China’s tryst with hot money

The PBOC’s decision could be an attempt to chase speculative capital away from the country 

China’s drive against speculative capital poses the risk of sending Chinese asset prices crashing. Photo: Bloomberg

 

The sharp decline of the Chinese Yuan over the past few days has drawn much speculation about its potential impact on the world economy. While the Chinese central bank has not confirmed its participation in the Yuan’s move, most have taken intervention by the People’s Bank of China (PBOC) as a given. Naturally, the famous Chinese carry trade—speculators borrowing cheap in the US and lending at higher rates in China—has come under the scanner.

Despite the US taper, the pure cross-border interest rate arbitrage opportunity may still exist. But with China’s recent actions, doubts over the sustenance of the steady appreciation of the Yuan—which has benefited carry traders for years—have crept up. Or, in other words, China wants to obliterate the interest arbitrage opportunity by the means of imposing offsetting currency losses.

The PBOC’s decision could be an attempt to chase speculative capital away from the country by changing expectations on the Yuan’s future value. With loose monetary policy in the US, a massive amount of liquidity has flown to the Chinese economy and added to the massive credit boom—something that has had as much to do with China’s own liquidity easing program. However, China’s drive against speculative capital poses the risk of sending Chinese asset prices crashing.

In 2011, amidst concerns of a Chinese landing, the economy witnessed hot money outflow (worth at least $128 billion, while some estimates provide a much higher figure) that outsized the capital exit following the fall of Lehman brothers.

Since this may not be the kind of “soft landing” the Chinese central bank has in mind, the PBOC is likely to resort to injecting more liquidity into the economy when asset prices drop. Note that despite talks of reforms and weaning the economy off cheap credit—which, by the way, has trumped the scale of liquidity expansion even in the United States and Japan—last year, China continued to inject liquidity as domestic rates witnessed sharp hikes.

Stepping back to allow the Yuan to continue its trend of appreciation and allowing capital inflows is an option. But the Chinese probably understand that this will only provide temporary relief—since capital flows will reverse anyway as rates in the US start to rise soon. Flushing more Yuan into the hands of foreigners to boost exports, on the other hand, is a much more appealing option for China given the control it provides the PBOC in both chasing away speculative capital in an “orderly” manner and managing export demand.

But given that long-term stability depends on letting the market decide the value of the Yuan, the latter may be a counterproductive objective to pursue. That is, since in its desire to fend off speculative capital through steady depreciation of the Yuan, China would have returned to the path of export promotion. Mal-investments driven by such currency manipulations, in turn, go bust eventually when currency values gyrate back to fundamentals. The catastrophic end of famous export-driven Asian growth episode should warn China’s leaders.

It is time the Chinese high command understands that beggar-thy-neighbour policies can offer temporary relief from speculative capital flows, but only at the risk of creating equal troubles elsewhere.

 

NITESH KUMAR SINGH

PGDM 2SEM

SOURCE-- LIVEMINT