Sheng’s warning comes amid a strong increase in capital inflows into China, as major central banks from a number of countries have injected an unprecedented amount of liquidity into their financial systems to offset the economic damage caused by the coronavirus pandemic. For instance, the United States Federal Reserve’s balance sheet has almost doubled to US$7 trillion since the beginning of the year.
It is usually hard to distinguish speculative capital from normal capital flows, but Chinese regulators are keeping a close eye on cross-border movements, given the strong capital flight that occurred in the wake of a domestic stock market rout and foreign exchange reform in 2015. That episode prompted China to impose strict controls on the movement of capital into and out of the country.
The worries over hot money come as US$147.4 billion worth of portfolio investment inflows was recorded last year. Portfolio inflows reached US$60 billion in the second quarter of 2020 alone, government data shows.
Morgan Stanley analysts recently predicted that global investors would flock to China for yuan-denominated financial assets, and that the value of portfolio investments could reach US$3 trillion by 2030.
The inflow has been supported by China’s economic fundamentals, with the country likely to be the only major economy in the world to report positive growth this year. In addition, Chinese government bonds and corporate bonds offer significantly higher returns than securities issued by major developed countries, whose yields are just above zero or even negative. For instance, the yield on Chinese government 10-year bonds is 3.11 per cent, well above the 10-year US Treasury bond yield of just 0.66 per cent, and a negative 0.49 per cent for the benchmark 10-year German government bond.
The demand by global investors to take part in China’s domestic financial markets, and the decline in the US dollar exchange rate, have also helped drive the yuan’s exchange rate up 4.92 per cent against the US dollar since its most recent trough against the dollar on May 27, to a 16-month high.
Xie Yaxuan, chief macro analyst at China Merchants Securities, predicted that the US dollar would continue to fall over the next two to three years, potentially helping the yuan exchange rate strengthen to the level of 6.0-6.5 from 6.81 at midday on Thursday relative to the US dollar.
A lower yuan figure in the US dollar-yuan exchange rate means it takes fewer yuan to buy each dollar, indicating a strengthening of the yuan.
Some, however, argued that the yuan’s 4.92 per cent appreciation against the US dollar since May is due in large part to the weakness of the dollar, which has dropped 6.02 per cent against the currencies of America’s major trading partners since mid-May. The yuan’s appreciation against a basket of currencies has been less than 1 per cent.
Chinese officials have openly mentioned the downside of stronger capital inflows, as they are trying to encourage greater foreign investment to deepen financial links with the outside world and stave off economic decoupling.
But Guan Tao, a former official with the State Administration of Foreign Exchange (SAFE), the country’s foreign exchange regulator, warned that Beijing did not do well in managing inflows in the previous round of currency appreciation from 2005 to 2014, leading to a rise in the nation’s foreign exchange reserves and its domestic money supply.
Although a more flexible yuan exchange rate has increased China’s monetary policy leeway, there remain significant risks, such as asset bubbles and excess credit expansion, that could result from strong capital inflows, especially after the US Federal Reserve announced that it would keep interests near zero for at least three more years, Guan said at a forum last week.
Given this environment, China should consider introducing measures to control capital inflows and design new channels for money to leave the country, creating a more balanced two-way flow, he added.
On Monday, the PBOC and the SAFE announced measures that would make it easier for foreign investors to directly invest in China’s domestic bond market and increase their ability to take any profits earned out of the country.
We still need to see if the US dollar will keep depreciating, and if China can attract persistent inflows under its current account
Larry Hu, chief China economist at Macquarie Capital, said the fundamental solution to the problem of excessive inflows is to let the yuan float freely, allowing unrestricted capital flows into and out of the country. However, this is unrealistic to achieve in the short term, he said, given concerns that too much Chinese money would flow out of the country in search of new investment opportunities abroad.
China now employs a managed float of its currency, setting an allowable trading range each day.
On the other hand, China is keeping a close eye on hot money, as the 2015 episode was not that long ago, Hu continued.
“Chinese policymakers will always have to strike a balance” between allowing sufficient flows while preventing excessive flows, Hu said.
Zhou Hao, a senior emerging-markets economist at Commerzbank, said that there is no convincing evidence to support the idea of a persistent appreciation of the yuan, and that the impact of capital flows on the exchange rate is generally neutral in the short run.
“It’s normal for capital to flow in or out,” he said. “From a long-term perspective, we still need to see if the US dollar will keep depreciating, and if China can attract persistent inflows under its current account.”