Good Time to Buy Chinese Currency: Follow the 'Hot Money'

For years, China pegged its currency to the dollar, thereby manipulating traditional economic theory. My classical economics textbook states that:

Currencies of economies with large current-account deficits should depreciate relative to those of countries with surpluses. A currency depreciation will stimulate exports and throttle imports, thereby helping to restore balance to trade gaps.

China gave into economic theory (at least partially) in July of 2005 when it allowed the renminbi to float against a basket of currencies. Since then, the yuan has appreciated by approximately 16%. However, I think the currency remains largely under-valued. Let me explain.

Despite China’s efforts to reduce its foreign-exchange reserves, its coffers are overflowing. It’s estimated that China’s reserves have exceeded $1.8 trillion and are accumulating at a rate of $100 million per hour. The Economist recently highlighted this phenomenon, noting that “hot money” is pouring into China at a break-neck pace. The article points out that “China’s trade surplus and foreign direct investment [FDI] explain only 30% of [the total rise in foreign-exchange assets in 2008]!” It’s estimated that $170-$200 billion in hot money has flowed into China within the first five months of 2008, leaving the People’s Bank of China [PBOC] stymied.

Immense capital inflows are fueling inflation in China. In fact, for the first five months of this year, inflation stood at 8.1%. You know it’s bad when one of China’s most respected economists publicly states the risk of stagflation. Such an occurrence took place last week. While I was kicking back at a barbecue celebrating our country’s founding, Li Yining, one of China’s top economists, issued a statement highlighting that China is facing a pressing challenge of preventing inflation from turning into stagflation. Clearly, inflation is a problem and PBOC needs to take action.

That being said, the PBOC has not been idle. In an effort to curb money-supply growth, the PBOC has raised banks' reserve requirements 16 times, from 9.0% to 17.5%. But reserve requirements cannot be raised forever. Sooner or later, the PBOC’s erstwhile monetary stance will have to change to successfully combat inflation.

With China’s foreign-exchange reserves swelling and inflation escalating, I think an outright reprising of the renminbi is not out of the question. Only after inflation eases will the yuan’s appreciation slow.

If the expectation of higher appreciation wasn't enough, even the interest rate differential between the renminbi and dollar is favorable. Yuan deposits are currently paying 4%, whereas dollar deposits are paying a paltry 2%. I think this higher yield, combined with the expectation of appreciation, provides an ideal investment opportunity. No surprise that $200 billion in “hot money” has poured into China since the start of the year.

The only problem is trying to figure out how to get some of my own hot money into China.

Comments

[Think-About-It:]

Answer: Buy CYB or CNY. I own CYB which pays a money market rate plus or minus any change in exchange rates between $USD & Yuan.

I have a dumb question. Everyone says that if there is a trade imbalance then one government adds to its current account while the other draws down their current account (lowering reserves or adding to their debt ala USA). But isn't that only true if the trade happens directly between governments? If if happens between private enterprises how does that translate to the government's respective reserves or current accounts?

2008 Jul 11 03:15 AM

[lordbuddha:]

China still controls money going in and out of China. The 70% cannot just go in. If these 70% is causing the raise of inflation, it can be stopped.

2008 Jul 11 08:28 AM

[James Lewis:]

Think-About-It - all the USD/foreign currency that is sent to private corporations can not be taken out of the bank by the private corporations. Instead the government the government puts it in its pocket and prints RMB to give to the corporations.

To keep RMB low the Chinese Government holds the USD.

This is basic crude example. But it effects the closed currency system and gives an idea how they keep the yuan under control.

2008 Jul 11 08:54 AM

[Think-About-It:]

James V, thanks for the explanation. Now I can easily see how the Chinese Governments balance sheet is affected by trade between private companies. Does trade between free market governments (say Canana & U.S.) work the same way?

Also, does it work the same way in the Euro zone even though they use the same currency?

2008 Jul 11 10:23 AM

[ViewFar:]

If there is a risk of stagflation, PBOC will look to raise interest rates and control it at the expense of growth. It will also cause the rate of funds inflow to slow as investors are usually scared off by the term stagflation... Things can turn around mighty fast as foreign investors get cold feet. Besides the pull out of funds willl be faster as is evidenced in India. Don't follow the hot money because it is very hot already.

2008 Jul 11 10:23 AM

[rlirph:]

Michael Pettis wrote earlier about where the "hot money" went. It could not go into the stock market because it was halved in seven months. The hot money could not go into local real estate market because housing prices everywhere in China except Shanghai has been going down for the past eight months. The inflow of money if calculated correctly went to the "underground finance companies" which loan out money at 5% per month.

For those who live in China please check with your local business pals. I live in Guangzhou and their answers lead me to believe it is impossible for local small businesses to borrow from local banks. To obtain the funding they must borrow from "underground finance companies" which in the US would be called loan sharks.

Who is to blame? Naturally the Chinese government who set up those ridiculous capital control mechanisms. While the government complains about the amount of inflow of foreign capital do you know that I can not wire out the "foreign capital"? Once the foreign capital arrives and even if the money moves to a CD it cannot be converted back into foreign currencies and to be wired out.

2008 Jul 11 10:29 AM

[pldragon:]

Totally agree with you, rlirph
in the East part of China, the Wenzhou underground "bankers" are among the most famous, and the most aggressive.
Also, to reply to the last line of the author of the article, it is not just how to bring in your US$ or Can$ that you need worry about...
For this, you could do like most Chinese and Overseas chinese do: use multiple benerficiaries accounts ...Since legally, each personal account is limited to us$ 50,000/ year...
The most difficult part will be to take your money out, the day hot money will not be hot anymore..and when everybody will be fleeing for the escape door at the same time.

2008 Jul 13 07:03 AM

[Macro Monitor:]

Arun N – Assuming growth remains robots, are you sure investors would head for the nearest exit?? It seems to me that higher interest rates would attract more USD capital. I certainly agree that things can change in an instant.
rlirph – That’s a very interesting point, and one that amazes me. China can certainly use a more open / complex financial system. Just look at Chinese firms who wither produce or consume commodities. Can you image being a ‘smaller’ firm not being able to hedge against commodity inflation, or being able to lock in profits??
pldragon - thanks for the comment.

2008 Jul 13 05:16 PM