Frank Lu made his first windfall by investing in property in his home town of Shanghai. The New York-based American Chinese bought a luxury apartment in 2001 with US$200,000, practically all his savings, and sold it for three times as much in 2005 when the central government cracked down on property speculation. Mr Lu then invested the money in Shanghai's stock exchange with share prices soaring about 130 per cent last year. His success is not uncommon. Mr Lu said many of his Chinese friends in America engaged in similar investments. Many overseas Chinese, including those from Taiwan, Hong Kong, Macau and Singapore, have been scrambling to invest in the mainland's property or stock markets in recent years. 'It is a double act of investing in China assets, exploring benefits from high-speed growth in the world's fastest-growing economy and gaining extra from the expected continuous appreciation of the yuan,' he said. Mr Lu is just one among many, including foreigners, who have contributed to the severe excess liquidity problem now facing the world's fourth-largest economy. A rapidly growing trade surplus, foreign direct investment and inflows of overseas funds via legal or illegal channels, combined with mainlanders' high savings rate have inundated China's banking system in the past two or three years. 'Money is flooding into the Chinese market from around the world with expectation of a continuous appreciation of the yuan - at least 5 per cent a year in coming years,' said Zuo Xiaolei , chief economist with Galaxy Securities. And the abundant money, in turn, puts banks under pressure to extend loans. Money was first pumped into infrastructure and industrial projects, leading to overcapacity as early as 2004. Then it went into an increasingly speculative property market in 2005 and since last summer had flooded into the bullish stock exchange markets, Ms Zuo said. 'Capital is looking for where the maximum profits are, and to 'invest in China' has become the catchphrase on international capital markets,' she said. With the bulls clearly on the rise, analysts note that massive inflows of new money make it difficult to forecast when the rally will end. Some observes say that market fundamentals have long ceased to explain today's valuations. The share price of China Life, the mainland's top insurance company, soared by more than 100 per cent on its debut on the Shanghai exchange early last month, with the stock trading now at more than 200 times its annual earnings per share. This surpasses the valuation of global insurance leader AIG, which trades at about 15 times its earnings. The Shanghai and Shenzhen stock exchanges were among the world's best-performing markets last year. Andy Xie, former chief Asian economist with Morgan Stanley, said excessive liquidity was creating an investment bubble on the mainland and warned of an impending market bust. 'Without the existence of excessive liquidity, the bullish market could not be sustained for long,' Mr Xie said. Credit Suisse economist Dong Tao said the government was worried about the overly fast surge in domestic share prices. Both Mr Xie and Mr Tao said the government would step in to intervene if policymakers saw a bubble developing. Nevertheless, any government intervention is unlikely to provide a solution and could contradict Beijing's efforts to build a market-based stock exchange. The problem of excessive liquidity is likely to worsen rather than improve despite government measures to rein in fund inflows, with the trade surplus, FDI and hot money continuing to drive growth in foreign reserves, which topped US$1 trillion by the end of October. The mainland's trade surplus jumped 74 per cent last year to a record US$177.47 billion on the back of a 27.2 per cent surge in exports. FDI is expected to have remained at about US$60 billion last year, topping the world. Chinese savings also kept growing last year, with almost half of earnings deposited in banks. Wu Jinglian , a leading government economist and former head of the State Council's Development Research Centre, estimated there was 30 trillion yuan of hot money in China's banking system. He warned that if only a fifth of banking assets were pumped into the stock exchanges, it would lead to another rapid 200 per cent jump in benchmark stock indices. The government acknowledges that commercial banks are awash with surplus funds. By November, the gap between bank deposits and loans reached 11 trillion yuan as the ratio between lendings and savings dropped to a record low of 66.74 per cent, according to statistics from the People's Bank of China. To add insult to injury, the surplus rose further recently after several leading lenders were fattened by hundreds of billions of yuan of new funds raised in initial public offerings on the Hong Kong and Shanghai stock exchanges. The Bank of Communications, the mainland's No 5 lender, was the first mainland bank to list on the Hong Kong Stock Exchange in June 2005. Three of the 'Big Four' - China Construction Bank, Bank of China (BOC) and the Industrial and Commercial Bank of China (ICBC) - have followed since then. BOC and the ICBC have also listed shares in Shanghai. Their public listing compels them to perform, adding pressure to extend lending. 'A large part of these funds may flow into the securities market,' especially since the government's crackdown on property speculation, Ms Zuo said. The central bank has strengthened its open market operations to absorb liquidity and, at the same time, adopted retrenching measures such as raising interest rates, lifting required reserves and issuing central bank bills in an attempt to keep growth under control. Despite the central bank having withdrawn about 1.2 trillion yuan from the market last year through open market operations and the upward adjustments of required reserves, People's Bank of China governor Zhou Xiaochuan acknowledged that the problem could not be alleviated in the short term. Stephen Green, a senior economist with Standard Chartered Bank in Shanghai, said the problem of excessive liquidity would continue this year with the central bank's primary tools limited to raising reserve requirements and interest rates. Sheng Minggao, China economist with Citigroup, and Ms Zuo questioned the effect of the central bank's increased reserve requirements. 'Each reserve requirement ratio hike could only freeze as much as China's net foreign reserves increase in one month, which is about US$20 billion,' Mr Sheng said. Professor Wu admitted the central bank's ability to ease excessive liquidity was limited and former central bank adviser Li Yang said the problem could not be resolved by monetary policy. 'The fundamental factors that trigger excessive liquidity are beyond the control of monetary policy,' Mr Li told a recent forum. 'If the foreign reserve management system and the government's role in the economy cannot be fundamentally reformed, continued growth in liquidity is unavoidable.' Ms Zuo said there was 'no workable solution ... unless the government takes dramatic action like the Thai government to stop inflows of foreign funds or announces a halt to the appreciation of the yuan'.
