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China braces for spectulation in the yuan
(New York Times)
Updated: 2005-07-25 15:38

A day after China moved to revalue its currency, the country is bracing to see whether the shift will set off a huge influx of speculative capital.


The move Thursday by the central bank to revalue the yuan, and drop its peg to the dollar, was praised by economists here as an important step for China as it moves toward a more market-oriented economy.


But these same experts say China now faces a difficult balancing act as it tries to control the amount of speculative capital, or "hot money," that flows in and out of the country. One measure of the giant inflows is the nation's foreign exchange reserves, which now total more than $711 billion, second only to Japan.


By raising the value of the yuan by just 2 percent, with the tantalizing possibility of further increases to follow, China may have made even more attractive what is already one of the world's most popular places to invest.


The Chinese economy has boomed in the last few years with money pouring in at a pace of nearly $20 billion a month, and the delicate task for Beijing officials now lies in making sure that this incoming tide neither increases nor decreases in large amounts.


"This is the most important thing for China right now," said Andy Xie, an economist at Morgan Stanley. "China has to be really careful not to encourage hot money to come in and not to push it out."


Tens of billions of dollars worth of speculative money is already flooding into China. If that torrent expands significantly, it could feed inflation in an already feverish economy. But if China acts too decisively to choke off inflows, useful investments could also be derailed and growth could suffer.


The currency move was seen by analysts largely as an effort by China to appease its biggest trading partners, many of whom had complained for two years that a weak currency gave China an unfair advantage in global commerce.

 
But with just a 2 percent increase in the value of the yuan against the dollar, some analysts said China was signaling that a larger yuan appreciation was in store and thereby inadvertently encouraging speculators to rush into the country.
While the Bush administration welcomed this first step toward currency reform, the huge speculative capital inflows that are now being forecast here could ignite inflationary pressure and further complicate the Chinese government's effort to manage the world's fastest-growing major economy, which expanded by a stronger-than-expected 9.5 percent in the second quarter of this year.


"As long as China's economy continues to grow, there will inevitably be hot money betting on the value of the currency increasing," Zhang Yuncheng, a researcher at the China Institute of Contemporary International Relations, said.


Some economists say the risks of speculative capital flooding into the country and overheating the economy are overstated, that the speculative inflows have begun to slow, and that the government has found new ways to prevent money from entering the country.


In the last few months, China adopted measures to assert greater control over inflows. Economists now say those were clearly an attempt to prepare for Thursday's shift in currency policy. One of the most important controls has been to limit further the ability of banks to borrow money overseas, bring it home and convert it into yuan to issue loans in China.


The State Administration of Foreign Exchange has also stepped up monitoring of foreign investments in China. Its officials are checking that investors actually build factories and other government-approved operations, instead of using money brought into the country to acquire property, invest in the stock market or simply sit in bank accounts awaiting a currency move, experts say.


There are many ways to evade the capital controls. The simplest is to sneak large sums of cash across the border; to make it harder to change dollars into yuan, clerks at Chinese hotels now demand to see a passport and insist that guests fill out a form when converting currency.


A more complicated approach is for a company to ship goods to its overseas subsidiary and overbill the subsidiary. Part of the subsidiary's payment is used to pay for the actual goods and the rest is invested, often in real estate.


"There are leakages," said Frank Gong, an economist at J. P. Morgan Chase. "Each year about $50 billion to $60 billion in hot money comes in. But that only accounts for 8 percent of fixed-asset investments. That's a small portion. So the impact on the economy will be small."


But other economists say the Chinese government statistics suggest that over the last few years there have been huge inflows of capital that cannot be accounted for in the normal foreign exchange channels.


"There was a massive increase in what they call errors and omissions," said Nicholas R. Lardy, a senior fellow at the Institute for International Economics, referring to national statistics on capital flows. "This was huge last year, about $20 billion. Historically, that number has been negative. It's been money flowing out."


After three years of capital flight, $7.8 billion flowed into China during 2002 and $1.8 billion in 2003. Then in 2004, that figure jumped to $27 billion. Now economists are warning that huge flows of money into the country could create inflationary pressure.


Thus far, however, inflation in China has been under control.


"When you have $1 trillion in trade transactions, it's very hard to control that money," Mr. Lardy said. "They've dodged the bullet so far on inflation. But if they have more inflows it may be difficult to keep this up."


Some of the inflows - more than $300 billion, by some projections - have come from overseas during the last few years and piled up here in China on the expectation that a significant currency revaluation would bring easy profits when converted back into dollars.


Many investors and speculators had been betting on a 10 percent to 20 percent appreciation in the yuan this year.


Now, some economists say the authorities might let the yuan appreciate further so that within 12 months, the currency could be worth as much as 10 percent more than it was at the start of 2005. A recent World Bank study projected that the yuan would be valued around 5.8 to the dollar by 2010, and 2.8 to the dollar by 2020.


Mr. Xie at Morgan Stanley says that if too much of that money comes at once, China's economy will roar. But if the speculators sense that the currency will not further appreciate, a huge amount of capital could flee the country and deflate asset prices, creating a situation similar to the 1997 Asian financial crisis.


"It's really a fine balance China has to pull off," he said. "This is what this game is about for China - stability."

(courtesy of New York Times)

 
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