China’s Options for Dealing with “Hot Money” Flows

If the Chinese government determines it is necessary to take action, it has a number of options on how to slow down the flow of “hot money.” However, each option has potentially negative side effects.

Appreciate — or Depreciate — the RMB.

An increase in the value of the RMB would arguably be an effective option for controlling inflationary pressures caused by “hot money.” A sharp appreciation in the RMB vis-a-vis the dollar — either by a sharp revaluation or quickening the pace of appreciation under its “managed float” regime — would eliminate one of the two main driving the . The move would probably lower the price of imports (including raw materials) and possibly slow the growth in foreign exchange reserves. Other analysts have suggested that China depreciate the RMB, a move that would undermine the speculators, but could prompt Congress to pass currency legislation (including sanctions) against China, rate differentials being the other major incentive.

Some Chinese officials contend that although a stronger RMB might reduce inflationary pressures, it would also likely raise the price of China's exports and diminish China's attractiveness as a destination for FDI, leading to widespread layoffs, factory closings, and slower . (Rising costs (such as increased wages) in China and an appreciating RMB are already prompting foreign manufactures to relocate to lower cost countries, such as Vietnam and Cambodia. An article in China Daily (June 28, 2008) quoted a Hong Kong business association official as predicting that 20,000 Hong Kong firms in Guangdong Province (29% of total Hong Kong firms located there) may shut down or move their operations in 2008 due to rising costs.) While export growth over the first six months of 2008 has been strong (up 22% over the same period in 2007), there is concern that rising costs in China and economic weakness in the United States could greatly slow China's export growth and reduce the domestic value of its foreign exchange reserves.

Regulate the Flow of Capital.

Another option for slowing the inflow of “hot money” is to tighten restrictions on the flow of foreign capital into China, a trend contrary to recent U.S. efforts to persuade China to liberalize its financial markets. During his first speech as Vice Premier on May 9, 2008, Wang Qishan spoke of “reinforcing supervision over cross-country capital flow.” There have also been reports that China is tightening its supervision of bank accounts held by non-residents to curb the influx of “hot money.”

In addition, China could attempt to further promote the outflow of capital to reduce the inflationary impact of “hot money,” using some of its foreign exchange reserves. China's overseas direct investment totaled about $91 billion (cumulative) at the end of 2006. However, many policymakers, including those in the United States, are concerned over the potential impact of wide-scale (and potentially government directed) Chinese investment in “strategic” economic sectors (such as oil and gas, high technology, etc.).

The issues concerning the potential of “hot money” flows to China reinforces the U.S. argument (and has been acknowledged by the Chinese government as a long term goal), that China needs to do more to implement policies to encourage domestic demand and lessen its dependence on exporting and fixed investment for its economic growth. Some U.S. analysts contend that adopting a free floating exchange rate is the best way to stop hot money inflows and to provide the government with the monetary tools it needs to control inflation. However, Chinese officials contend that such a move at this time would shock the economy, especially the export sector, and thus would be too risky (although they contend that a fully convertible currency is a long range goal). The “hot money” issue is a further indicator of the growing economic integration between the United States and China.