The PBoC battles hot money

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.