Does the PBoC Think Hot Money Is a Problem?

Includes: FXI, PGJ
by: Michael Pettis

Yesterday I quoted extensively from a UBS report that argued very strongly against the likelihood of a one-off revaluation of the RMB. Much of my discussion concerned why I think that although I agree with some of the author’s points, I do not believe they are relevant to the case. I had planned to write in today’s entry about one of his arguments which was in fact relevant but with which I disagreed – that there was no evidence that hot money inflows have become a problem for monetary policy.

When I checked Brad Setser’s blog (which I do every day and strongly recommend to anyone interested in central banks, global monetary policy, and international capital flows) I saw that he had beaten me to the punch. In his very extensive entry he summarizes the argument proposed by UBS and others that, based on residual reserve growth (after things like the trade surplus, FDI, and other non-portfolio inflows are subtracted from the total increase in reserves), hot money inflows do not seem to be a serious problem. He counterpoints these with the arguments of folks like Morgan Stanley’s Stephen Jen that hot money inflows have actually been very high, adding his own and Logan Wright’s calculations that suggest headline reserve growth may significantly underestimate effective reserve growth, and so underestimate the residual.

Brad Setser seems to come down on the aside of arguing that hot money inflows are indeed a concern for the monetary authorities and, needless to say, I strongly agree with his assessment. Since it is an excellent post there is no need for me to belabor the point when I can simply cheat and recommend that anyone who is interested read it himself here.

I do however want to add two things to his argument. First, in today’s Bloomberg I read the following article:

Yuan Declines on Speculation China Seeking to Deter Speculators

Feb. 21 (Bloomberg) -- The yuan fell, snapping a five-day gain, on speculation China is seeking to deter speculators betting on faster gains in the currency. The central bank set a weaker foreign-exchange reference rate for trading, making it the only loser of the 10 most-active Asian currencies today outside of Japan. The People's Bank of China pledged to boost the currency's flexibility in a five-year plan released this week. China may ``flush out speculators from time to time, before allowing the yuan to appreciate again,'' said Nizam Idris, a currency strategist with UBS AG in Singapore.

This is the second time in recent weeks the PBoC has suddenly reversed RMB appreciation, supposedly to “flush” out speculators. They have been doing this regularly in the past few months.

Leaving aside the usefulness of their actions (if everyone knows the RMB is headed up, why should a small one- or two-day reversal worry anyone?), I would wonder why the PBoC is bothering with all this if they didn’t believe there were significant hot money inflows. One could argue that they are trying to teach Chinese corporations about currency volatility so as to prepare them for the brave new world, but since purchase and sale contracts are usually priced forward, I doubt it would have much impact. This action seems to be aimed at speculative inflows, and if the PBoC thinks speculative inflows are a problem, should any of us disagree?

Just a few minutes ago before I could post this entry I received an angry and impassioned email from one of my former Chinese students who is now an FX swap trader in Shanghai for one of the largest global investment banks (with the Subject heading “China Market SUCKS”). I found his email very interesting and perhaps very relevant (it’s great that so many of the best young traders in the Chinese markets are my former students). He allowed me to excerpt his email, with a few clarifications and some editing to eliminate trader’s slang:

Some officials from SAFE called the only two onshore money market brokers yesterday after the market closed, and told them verbally that they must stop brokering FX swap onshore immediately. The reason they gave verbally (and only verbally, no written notice) is that FX swap is an FX instrument (because an FX forward = an FX swap + an FX spot trade, so that if the FX swap price changes, an FX forward’s price will follow – how silly this is!). They said that the foreign exchange market is so important to China that it is highly co-related to national security, and because of the brokers’ activity, the market is too volatile and out of the control of SAFE.

By closing down the broker shops, they hope the onshore fx swap market will be more stable, and easier to monitor, and China’s financial market, or at least China’s FX market, will be safer!

Here is what we got today after this new rule, which is nothing surprising to traders. Since banks are only allowed to trade by calling each other direct and no one really knows what is happening and where the real market is, every bank quotes very wide bid/offer spread, and during whole morning only five trades were done in the market. If any big flow hits the market, which is very likely because no corporate is willing to hold long USD forward position, the market will be more panicked than ever as it lacks liquidity.

Well, at the end of day, I am surprised to find out how little they know about this market (how can a FX swap be an FX instrument?!) and that how rapid policy can be changed in China (as this verbal notice came to everyone as a surprise). More importantly, it shows how desperate they want to control the market in their good hands, and maybe it shows they feel that they are in the threat of losing control.

Very honestly I am not sure why SAFE is doing this and what they expect to accomplish, but it seems they are very concerned about what is happening in the foreign exchange markets. There have rumors for a long time (actually, much more than rumors) of corporations using the market to speculate on RMB appreciation, and maybe this is a way to try and control the market. At any rate I welcome any of the readers of this blog, especially traders and especially my former students, to write to me either online of offline and explain what they see happening.