Banking on cooler inflows of hot money

CHINA ECONOMIC QUARTERLY

(This article originally appeared in the January 19, 2004 issue of South China Morning Post in Hong Kong and is reproduced here with permission from the publisher)

One of the least-noticed aspects of the bailout of two of China's big banks was its impact on foreign reserves, inflation prospects and monetary policy.

On December 31, the People's Bank of China took US$45 billion out of its huge stockpile of foreign reserves and parked equal chunks in the China Construction Bank and Bank of China. As everyone observed, this new capital will help the two state banks list on international stock markets within the next year or so.

What almost no one observed was the impact of this transfer on the national reserves. The People's Bank announced that at year end, total foreign currency reserves were US$403 billion.

Without the bailout, therefore, reserves would have been US$448 billion. This means reserves increased by a staggering US$162 billion during the year. The trade surplus (US$26 billion) and foreign direct investment (probably about US$52 billion) account for less than half of that figure. Much of the remaining US$80 billion or so represents "hot money" flowing into China, betting on a currency revaluation. What is more, those inflows accelerated dramatically during the year. In the first quarter, China's reserves increased by US$30 billion, followed by increases of US$31 billion and US$37 billion. In the fourth quarter, they rose by US$64 billion.

These figures strongly suggest that the injection of reserves into the banks was timed not only to prettify the banks' year-end accounts, but also to disguise the fact that the problem of hot-money inflows is growing worse, not better.

In theory, China's closed capital account should mean that it is immune to such inflows (or to the reverse problem of capital flight). In reality, there are many ways to get around exchange controls if you can get your banker to co-operate.

The State Administration of Foreign Exchange is well aware of the problem and late last year launched a broad investigation into the foreign-exchange practices of the nation's banks. Although it did not publish any figures on illegal capital transactions, it did reveal a variety of tricks used to bend or break the rules against capital transfers.

These included: the illegal conversion of foreign-currency loans into yuan; the creation of bogus trade transactions; disguising capital infusions as transfers to personal accounts; and illegal foreign-currency loans to domestic enterprises (for the purposes of betting on a yuan revaluation, taking on foreign-currency liabilities is just as good as taking on yuan assets). Some banks simply falsified their records of foreign-currency transactions.

The flood of foreign currency matters because it can pump up inflation. If US$1 billion enters the country and is then sold to the People's Bank, 8.3 billion yuan of new money is injected into the economy. The increase in the money supply should stoke price rises.

So far, this effect has been muted because, since last April, the People's Bank has been taking that extra yuan out of the market by selling central bank bills to the banks.

But the last few auctions of central bank bills failed, because the interest rate is capped at a miserly 2.5 per cent. With inflation expectations now rising, banks want a better return on their money. In addition, the bank's reserve ratios are now so low that they have little ability to buy the bills.

The bailout provides a temporary respite. With US$45 billion in fresh capital, the Bank of China and China Construction Bank now have sufficient reserves to buy more central bank bills; and swallowing the low interest rate is probably one of the hidden prices of the bailout. But this is a stopgap; how the People's Bank stems the inflow of hot money will be a crucial question for this year.