Tags: Jason Simpkins

Although "Hot Money" Flees China the Red Dragon Will Emerge From Financial Crisis Unscathed

By , Money Morning •

By Jason Simpkins
Associate Editor
Money Morning

On the surface, it appears as though the Chinese economy is suffering along with the rest of the world. The economic crisis that has ensnared Western economies is expected to dampen Chinese exports and there is already evidence of capital flight.

But the real story is that China’s foreign exchange reserves – at $1.9 trillion – remain at an all-time high, and the outflow of capital, or “hot money,” will actually deflate many of the asset bubbles that speculative investment has created over the past several years.

Ultimately, the so-called “global recession” that many analysts have projected as a virtual certainty will serve as only a temporary correction for China’s economy, which is still projected to expand by at least 8% this year and next – even as its Western counterparts sputter

Is Hot Money Leaving China?

“Hot money” refers to foreign funds that are temporarily transferred to a financial center and can be withdrawn at any time, or to the massive quantities of capital that international speculators can shift from one market to another across the globe – whipping a market into a frenzy when it flows in, and potentially leaving it flat and shattered when it’s whisked away. It’s a boom-and-bust cycle that’s occurred time and again throughout history: In the early 1990s, for example, hot money flowed into such emerging-market economies as Hong Kong, causing some stock markets to double in a year. But all those gains – and then some – were given back a year later when speculators pulled out of the emerging markets in pursuit of the next “hot money” investment opportunity.

The emerging economies have been the target of the hot-money crowd again in recent years, as investors and speculators scoured the planet for the highest-possible returns. But with the onset of the current financial crisis and drum-tight credit markets, much of that hot money is on its way back to where it came from.

The Institute of International Finance estimates that capital inflows to 30 emerging markets will decrease by nearly a third this year, from $900 billion in 2007 to $619 billion this year, before declining to $560 billion in 2009.

Analysts estimate that anywhere between $10 billion and $25 billion fled China in September, as the global financial crisis worsened.

To support this claim, analysts point to China’s massive foreign exchange reserves. Foreign exchange reserves increased $96.8 billion in the third quarter to a record high $1.9 trillion, but even though China’s currency stockpile grew, it expanded at a slower rate than previously seen. China’s broad measure of money supply grew by 15.3% last month, down from 16% in August.

China recorded a $29 billion trade surplus in September, and nearly $10 billion in foreign direct investment, yet the country’s reserves grew by just $21.4 billion – a red flag for many analysts.

“I think it’s pretty certain that we are seeing an outflow of capital at this stage,” Glenn Maguire, Asia economist for Société Générale SA (OTC ADR: SCGLY), told The Wall Street Journal. However, he said, "what we are seeing is an unwinding of the hot-money flows that occurred earlier in the year, rather than outright capital flight."

Indeed, roughly $120 billion in hot money poured into China throughout all of 2007, and Michael Pettis, a finance professor at Peking University, estimates that more than $200 billion flooded in during just the first half of 2008. But as credit tightened over the past several months, it’s likely that many financial institutions called much of that money back in an effort to shore up their own balance sheets and ensure adequate liquidity.

“This outflow likely reflected foreign financial institutions attempting to repatriate capital and hoard dollar liquidity in the midst of the credit crisis,” Logan Wright of Stone & McCarthy Research Associates in Beijing told The Journal.

The dollar’s appreciation against foreign currencies, including China’s yuan, is another reason for the recent shift in hot money flows The yuan has appreciated 17% against the dollar since the peg between the two currencies was dissolved in 2005. It rose roughly 7% in the first nine months of the year, drawing in speculative investors looking to cash in on the currency’s continued appreciation.

However, Beijing likes to keep the yuan artificially low as a means of boosting exports, and the currency has climbed far too fast in the first half of the year for the government’s liking.

“Worries about the economy have escalated,” Yang Bin, a Beijing-based dealer at Bank of China Ltd., the country's biggest foreign currency trader, told Bloomberg News. “A return to the fast pace of appreciation in the first half would stifle struggling export industries at this difficult time.”
Indeed, a dealer confirmed to the Economic Times, that “despite the global dollar weakness, the market believes China's slowdown won't allow the yuan to strengthen too much in the near future.”

Additionally, the dollar has rallied nearly 20% against the euro since April, and because China’s reserves are reported in dollars, the value of its non-dollar holdings has been shrinking. That, too, has contributed to the apparent slowdown in China’s reserve growth.

"We think the (reserve-growth) slowdown is related to the dollar's recent strengthening," Li Heng, a Beijing-based economist with TX Investment Consulting, told the AFP. "We believe [the] forex-reserves growth will stabilize in future. So far, significant growth in capital outflows is not happening."

So long as there is no dramatic withdraw of cash from China – and there hasn’t been so far – a slight correction or pullback would actually be beneficial for an economy that has been growing too fast for its own good in recent years.

All of the speculative capital flowing into China over the past decade has fueled inflation, driven up stock prices, and helped accelerate a worrisome bubble in the real estate market – similar to the one created in the United States. So, in that respect, the recent outflow of capital is actually restoring fair value to the marketplace.

"The excessive influx of hot money will expand market liquidity, cause excessive money supply, and will eventually push up inflation," Zhao Qingming of China Construction Bank told the Beijing Review. "The hot money inflow also poses more pressure for yuan appreciation. It can also create bubbles in the property and stock markets."

Stephen Green, of Standard Chartered PLC, told the Financial Times that, given the exodus of foreign capital in the third quarter, the problem of too much hot money is “beginning to sort itself out.”

“This is certainly reducing some of the pressure, which will be welcome in Beijing,” Green said.

China’s Leaner, Meaner Economy

When China’s foreign-exchange reserves jumped to their world-record high in the third quarter, its currency holdings were up 33% as of the end of September, from a year earlier.

The Chinese market “remains liquid and the financial system is broadly sound,” said central bank Deputy Governor Yi Gang. 

Indeed, liquidity is not an issue in China. Instead, the question is how will the economy hold up in the face of a severe global downturn. So far, the signs are encouraging.

Of the world’s large economies, China has fared the best throughout the duration of the current economic crisis. Whether Chinese banks were “wise, lucky, or better regulated,” they avoided exposure to the risky subprime mortgages and derivative products that caused the current financial firestorm, said Liu Erh-fei, managing director and chairman for China at Merrill Lynch & Co. Inc. (MER).

“There is no systemic risk in China’s banks that could spill over into a full blown financial crisis,” Liu said. “China is not affected by this virus that permeates the U.S. and European economies.”

Liu added that China would be able to maintain “reasonable” growth at, or above, 8% so long as it is able to tame inflation and increase domestic demand.

There are already signs that inflation is subsiding, and the outflow of hot money may be, in part, responsible for that. Another factor is the decline in commodity prices that has accompanied weaker global demand and a stronger dollar.  The price of oil, for instance, has plummeted more than 50% from its record high of $147.27, set July 11.

Inflation in China receded to 4.9% in the year to August from 8.7% in February. And Goldman Sachs Group Inc. (GS) forecasts that it will fall as low as 1.5% in 2009.
That means the biggest task ahead for China will be spurring domestic demand to compensate for a decline in exports.

Exports rose 21% in August from a year earlier, after soaring 27% in July, and that growth rate will likely continue its downtrend as economies in the United States and Europe, China’s two biggest trade partners, continue to weaken if not contract.

Fortunately for China, domestic retail sales are up, having jumped 23.2% in August from a year earlier. 

According to Merrill’s Liu, Beijing is well enough equipped to steer its domestic economy towards stable growth by aiding rural development and sponsoring infrastructure projects.

“The government has all this cash and it should use it,” Liu said.

China has a budget surplus of 2% of gross domestic product (GDP), according to Standard Chartered’s Green. And public sector debt is just 16% of GDP.

Beijing already has plans increase the number of rural banks and lending firms to 100 by the end of the year, from 61 at the end of August, Bloomberg reported. This will improve farmers’ access to credit.

The government could also change current land ownership laws to give farmers the ability to transfer (lease or sell) the rights to 30.5 million acres of rural residential land, to market-oriented farm corporations. That would give those farmers looking to sell their property more access to capital and income, as well as aid companies in need of land to develop Bloomberg said.

Additionally, China still has strong growth in its burgeoning cities. Fixed asset investment in urban areas rose 27.4% in the first eight months of the year.

“Despite negative shocks of the financial crisis, China will accelerate transformation of the growth model, promote domestic demand – especially household consumption – and maintain fast and stable growth,” said Deputy Governor Yi.

The Chinese economy accounted for one-third of global GDP in the first half of the year. It could play an even greater role in 2009.

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