China battles Hot Capital - again

Written by Oskar Helling, November 27th, 2009

COMMENTARY: After three years of slow appreciation the Chinese Central bank stabilized the USD/CNY ratio at 6.83 in August 2008. Now the debate is about when the current "peg" will break.

The other day Shanghai Daily reported that the central bank had imposed new rules limiting the splitting of individual foreign exchange transactions. These tricks were used to circumvent the USD50k annual limit on individual influx of foreign currency to China. This measure is yet another signal of the Central Bank’s battle against hot capital and the increasing debate on when and how the current peg of CNY to USD will be broken.

Hot Capital is a term used to describe the speculative influx of funds, in essence the parking of money, into a growing economy, such as China’s. From 2005 to 2008 the Chinese Yuan appreciated at a slow and predictable pace while at the same time the Chinese economy expanded heavily offering very attractive investment opportunities. As the Yuan grew stronger a global investor was able to enjoy, on top of the locally made profit, a tailwind of favorable exchange rates on his way “home”. In August 2008 the Chinese Central Bank re-pegged the Yuan to the Dollar thus halting the three year long appreciation.

The Chinese economy is still marching forward at a pace unparalleled to the western world. The US economy is - according to recent reports - just about starting its recovery. Having the monetary policy of two economies in such different phases tied together through a "common" currency and, by extension, equal implicit interest rates is non-sustainable in the long run says Professor Farrokh Langdana of Rutgers Business School.

Professor Langdana held a seminar in late November to students and alumnus of the Rutgers International EMBA program in Shanghai. One of the topics of the talk was the current global economic situation and the US and Chinese economies in particular.  “The current rally is to a high degree due to the ‘over’-liquidity on the markets”, says professor Langdana. “Governments all over the world have flooded the markets with cash at close to 0% interest in order to battle the Global Financial Crisis”. Investors around the world are frantically seeking investment opportunities as the money needs to be “parked” somewhere. Due to the low interest rates the fixed income market is not very attractive at the moment. The Stock-markets, gold and other natural resources are, of course, the traditional options.  China is- well, hardly a novelty anymore - but definitely an option many investors seem to seriously consider in these times when good investment alternatives are scarce.

The problem with hot capital is that it fuels speculative asset bubbles and could cause an economy to overheat. In the end the influx of hot capital is unstoppable. Cash will find its way into the economy one way or another despite the measures any central bank will take. The above mentioned restrictions will, at best, only slow down the process. China seems to be having a hard time in finding a nice and slow middle way. During the last 18 months the central bank has gone from trying to prevent the economy from overheating to jumpstarting it, to once again preventing a overheating and a subsequent hard landing.

The Chinese Yuan is bound to break its peg with the US Dollar sooner or later.  However, as some experts say, this will not happen while the exports are weak. On the other hand, keeping the current peg is becoming become costly to China as the dollar has been depreciating during the fall. China still needs to shop around the world for natural resources and as both the Dollar and the Yuan are depreciating this is becoming more expensive. The Chinese war-chest might be deep, but it is not bottomless.

Some analysts have pointed to political and PR factors determining the timing of the de-pegging of the Yuan. However, the 18th party congress won’t be held until the autumn of 2012 and three years is a long time for China to uphold a peg against the world-markets. Then again, you have the World Expo that will be hosted in Shanghai from May to October of 2010. Even if the investments (and de-investments) of various nations into this project are enormous, they are a mere drop in the ocean when compared to the regular foreign exchange flows. Therefore, the monetary issues pertaining to the Expo will hardly come into play when timing the de-pegging. However, one must not forget that during this time China, and Shanghai, will be closely monitored by the international press and China might not want to “rock the boat”.

May it be as it will; many on this planet still seem to view the Yuan as undervalued and are expecting the peg to break sooner or later. Thus now the need for currency inflow restrictions, just like during 2008 before the re-pegging. Should the Dollar keep depreciating further against other major currencies or resources such as oil and gold this contrast will only grow clearer and the pressure on the Chinese Central Bank only harder. Sooner or later something will have to give. The question is not if, but when. This is why China is once again battling hot capital. However, this time with the added burden of a domestic economy that is already flooded with liquidity from the 4 trillion Yuan stimulus package.

Events

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September - Golf: FBCS invitational 2010

Sept 6th - Joint Nordic Seminar: Dr Dan Steinbock. Details to Come. Mark your calendar.

Sept 14th - Luncheon discussion with minister Häkämies. Details to Come. Mark your calendar.

Sept 17th - China Business Councils meeting in Kirnu. Details to Come. Mark your calendar.

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FinnBiz Winter '10

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You can download a PDF version by clicking the link below.


The second issue of FinnBiz for 2010 is planned for fall. Sponsor-slots for this issue is still available. These will be allocated on a first come - first served basis. If you are interested in reaching the decionmakers of the Finnish Business community in China, please contact oskar@startupshanghai.com