My Blog

July 3, 2008

Sorry for posting two longish entries on the same day, but I wasn't able to post yesterday's entry until this morning, and both days have had some important events worth writing about.

Last night SAFE came out with an announcement that I think many of us were openly expecting and secretly dreading.  According to today’s Xinhua (“China toughens forex receipts and export settlements”),

Stepping up the battle against "hot money" flowing into and out of China, three Chinese central governmental departments are to link their internal electronic systems from July 14 in a trial check of foreign exchange receipts and exports settlements, the State Administration of Foreign Exchange (SAFE) said Thursday.  These measures were interpreted by analysts as one of the latest efforts by the Chinese government to monitor capital flows and prevent more so-called "hot money" from flooding in and out of the country.

Exporters will now be required to place revenues in special accounts while the authorities verify that the funds were the result of genuine trade transactions.  We now begin an extended curriculum on the difficulty of eliminating hot money inflows through administrative measures.  I am reasonably confident that this new move will slow hot money inflow through the trade account in the short term while in the medium term it will have little impact (although it is worth noting parenthetically that most of our estimates for hot money don’t take these into account anyway, and if the measure only succeeds in driving hot money inflows out of the trade channel and into other channels, its main impact will have been a welcome but unintended increase transparency).  It will also create significant frictional costs for the trading sector and so dampen real trade transactions.  Finally, the new administrative measures may ultimately be used as a tool to manage trade, i.e. minimize imports, and so add to international trade tensions.

I won’t say too much about this directly because I think the press is covering it quite well (see for example Geoff Dyer’s “China in clampdown on ‘hot’ money” in today’s Financial Times), but I will say that it does suggest that there isn’t an awful lot the authorities can really do about inflows.  It is also not going to make a big difference.  Bloomberg today gives one expert’s reasoning, citing Li Youhuan, a researcher at the Chinese Academy of Social Sciences:

“Speculative money can always find loopholes,'' said Li, who undertook an investigation last year into how hot money was entering China. “Inflows through service deals are even faster and simpler than via the exchange of goods. How can the regulators judge whether the prices paid for corporate identity designs, for example, are fair or not?”

As Stone & McCarthy Logan Wright pointed out in a note today:

Overall, this is likely to be the first of several attempts by financial regulators to monitor speculative capital inflows; more supervision of foreign companies' bank accounts and registered capital may appear in the coming weeks or months. However, independently, the new SAFE restrictions on exporters are unlikely to have a significant effect on hot money flowing in through the trade account, and are likely to create cashflow difficulties for exporters already suffering from declining sales volumes and higher input costs. The measures suggest that the central government is much more likely to turn to administrative measures to target capital inflows rather than accelerating the pace of yuan appreciation (or pursuing a one-off revaluation), because controlling capital flows reflects the path of least political resistance. However, as long as market expectations for further yuan appreciation exist, speculative capital flows are likely to continue, despite the Chinese government's attempts to tighten controls.

On a related note, two days ago Morgan Stanley published a widely-read piece by Qing Wang on hot money flows (“China: Counting Hot Money”) in which the author cautions about attributing too much of the reserve accumulation net of the trade surplus and FDI to hot money, which he refers to as the “residual” method.  In particular he points out that there are several other types of transactions that can affect the net number which have not been taken into account by most analysts estimating hot money inflows. 

First, this indicator treats some items under the current account such as remittances and income, for which high-frequency data are not available, as part of hot money flows. This tends to overstate the amount of hot money flows.  Second, this indicator is a net flow concept and fails to take into account capital outflows/inflows originating from China-based financial institutions, which are at times heavily influenced by domestic policy changes.  Third, changes in US dollar-denominated FX reserves could simply reflect changes in the cross rates between the US dollar and other major reserve currencies (e.g., euro, yen); however, this indicator attributes these valuation effects to changes in ‘hot money’ flows.

Some of his comments are fairly obvious – and most credible estimates of hot money do take them into account, but he does point out two things that are worth repeating.  First, the net numbers do not take into account capital outflow transactions, most of which officially directed:

Capital outflows originating in China are mostly carried out by domestic financial institutions and closely reflect government policy, in our view.  For instance, we think that the large amount of purchases of MLT debt securities that originated in China in 2006 reflected the special FX swap arrangements between the PBoC and several large domestic banks in 2006, under which the banks were asked to park their funds (some of which were raised from the mega bank IPOs in Hong Kong) offshore.

Wang concludes that the “residual” method of calculating hot money underestimated hot money inflows in earlier years and over estimates them currently, which, if true, suggests not that hot money inflows are not substantial but rather than they have been less volatile than previously estimated.  This is a point well worth making.

In fact much of what Wang says is reasonable, but I have some disagreements with his conclusions.  He says:

A key reason for ‘hot money’ becoming a popular issue among market participants is the concern about the potential negative impact on the economy if ‘hot money’ inflows were to turn suddenly into outflows.  The common fear is that in the event of ‘hot money’ outflows, the renminbi exchange rate would come under considerable depreciation pressure and there could be serious domestic liquidity shortages that may potentially destabilize the domestic banking system.

While these concerns are not entirely unwarranted, they are overdone, in our view.  First, despite the considerable uncertainty in the current market environment, the underlying fundamentals of the Chinese economy remain very robust, and we do not envisage circumstances that could bring about a major downgrade of investors’ medium-term outlook for the economy and thus reverse the direction of capital flows.

Second, we estimate that the potential amount of the ‘hot money’ stock is likely to be US$200-300 billion.  Even if all these funds were to leave China, this would be unlikely to generate much depreciation pressure on the renminbi exchange rate.  With US$1.8 trillion in FX reserves outstanding and rising, China should be able easily to defend the renminbi exchange rate in the event of potential outflows of a magnitude of about 15% of the total FX reserve stock.

Third, the potential negative impact of ‘hot money’ outflows on domestic liquidity can be easily mitigated as well, in our view.  With China’s current ratio for required reserves (RRR) at 17.5%, one of the highest levels in the world, the potential liquidity impact as a result of US$200-300 billion ‘hot money’ outflows could be effectively offset by the PBoC lowering the RRR.  We estimate that the liquidity impact of US$200-300 billion in outflows could be offset by a reduction in the RRR of about 500bp from 17.5% currently to 12.5%.  Even at 12.5%, the RRR level is still very high by international standards.

His first point is correct as it stands, but Latin American and other developing country experience suggests it is irrelevant.  Of course the underlying fundamentals in China seem robust.  This is almost a precondition for hot money inflows.  But in previous cases, whether we are discussing hot money inflows into Argentina in the late 1990s, or into Thailand, Malaysia, Indonesia and Korea in the three or four years before the 1997 crisis, or in Mexico in 1992-93, it was robust-seeming conditions in every case that precipitated the inflows.

These inflows themselves created the conditions for the subsequent outflows – most importantly over-extended balance sheets and unstable financial systems.  In the case of China the danger is not that hot money is pouring into a country that is clearly on the edge of disaster – it never does.  The real danger is that if conditions turn, whether because of domestic or international shocks, the inflows can reverse and exacerbate the impact of the shock.

My problem with the second point is that I think he dismisses, and very effectively, the wrong concern.  I don’t think the worry people like Logan Wright, Brad Setser and me have is simply that capital outflows could force a depreciation of the RMB one day (in my case I don’t even think it is likely).  The worry is that capital outflows could drive domestic liquidity from the financial system and expose very vulnerable balance sheets.  The idea that a financial crisis is by definition a currency crisis may be deeply established, but it is wrong.  Most financial crises historically have been domestic financial crises, and as I have said perhaps too many times, the next set of crises will more likely be domestic banking crises than external debt crises (with Argentina being, as it always has been, the honorable exception).

This also suggests what it wrong with his third point.  It is true that rising minimum reserve requirements constrains lending growth, but it is not equally true that lowering them forces lending growth.  Minimum reserve requirements are a constraint on, not a determinant of, lending volume.  If we experience the conditions in which China would suddenly see massive capital outflows, it is a pretty safe bet that banks would be more concerned about preserving liquidity than about lending as fast as they were legally permitted.  This does not even consider the impact of illiquidity on the informal banking sector, which according to one estimate (see yesterday’s entry) may comprise not too much less than one-third of total banking assets.

One final point, the biggest concern about hot money is not whether or not it is hot money by definition.  The biggest concern, for me at any rate, is its sheer size and its pro-cyclicality.  It doesn’t matter too much whether a specific inflow is illegal or otherwise constitutes someone’s definition of hot money.  What matters is whether it forces the PBoC to expand the money supply, and whether it is likely to increase or decrease underlying economic and financial volatility.  I would argue that most of the recent increases in headline reserves do both.

Certainly last night’s announcement by SAFE indicates that the PBoC is also very worried.

Comments (9) for "The PBoC battles hot money"

Another take on the 'hot money' issue at Fallows' blog here: http://jamesfallows.theatlantic.com/archives/2008/07/post_2.php Quite interesting as I have been doing the essentially same through my HK bank account. By the way, I think you are right that this issue is about to get much greater profile... check out this piece by Jin Li and Li Shan in today's Asia Wall St. Journal here... http://online.wsj.com/article/SB121503329669924121.html?mod=googlenews_wsj I would be curious to hear your reaction to their proposed solution. I guess the question is how ugly things will get and how soon once these flows start to reverse. By Adam - 7/2/2008 8:28 PM

Mr Pettis Not to be rude, but I think your point on domestic banking crisis being more likely than a financial and currency crisis, has effectively halved the piocture. Sure the bs may not stand up to scrutiny and the banking system leaves much to desire, there are 2 factors at the very least which determine whether it stays a banking crisis or a currency crisis; whether the current hot flows are effectively a form of financing for sectors of the economy or somehow form part of the banking/financing system and how convertible or easily exchangeable is the RMB going to be. A crisis could well start from domestic banking; for instance, slowdown in profit growth or reversal of profit trends, the bs start looking bad, the banks suddenly wake up tro the fact that NPLs are becoming a crystallized problem, a sudden tightening of credit/liquidity, the sense that all is not fright in the Middle Kingdom spreads, foreign banks and investors; the source of at least part of the speculative flows; pull the plug on the hot inflows, inflows stop, the momentum of growth jerks to a stop/crawl. What next for inflows already in the country? They have to find alternative investments, that's what's causing outflows, which then impact currency, transforming the banking /liquidity crisis to a currency problem, not because fundamentals have suddenly changed but because perceptions of the country's economy, banking system have and this shaken confidence means that , guilty by association, no other investment in that particular country is safe, hence the rush to get capital out. How? Well, that brings the question of currency convertibility and channels by which hot flows move. After all, it's going to be difficult masking large flows . The very "lacfk of freedom of " the RMB might well be the saving grace, in which case, inflows don't convert to outflows, speculative investors are made to suffer right along with the rest of the market participants. Outflows depend on at least 2 steps; getting out of the particular asset/investment and getting out of the currency, that's what happened in South America and Asia. There are no exact replicas but there is a reason why financial crises often take on similar forms once they are far reaching; liquidity is the lifeblood of almost all economies in this world. Would China be reduced to a huge distressed assets market? what the PBoC and state decides may well determine that By Judy Yeo - 7/2/2008 8:34 PM

Well, based on your argument, you can also conclude that the capital outflow is somehow irrelevant. Of course the macroeconomic condition changes lead to capital outflow and lack of liquility. But the economic condition going south ifself will make financial institutions unwilling to lend, with or without capital outflow. Hot money flow is not a determinant of lend volumn either according to your argument. Then the macroeconomic conditions in China depend on global economy. Demand goes down and input prices go up, the slowdown has come to China as well. The basic point is that economic growth is the most importnat determint of the banking lending. You want banks have a health balance sheets? Better help their clients find profitable markets and improve productivity. By fatbrick - 7/2/2008 9:26 PM

Pettis "It is true that rising minimum reserve requirements constrains lending growth, but it is not equally true that lowering them forces lending growth" I think you forget that the PBoC and all the satellite banks around it are not independent economic units; they will raise lending volume if told so by the central government. I am guessing that if raising lending volume is the overall motive of the central government, when flooding the economy with money through a lowering of the minimum reserve levels, then the central government will tell the banks how to act when they lower the minimum reserve levels are lowered. Even if there is a huge capital outflow the Central Government could still order a massive lending campaign with focus on selected areas in the economy, that they still have good control over, and the banks would have no choice but to comply. The central government could do like they did after the oil hike subsidize a lending volume growth by securing a certain amount of any defaulted loan. Inflation would rise, but growth and stability are secured. If the central government at the same time makes it a hassle to obtain liquidity and exchanging it into something other then RMB, then the glory days of a command economy are back again and this time it might work. By Anders - 7/3/2008 7:32 AM

Adam, honestly I thought the Jin-Li proposal to be bizarre at best. Most of the evidence suggests that the overinvoicing of exports is only a small part of hot money inflows, so piling on complex export-management mechanisms is not only incredibly inefficient and damaging to the export sector (which, among other things, will need to finance itself in the very costly informal bank market if they can't sell their dollars), but is almost besides the point. The main thing in favor of their recommendation, I think, is that it involves the kind of (mostly ineffective) administrative measure beloved of the government. Venezuela and other countries have tried similarly complex capital restrictions with very poor results -- except of course for those officials lucky enough to be part of the approval process. Judy, I agree with much of what you say except that it will take a huge amount of outflow before there is downward pressure on the RMB. There is no reason why China needs much more than $500-800 billion in reserves, at most, so it has a pretty thick cushion. By Michael Pettis - 7/3/2008 7:53 PM

Fatbrick, I think capital outflows are irrelevant only if your main worry is a 1997-Asian-crisis-style collapse. They are relevant domestically because an overextended banking system can rarely suffer a liquidity contraction without itself getting into trouble and feeding the contraction -- just look at US and European banks over the past six months. Anders, it is unlikely that I would forget that Chinese banks are state controlled. However, as I have said dozens of times on this blog, the idea that government ownership of banks can prevent a banking crisis is a pretty strange one to me, and doesn't fit well with historical experience -- for example Mexico nationalized its own banks in 1982 and then spent the rest of the decade in the worst financial crisis in its history. China experienced a banking crisis just a decade ago, when government ownership was even greater, and according to the World Bank it cost the country 45% of GDP to clean it up. Banks contract in a crisis because it makes sense for them to do so. Forcing them to do otherwise is just another way of resolving a crisis through massive fiscal expansion -- and if that were a good way to solve financial crises, global financial history would have been a lot less eventful. By Michael Pettis - 7/3/2008 8:02 PM

If the outflow of hot money will as you argue "drive domestic liquidity from the financial system and expose very vulnerable balance sheets" then the exposed balance sheet owners will activate their party membership. This would bring pressure on the central party leadership to act, because economical instability is still the great big fear of the CCP. The CCP is willing to cover bad loans for billions of RMB to protect large important exposed balance sheets even in the private sector. The price hike in oil last week showed all too clear, that the CCP gives and takes at the same time with the massive subsidizing of farmers, public transportation and taxi drivers as a compensation. I still think they will open the economical flood gates with a direct massage to the local banks that they have to produce lending growth, if there is a hint of a liqudity problem in any of the mayor sectors. This could mean that the GERD (Gross Domestic Expenditure on R&D) would raise to new levels in form of tax deductions on R&D related work (has to be understood in the broadest definition possible), direct subsidizing with state guaranteed loans and much more. I say this because the 15 year tech plan that was revealed in 2006 covers all the important sectors in the economy with suggested investment areas, so the blueprint for a massive fiscal expansion has been drawn. Of course this will produce inflation, but if speculative money are leaving China at the same time then it might not effect the price levels that much. There is historical precedent for NPL in China, the question is just how large a part of the GDP they are willing to set aside to maintain social stabillity I bet it is a lot. By Anders - 7/4/2008 12:31 AM

Michael, I think I agree with fatbrick here. While it is true that "an overextended banking system can rarely suffer a liquidity contraction without itself getting into trouble and feeding the contraction", the situation in China is far from ordinary, with huge FX reserves and a sky-high required reserve ratio - totally different from the situation in the U.S. and Europe last year. As Wang Qing points out, the PBC could counteract any outflow of hot money by simply bringing the RRR down to a more normal level. Sure, banks may be unwilling to lend at that point if we assume the economy is already in trouble, but isn't that just assuming your conclusion to be true? I am inclined to not worry about the prospect of possible future hot money outflows, but rather worry about the margin-distorting effects of the inflows themselves. By Richard Warfield - 7/4/2008 5:23 AM

RW, you are probably right that the most worrying impact is the distortionary effects of the inflows, but the point is if we have an economic downturn (which is not a crazy assumption -- we have had three in the last twenty years and the government seems to think there is a high probability of another in the near future) the outflows will seriously exacerbate the downturn. Crisis don't occur because of a sudden collapse of the asset side of the balance sheet. They occur because an eoconmic slowdown or a liquidity contraction interacts with very unstable balance sheets which then are forced to contract sharply. It is the sudden and self-reinforcing contraxction of the balance sheet that causes "crisis". By the way FX reserves are almost useless in dealing with a domestic contraction. The US had massive reseves in 1929 but they served little use in the banking crisis of 1930-31. Anders, with nominal debt plus existing contiengent liabilties probably at around 50-80% of GDP already, another crisis that costs even 20-30% of GDP in direct or contingent (through the banking system) fiscal expansion is likely to lead to a loss of credibility and perhaps even more capital flight. It is not always possible to borrow and spend one's way out of a crisis. Japan did it in the 1990s and government debt levels shot up from roughly 0% to over 120% of GDP (and it would be hard to argue that it was a terribly successful evasion of the crisis). I really doubt China's government has that level of borrowing capacity. By Michael Pettis - 7/4/2008 2:14 PM