Weaker market beats hot money mopping
Last week's news that the mainland's foreign exchange reserves shot up by US$130 billion in the second quarter of the year has prompted fears that hot money flowing in is running out of control and that as a result the financial authorities in Beijing are in danger of losing their grip over domestic inflation.
So far this year, mainland foreign exchange reserves have risen by a massive US$266 billion, more than in the whole of 2006.
The reason for the increase is not, as most people first assume, the trade surplus. During the first six months of the year the mainland racked up a trade surplus with the rest of the world of US$112 billion. That is sizable, certainly, but it can only explain about 40 per cent of the rise in reserves.
When the reserves rose by an unexpectedly large US$136 billion in the first quarter, a number of analysts suggested that the increase was largely an illusion. They argued the unusually large rise could be explained by the maturing of foreign exchange swaps the central bank had earlier contracted with the country's big four commercial banks. The exceptionally big increase was a one-off, they said, and reserve accumulation would revert to a more normal pace in the second quarter of the year.
It did not happen like that. Although it is possible that the second quarter's rise in reserves could have been the result of maturing swap contracts, it seems unlikely. The increase was too big and the timing appears wrong. More probable is that the growth in foreign reserves was driven by a sharp rise in inflows of short-term capital, or hot money.
Through most of last year, mainland authorities succeeded in keeping hot money inflows down to about US$6 billion a month. They were able to do this by keeping domestic interest rates low and limiting the yuan's annual pace of appreciation to a shade over 3 per cent, which made the potential returns of holding the currency look unattractive.
The strategy ran into difficulties, however. Low interest rates helped inflate the bubble in A-share prices, which in turn attracted inflows of capital from speculators eager to get a piece of the equity market action. According to HSBC, average monthly inflows of hot money have shot up to US$20 billion this year.
The central bank has worked hard to mop up the domestic liquidity created by the inflows. Just last Friday, it issued 101 billion yuan-worth of special sterilisation bonds in an attempt to soak up some of the excess money.
Now, however, some observers are getting worried that the authorities may be in danger of losing the battle to contain monetary growth. 'The risk is that a wave of new capital inflows coupled with rapid growth in the current account surplus could overwhelm the People's Bank of China's capacity to sterilise. A destabilising bout of inflation could result,' warned Mark Williams of independent research house Capital Economics last week.
Happily, with A shares now down 10 per cent from their peak last month, there are some signs that hot money inflows are abating. If so, the slowdown will come as a welcome relief for the beleaguered inflation-fighters at the central bank.
