Cheng Xiaonong
During summer in China, the temperature there reached one new height after another. By contrast, the Chinese economy shivered with cold due to money shortage.
In late June this year, the whole of Chinese banking system experienced a sudden financial strain. Some banks had to resort to borrowing usurious loan at a rate of 30% to barely maintain operation; and of the four major Chinese banks, the Industrial and Commercial Bank (ICBC) and the Bank of China (BoC) both experienced temporary “ATM system failure”.
Some media outlets joked that banks of China “staged a thrilling finance blockbuster”; and Gao Shanwen, economist of Essence Securities, called the “money shortage” a 9.0 earthquake in the financial sector.
Why were banks suddenly in short of money? As the central bank released recently the financial statistics for June, it seemed the answer has been revealed. In May and June this year, China’s foreign exchange reserves fell again and again. In that two months, the reserves slumped by $ 37.8 billion.
As a result, people in the media and financial sectors in China became concerned with the hot money that fled the country. Economic Information Daily, a subsidiary of Xinhua News Agency, sent journalists to interview forex intermediaries in the Yangtze River Delta region to find out the movements of hot money; and reporters of Shanghai Securities News went to Luohu, Shenzhen to observe the activities of illegal forex traders.
By late July, the financial “cold front” that hit China didn’t appear to be over, as Shanghai Securities News reported, in July the deposit with the four major banks decreased by almost a trillion yuan.
Since the flow of hot money could trigger a huge impact on the Chinese economy, the Chinese people would naturally want to understand what it is about hot money in China, why it could deliver such an impact and whether or not the mass exit of hot money was caused by forex intermediaries and illegal traders.
I have been tracking the issue of hot money for many years. From my study I concluded that of the foreign capital introduced into China over the past 15 years, the proportion of hot money has been growing, and massive inflow and outflow of hot money occured quite frequently. Therefore, the impact hot money could have on the Chinese economy becomes increasingly powerful.
However, China’s monetary authority often seems to conceal the truth about the outflow of hot money, and that led to misreading among the media and the business sectors. The money shortage this summer was related considerably to a business community that lack understanding of the true situation of how hot money moves in China.
Since media reports concerning the actual situation of the flow of hot money were mixed with not a few misunderstandings, to clarify matters, I have to discuss some basic concepts and data. In this article, I try best to explain the issue in simple language. Those readers who are interested only in the conclusion may as well skip the technical details.
- Exactly How Much Hot Money Is There in China?
Over the years China introduced massive foreign capital, hoping that through industrial investment the desperately-needed industrial technologies would be brought to China, thereby accelerating China’s industrialization.
Once foreign businesses made industrial investment in China, whether in newly-established companies or in joint venture with Chinese enterprises, their capital became long-term investment after plant equipment completed installation and would not be withdrawn so easily.
As opposed to industrial investment, hot money is capital that does not have specific industrial development target and aims only to speculate. It is of course not a good thing when there is more hot money in the foreign capital introduced.
Industrial investment should primarily come from industrialized societies such as Europe, the U.S., Japan, Korea, Taiwan and so on. Therefore, by looking at the composition of the country of origin of foreign capital, one could by and large make out which form of foreign capital dominate the funds introduced: industrial investment or hot money.
From 1997 through to 2008, of the foreign funds introduced into China, those that came from industrialized countries stabilized at about 21 to 25 billion U.S. dollars a year. As the total amount of foreign capital introduced rose, the proportion of industrial investment gradually fell from roughly 60% to about 20%.
According to a “21st Century Business Herald” report on July 29 this year, Cao Hongying, Deputy Director of the Foreign Investment Division of the Ministry of Commerce said, “the main source of China’s foreign investment (EU, U.S., Japan) is basically unchanged.” His remarks confirmed one thing: the amount of foreign funds from industrialized countries introduced in recent years hovered around their previous levels.
Since over the years the ratio of industrial investment of the foreign capital introduced declined markedly, then there is no doubt that correspondingly, hot money surged rapidly in proportion.
In the last decade or so, the predominant part of foreign funds that were introduced into China changed from industrial investment to speculative hot money. Every year, tens of billions of US dollars of hot money enters China. Accumulated year after year, the sum of this hot money has probably reached a staggering amount of hundreds of billions of dollars. This conclusion may seem difficult to accept, but unfortunately, it is true.
2. These Funds Can’t Leave after They Entered into China?
Upon entry to China, hot money, speculative in nature, tends to go into the real estate and stock market. Some may ask: foreign funds buying luxury mansions in China can help shore up the Chinese housing market, isn’t that a good thing? This could indeed be the case. But, is hot money really “stuck” in China after it got in?
China implements forex control, which puts a strict limit to the amount of forex ordinary Chinese people can transfer overseas through legal channels. However, domestic enterprises can make use of the foreign trade opportunities to find ways to transfer their funds abroad; and as for foreign enterprises, they can legally transfer their profits out of China. In addition, individuals and companies with connections too are able to channel forex offshore.
Occurred during the first quarter of this year in Shenzhen were a large number of fake export activities, a common illegal means for capital flight that already existed for years.
In fact, there are in China illicit forex transfer channels that have been deeply concealed for years. They facilitate the to-and-fro of hundreds of billions of hot money. Those forex intermediaries and illegal traders are merely doing some petty business and nothing more.
Given that hot money can easily enter and leave China, traveling to and fro as if without hindrance, should owners of hot money want their funds out of China, the country’s law and institution probably could do little to stop them.
3. Can Movements of Hot Money be Tracked?
To understand the direction of hot money flow, one can observe changes in forex reserves. Usually, there is surplus from China’s foreign trade. Assumed that massive amount of hot money does not flow out of China then, under normal circumstances, forex reserves would be rising slowly. Analysts in China, however, are unable to use this data when they do monthly analysis because, in China, this data often won’t be released until a month after a quarter ended.
An alternative indicator for this would be funds outstanding for foreign exchange (forex funds) in banks. Published every month, this data is convenient for analysis and study. Therefore, general speaking, media and people in the financial sector in China based their judgment of hot money outflow on the decline of forex funds in financial institutions.
In recent weeks, this term has appeared repeatedly in newspapers. China’s forex reserves are composed of two parts: forex acquired and maintained by commercial banks and forex retained by the central bank. When holders sell their forex to banks, the latter would pay in Renmenbi (RMB). The RMB invested amount accumulated this way is represented as RMB-denominated forex funds in the “RMB Credit Balance Sheet of All Financial Institutions” and the “Balance Sheet of the Monetary Authority”. If forex reserves declined, so would forex funds. At the same time this means also that money supply in RMB is reduced and a monetary tightening would take place. That is to say, in the event that the ordinary Chinese people, domestic enterprises and foreign-owned business shift massive amount of funds out of China, money shortage would become a possibility inside the country.
However, when China’s media and people in the financial sector analyze the movement of forex funds, they are often unwittingly trapped in a maze set up by the central bank. Each month when data on forex funds of the central bank and those of financial institutions (both the central bank and commercial banks included) are released, they are denominated in RMB.
The fluctuations of forex funds are influenced by two factors. Firstly, it is the changes in the amount of forex reserves as denominated in U.S. dollar; secondly, it is the variations in exchange rate of RMB when forex funds are calculated.
From January 2011 through to June 2013, the exchange rate of RMB against forex funds stayed consistently at around 7.8. But there’s a catch: whenever forex reserves decreased sharply (by over 1%), the central bank would lower the RMB exchange rate when it calculates the amount of forex funds, so that the reduction in forex funds would appear smaller than it truly is. The central bank would then gradually raise the RMB exchange rate back to 7.8 in months that follow. And in months with huge influx of hot money, the central bank would raise the RMB exchange rate and then slowly lower it back month by month. In so doing, the volatility of forex funds is reduced, creating an impression that the flow of hot money doesn’t pose too big an impact.
Because of this, the monthly changes in forex funds become confusing. Sometimes even the professionals are fooled.
If the influence of fluctuating exchange rates is excluded, and use instead a MoM constant exchange rate (exchange rate of the previous month) to calculate the amount of forex funds, one would discover that, whenever the central bank adjusts the exchange rate in its calculation of forex funds of the month, the figure it announces would deviate from the amount calculated with the MoM constant exchange rate.
Sometimes, it actually turns out that the changes of the two figures would be headed for opposite directions.
For example, foreign reserves declined in September 2011, March and May 2012, and February and May 2013, yet the forex funds figure released by the central bank showed the amount had gone up.
On the contrary, when forex reserves increased in October 2011, August and November 2012, the forex funds figure by the central bank indicated a decline instead.
Without doubt, if people in the media and the financial sectors judge the movement direction of hot money purely according to the adjusted forex funds figures released by the central bank, their reading of the situation would surely be full of mistakes.
4. Is Hot Money Stationary in China or Is It erratic, Going in and out Frequently?
I used the MoM constant exchange rate to calculate the figures of forex funds from January 2011 to June 2013 and found out that hot money in China does travel to and fro frequently. For example, in the past two and a half years there were several counts of hot money fleeing China, all actually in scale similar to the one that took place between May and June this year, even though the financial sector and the media didn’t pay much attention to them back then.
Although the central bank announced that the amount of forex funds for June reduced only by 41.3 billion yuan, the actual reduction was, if calculated using the MoM constant exchange rate, 314.2 billion yuan.
Even more surprising was that, there were several other occasions of hot money fleeing China, at scales much larger than this. For instance, the reduction of forex funds in September 2011, as calculated using MoM constant exchange rate, was 483.4 billion yuan; in November and December 2011, the sum of forex funds slumped by another 716.4 billion yuan; in May 2012, 709.5 billion yuan of forex funds vaporized.
In fact, if the RMB-denominated forex funds of commercial and financial institutions are observed (by subtracting the forex funds figure showed in the “Balance Sheet of the Monetary Authority” from that appeared on the “RMB Credit Balance Sheet of Financial Institutions”), it would also be possible to discover the trends of movement of massive hot money. I am not going into the details here.
Of course, if hot money simply flees China for good and never returns again, the Chinese economy would have suffered a huge blow long ago, and money shortage there would also have long been earthshaking.
But in fact, hot money travels to and fro China frequently, and its movements appear somewhat erratic. I analyzed the fluctuations of forex funds during the past two and a half years and concluded that there were some large scale inflows of hot money between April and June 2011; and a small scale inflow took place again in August 2011; then again in January and September 2012 and January and April 2013, there were inflows of hot money while in September, November and December 2011, April and May 2012, and May and June 2013, outflows of hot money occurred, as discussed above.
Who own this hot money, the scale of roughly one-tenth of China’s monthly GDP that goes in and out of China so frequently, and what impact(s) would it have on the Chinese economy? I will go into that in my next article.
