Money flows may be hotter than they look
Chinese officials have reported that as much as US$80 billion worth of 'hot money' flowed into China during the first quarter of the year.
If true, this is an enormous amount of money - worth some 560 billion yuan (HK$623.59 billion) - and is enough to stoke inflation fears and severely complicate monetary policy-making.
But working out whether a hot money figure of US$80 billion is too high, about right, or too low for the first quarter is tricky.
At first sight, US$80 billion looks about right. We start by looking at China's foreign reserves. At the end of March, the central bank held an enormous US$1.68 trillion of foreign exchange reserves, up from US$1.53 trillion at the end of December; an increase of US$154 billion in just three months (see chart).
The most obvious sources for this increase are trade receipts and inflows of long-term capital in the form of foreign direct investment. Over the first quarter, China ran a trade surplus of US$42 billion, and received US$27 billion in foreign direct investment. That adds up to US$69 billion, which leaves US$85 billion of the first quarter's increase in reserves unaccounted for.
But not all that amount is hot money. Some has been earned. Let's imagine that at the beginning of the year China held 65 per cent of its reserves in US dollars, 25 per cent in euros and 10 per cent in yen. Over the first quarter, the euro rose 7.5 per cent against the US dollar and the yen 12.4 per cent.
In that case the original reserve holding of US$1.53 trillion would now be worth US$1.58 trillion, an increase of US$48 billion purely on currency valuation gains.
That's not all. If we assume the reserves are held as government bonds, earning an average annual yield of 3.5 per cent, then the stock of assets generated income of about US$13 billion in the first quarter.
Subtracting these additional gains from the overall increase in reserves leaves US$24 billion unaccounted for - a sizeable sum, but a lot less than US$80 billion. And if we assume China marked its bond holdings to market, that amount shrinks even further. Maybe hot money is not such a problem after all.
Unfortunately things are not that simple. During the quarter, the central bank twice raised the proportion of deposits commercial banks are required to lodge with the central bank as reserves. This should have removed about 400 billion yuan worth of liquidity from the banking system.
However, there are persistent reports that banks were ordered to lodge some or all of this amount with the central bank in the form of foreign currency. If true, that would imply that an extra US$56 billion had flowed into the country and been successfully mopped up without showing in the official foreign reserves data.
If we add this extra money to the US$24 billion unexplained increase in reserves, we get a figure for hot money inflows during the first quarter of - wait for it - US$80 billion; exactly the sum Chinese officials were complaining about.
Of course, this is a grossly simplified back-of-the-envelope calculation. But the sharp increase of yuan deposits in Hong Kong over recent months (see second chart) proves that there is great interest in holding the currency.
As a result, it would be sensible to assume that hot money inflows into China are on the high side of recent estimates, rather than the low.