Hot money inflow too hot to handle

The Chinese economy may have caught a cold but it remains very attractive for speculative "hot money". And despite allowing the yuan to rise strongly, the authorities have not been able to handle the situation in a proper and coordinated manner.

The first quarter of the year has given enough indications that, despite the slowdown in the Chinese economy, foreign capital has been flowing in to cash in on the yuan's appreciation and relatively high interest rates.

Although it is difficult to calculate the exact scale of speculative "hot money" in the market because of its secrecy, some indicators, such as foreign exchange purchase and export value, have shed enough light on the undercurrent of abnormal capital inflows.

The country's new foreign exchange purchase - an indicator of monitoring capital inflows - amounted to 1.2 trillion yuan ($193.5 billion) in the first quarter, compared with only $500 billion yuan for the whole of 2012. According to the State Administration of Foreign Exchange, China had a surplus of more than $100 billion in its capital and financial accounts in the first quarter, compared with $20 billion in the fourth quarter of 2012.

Moreover, the increase in the exports growth rate in April - 14.7 percent year-on-year - was far higher than market expectations of about 10 percent, resulting in a trade surplus of 114.5 billion yuan. In the previous month, China had a trade deficit of 7.24 billion yuan.

The abnormal changes in these indicators have added to the belief that an undefined amount of speculative money is flowing into China. Reuters news agency estimates that the speculative cash inflow could have been as high as $181 billion in the first quarter. Researchers with other institutions, too, say more than $100 billion could have flowed in during that period.

Earlier, whenever the market became worried about speculative capital flowing into the country, the monetary authorities used to routinely deny such a possibility. But unlike what they usually did before, this time they have issued new rules to thwart such inflows.

The SAFE issued a guideline on May 6 tightening scrutiny over export invoices and imposing limits on long yuan positions. And on May 8, the central bank resumed the issuance of bills, a move to sterilize money supply in the market - the first such move since late 2011. Analysts see that as a sign of the central bank joining hands with the foreign exchange regulator to keep hot money out of the economy.

The two moves, however, are a de facto admission that the risk of hot money has become substantial and a sign that policymakers will not sit idle. The central bank does not have many handy tools at its disposal to tackle the problem of amassing speculative capital without affecting the stability of the economy.

Theoretically, the country can discourage such capital inflows by cutting interest rates, but that will make money even easier to get. Given the already ample liquidity in the domestic market, such a move could prove especially costly.

In such a case, the least that policymakers are expected to do is to carefully handle the financial policies in order to avoid adding fuel to the fire.

The yuan has risen sharply against many foreign currencies in recent months. Its daily reference rate has increased by 1.4 percent against the US dollar this year, with about 1 percent gained since April, when during the whole of last year, it had risen by just 0.23 percent against the greenback. Such a sharp rise is hard to understand given the country's fragile economic fundamentals and the rapid increase in the dollar's value over the past months.

Right or wrong, the market has generally deemed the daily reference rate of the yuan as being reflective of the central bank's stance. The continually rising rate, therefore, could easily create the impression that the Chinese authorities are seeking faster appreciation of the yuan, thus further encouraging long yuan positions.

China is rightly seeking to gradually liberalize its financial regime and make the formation of the yuan's exchange rate mechanism more flexible and market oriented. But then the short-term strong appreciation is a great boost for speculative foreign capital inflows.

As part of the reform agenda, China may also gradually expand the daily floating band for the yuan against the dollar, as hinted by a senior central bank official in April. The move, according to analysts, could come as early as next month and make the yuan more flexible, and thus facilitate the country's drive to liberalize the foreign exchange market and internationalize its currency.

But some analysts are also worried that the market could see the move as a sign of the central bank wanting a faster appreciation of the yuan. Given the potential pitfalls, therefore, the monetary authorities should better coordinate their decision-making process to minimize its impact on the economy.