Causes of China’s Inflow of Hot Money

While there may be some uncertainty about the precise amount of “” flowing into China, there appears to be a general agreement as to why speculators are moving their capital into China. Analysts point to two key factors: (1) the relative rates in China and the United States; and (2) expectations of the future appreciation in the value of China's currency, the renminbi (RMB).

Over the last year, interest rates in China and the United States have been moving in opposite directions. The U.S. Federal Reserve lowered the federal funds rate nine times over the last year from a high of 5.25% in June 2007 to its current low of 2.00%.

Over the same time period, the People's Bank of China raised its benchmark one-year interest rate on deposits from 2.52% to 4.14%. The reversal in the relative interest rates of the two nations has created an incentive for investors to move their deposits from the United States to China in order to earn a higher rate of return.

In addition to the attraction of the interest rate difference, speculators are moving “hot money” into China because of the general expectation that the RMB will continue appreciate in value against the U.S. dollar and other currencies. On July 21, 2005, China announced it was dropping its fixed exchange rate policy for a “managed float” policy that would allow the value of the RMB to fluctuate within a specified range on a daily basis.

Since then, through July 15, 2008, the RMB has appreciated in value by 21.6%. Most analysts expect the to continue the RMB's appreciation.

The combined effects of the interest rate differences and the expected appreciation of the RMB provide a strong incentive for “hot money” flows into China. Li Yang, a financial researcher at China's Academy for Social Sciences calculated that “hot money” speculators can obtain profit rates of over 10% per year with little investment risk.

In theory, despite its recent capital market liberalizations, China still maintains some restrictions over foreign exchange and international capital flows, providing it with various instruments to prevent the inflow of the unwanted “hot money.” However, sources report that speculators are using various methods to circumvent Chinese laws and regulations. According to a Deutsche Bank survey of 200 companies and 60 “high income” individuals, over half of the “hot money” coming into China is being done in the form of overreported or false foreign direct investment (FDI). An additional 11% of the “hot money” is generated by underreporting the value of imports, and another 10% comes from the overvaluing exports. The Deutsche Bank study also reported that 5% of the “hot money” enters China via “underground money exchangers” (dixia qianzhuang).

Employee compensation (wages sent to China by overseas workers and remuneration paid by Chinese enterprises to overseas staff working in China) and current transfers (emigrant remittances, gifts, and donations) may be another major source of hot money.

According to some analysts, U.S. economic policies (and the slow U.S. economy) may be exacerbating China's “hot money” problem, creating a “Catch-22” situation for Beijing. Years of large federal deficits and comparatively low U.S. interest rates have contributed to the weakening of the U.S. dollar against many currencies (including the RMB) and the outflow of “hot money” from the United States. One Chinese official indicated that he thought the U.S. subprime crisis was also fueling “hot money” flows.