Daiwa Capital Markets’ Kevin Lai delved into the latest data and concluded that the surge in foreign exchange reserves might be an indication of tight credit conditions and the growing desperation of mainland Chinese companies to source external funding.

Lai estimates that about US$256 billion of the foreign exchange reserves growth is “unexplained” or cannot be accounted for in terms of China’s trade surplus, foreign direct investment (FDI) inflows, or other line items.

Instead, it’s likely that rising yields in China are drawing speculative capital from across the border in Hong Kong, where interest yields are low and liquidity abundant. It’s also likely, he says, that some of the inflows represent funds tapped in Hong Kong by mainland companies in the form of loans or bond issuance “It is a huge pot of money inflows that cannot be explained by normal trade inflows…so they must be short-term speculative money flows,” Lai said.

Lai said he adjusted trade data of various Chinese government agencies compiled by the CEIC. China’s foreign exchange reserve statistics are released separately by the PBOC, which doesn’t provide a breakdown of trade flows.

Lai rounded down China’s trade surplus for the second half by US$49 billion to offset what he believes were falsely inflated trade transactions figures filed by companies seeking to evade capital controls. In addition, Lai cut the FDI figure to US$20 billion from $56 billion, saying many of these funds were likely converted into yuan before the reporting period and therefore shouldn’t be counted. Another category, which tracks balances in services and income accounts, and which are normally negative, was also reworked. Lai says he assigned a deficit of $86 billion for the half-year period. Smaller adjustments include a US$30 billion valuation gain to account for currency fluctuations and likely losses on underlying Treasury bond holdings. The figure is significantly down from the US$77 billion valuation gain in 2012. 

Importantly, the increased pace of foreign exchange reserves growth picks up around mid-summer, or about the same time that China underwent an interbank lending crisis. That shows, according to Lai, China been sucking up funds from offshore as its own lending markets remain in a deep freeze. 

He likens the practice of borrowing in Hong Kong to invest in higher yielding assets in China as a “carry trade”. But while such trades can be profitable for a time, they also carry big risks.

Lai says it appears to him that a staggering large amount of capital has sailed into China just at its credit problems look set to get worse. 

He doubts that high-quality rated credit will hold up well if the reckoning after such a long period of credit-fuelled growth comes to pass.  

Lai is reluctant to lay out a time frame, but he believes the pressure is continuing to build. Whether a tightening up of the Federal Reserve’s quantitative easing programme, slated to get underway this month, will spark an even sharper riser in global credit cost is one concern.

Indications of a mini credit crisis are already appearing in China, with at least one investment trust set to default on Jan 31. Chinese authorities, mindful of the risks, are likely monitoring the situation and prepared to take steps so that are no surprises unfold over the Lunar New Year.

But Lai warns that while things can keeping over ticking over as usual for a while, investors should grab this window to exit risky investments.

“When credit becomes as overstretched as it is now, a full-blown crisis is only a matter of time,” Lai says.