to $61 billion in 2007, some $75 billion over 2006-08, and potentially a lot more in the near future. That would do something to ameliorate the $15 billion+ trade surplus et al. But it clearly will also require appreciation and getting rid of the manifold tax incentives for export that China currently offers. But as part of the package, it will help.
Stephen Green is a senior economist at Standard Chartered Bank in Shanghai.