Beware Of Hot Money

With foreign cash piling in, China's economy could boil over

How frothy is Shanghai's property market? Well, consider this: New hundred-square-meter apartments in posh sections of Shanghai have doubled in value, to $550,000, since 2003. High-end properties in the Chinese megalopolis have shot up 20% during the past three months alone. It's not just Shanghai. UBS Securities (UBS ) says overall urban land and property prices in China last year were up 70% over 2001. Hong Kong and Taiwan-based investors have been snapping up flats in China for years, but new money is flooding in from Japan, Korea, and Europe, says Clement Luk, a director with Centaline (China) Property Consultants in Shanghai. "It really is crazy," he says.

The real estate buys are just one sign that China has more money than it knows what to do with. The country last year pulled in $500 billion in export earnings, $60 billion from foreign direct investment, and some $129 billion in additional capital inflows -- including massive bets on a rise in the value of the yuan, says Standard & Poor's. And the capital inflow shows signs of intensifying. Chinese exports in January and February alone were up a third over the first two months of last year. China's global current account surplus could hit $100 billion or so in 2005, up almost two-thirds from last year. Foreign currency reserves could reach $800 billion this year and, at this rate, could top $1 trillion by 2006.

The rush of funds threatens China's ability to absorb it. In the worst case, the country's money supply could run off the rails, creating a bubble that affects not only Shanghai real estate but also an array of key industries. Worse, it might set off an inflationary spiral with global implications.


The Chinese government vowed to clamp down on these excesses last year. Last March, Chinese President Hu Jintao and Premier Wen Jiabao started leaning on Chinese banks to curb lending to overcrowded industries such as steel and aluminum. At the same time, the government issued loads of bonds and notes to soak up extra liquidity. That kept money-supply growth at a manageable 14.6% through 2004, down from 20% in December, 2003. Even while capital spending cooled, the economy still grew nearly 10%. By the end of last year, Beijing seemed to be making headway in preventing the economy from boiling over.

Not so fast. Given the rate at which money is pouring into China, it's not at all clear that Beijing can repeat that balancing act in 2005. It looks like the People's Bank of China, the central bank, will have to recycle anywhere from $300 million to $500 million a day in 2005.

How do Chinese monetary authorities cope with this flood? To defend the fixed currency peg between the yuan and dollar, the central bank buys (or sells) foreign currency in exchange for yuan. When too much yuan is circulating around the money system, the PBOC withdraws that extra cash through what money traders call "sterilization" -- issuing notes and bonds.

Here's how sterilization works: Chinese companies that earn export earnings in dollars and other foreign currencies usually have their banks exchange them for yuan. A company with $100 million in export earnings could wind up with some 800 million yuan in its bank account. Foreign investors also ship dollars into China by the truckload to spend on new plants and securities. This money is converted into yuan deposits, too, giving China's banks huge wads of yuan to lend. In the past the banks had a bad habit of recklessly lending this money for construction of steel plants and other industrial enterprises. To keep a lid on such lending, the PBOC has been selling short-term bills to the banks, taking excess yuan out of circulation.

Right now the cost of neutralizing the flows is low. The PBOC can sell its short-term central bank bills to Chinese banks for 1.5% and reinvest that cash in longer-range domestic and foreign bonds at higher returns. Yet if the government bumps up interest rates to cool China's economy, this mopping-up process could get expensive, driving up the already sizable liabilities of the Chinese government. The other risk is that China's foreign exchange stockpile -- already equal to about 40% of gross domestic product and parked mostly in U.S. Treasuries -- could face a valuation hit if the yuan appreciates. "The more accumulated [reserves], the greater the losses," says Frank F.X. Gong, chief China economist at JPMorgan Chase & Co. (JPM ) in Hong Kong.

Analysts give the central bank high marks for its efforts. But even the PBOC can't corral all the speculative money coming in. Overseas Chinese investors in Hong Kong and Taiwan are converting billions of Hong Kong and Taiwan dollars into yuan to buy property, and so are other foreign investors -- a logical move if you think the yuan will appreciate and real estate prices will hold. Another force is mainland Chinese companies that see an arbitrage opportunity, borrowing abroad and flipping the proceeds into yuan to invest in operations back home. Outstanding foreign-denominated debt (mostly dollars) borrowed in China grew 18%, to $228 billion, in 2004 year-on-year. Paying back foreign loans in yuan is a sweet deal -- if the yuan strengthens. "Every CFO at a Chinese company is trying to find ways to borrow in dollars," says Nicholas Lardy, a senior fellow and China watcher of the Institute for International Economics.

One way to dampen flows of borrowed money is to raise interest rates, which the central bank has tried. On Mar. 17, China raised the interest rate for mortgage loans of five years by 20 basis points, to 5.51%, while increasing the required down payment to 30%, from 20%, on deals in cities experiencing rapid rises in prices. Credit Suisse First Boston (CSR ) economist Dong Tao sees more interest-rate hikes by late 2005. But the sure way to cool the ardor of the quick-money crowd would be a sudden, substantial revaluation. China watchers, including Lardy, think it would take a 15% to 25% hike against a basket of foreign currencies to slow money flows.

There are few signs that such drastic measures will be taken anytime soon. Chinese leaders are obsessed with job security in the country's vast farm sector, which could be hurt by a flood of foreign grain if imports get cheaper. Beijing also wants to keep export factories humming, but a more expensive yuan could weigh on demand. Most observers expect at most a token boost to the currency. Or the government may do nothing at all. If so, the Chinese -- and the world -- face another year of living dangerously.

By Brian Bremner and Frederik Balfour in Hong Kong, with Dexter Roberts in Beijing

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