My Blog

March 8, 2008

SAT 8 MAR

Political advisor: Hot money rush may worsen inflation By Michael Pettis

Regular readers may think I am spending too much time looking for evidence of hot money inflows into China, but this has the potential to be a very seriously destabilizing problem and, given the opacity of Chinese accounts, it is not always easy to get conclusive evidence one way or the other.  In fact some very smart commentators still do not seem to believe it is a serious problem.  For example I received today a report from Mark Williams, of London-based Capital Economics, who has consistently seemed less concerned than I am about the risk, and who argues that worries over hot money inflows within the PBoC may have actually eased recently.  

 

What’s more, he seems much more on the side of “pork” as an explanation of China’s CPI inflation, to put it in Ken Rogoff’s now-well-known “pork or money” terms.  (In a February 4 Op-Ed piece in the Financial Times Rogoff says: “Those who think inflation is caused by too little pork rather than too much money are wrong.”)  I suppose this exemplifies the split between the “monetary” and the “real economy” sides of the China debate.

 

In that light today’s China Daily had an interesting article about comments made by a senior political advisor Saturday morning at a plenary meeting of the First Session of the 11th National Committee of the Chinese People's Political Consultative Conference, part of the NPC meetings being held here in Beijing.  The comments were by Li Deshui, former director of the National Bureau of Statistics.  

 

According to Li, “The yuan's rising exchange rate against the greenback has attracted international surplus capital to flood the Chinese market via various legal or illegal channels.”  He went on to say that effective monitoring of capital flows should be at the core of the government's macro-control work.  

 

“More international speculative funds will pour in through various channels,” Li said.  China has now an accumulation of about US$500 billion of hot money, according the analysis of relevant research institutes, he said.  Hot money, if not blocked effectively further, will aggravate the imbalance between China's internal revenues and expenditure, worsen the already excessive liquidity, add more uncertain factors to Chinese capital market, overheat the economy, intensify the inflation pressure and may even trigger a financial crisis, he warned.

 

This is a fairly blunt description of what I believe to be among the biggest problems facing China.  I am not sure how he got to the figure of $500 billion of accumulated speculative inflows, but if even marginally credible it suggests that a significant fraction of the reserve accumulation in recent years was hot money.  It also gives some idea of the magnitude of possible hot money outflows in case of a domestic crisis.

 

Against this backdrop I noted a story in today’s Financial Times about moves by the Fed to expand domestic liquidity:  “A deepening sense of financial crisis yesterday spurred the US Federal Reserve into new emergency action to try to ease strains in the credit markets – and convinced investors that another major interest rate cut is on its way.  The Fed said it would increase to $200bn the amount it lends to banks in one-month funds through two different channels. The action will make it much easier for banks to raise cash against illiquid securities.”

 

China is trying to slow capital inflows even while it is offering a low-risk, with very high and increasing returns, investment opportunity, at the same time that money is fleeing risk assets abroad and the Fed (and others) is pumping liquidity into the system.  Granted, it is not terribly easy to make the low-risk, high-return Chinese investment – capital controls complicate the process – but the former head of the National Bureau of statistics doesn’t seem terribly impressed by the usefulness of those capital controls. 

 

As a good bureaucrat he asks for stricter controls, but while these may add some disruptions, it is unlikely that they will be a lot more efficient.  Countries as big as China with such long histories of capital controls (and so equally long histories of ways of evading them) tend to have a hard time restricting capital flows while at the same time trying to encourage open trade and investment relations with the rest of the world.  I haven’t really thought about the impact of the Olympics, but I would guess that we should see a surge of tourism-related inflows beginning in a few months, and along with it a surge in new ways of smuggling money into the country.