• China’s FX reserves reached a new record high in December 2009 and there are no signs that China’s FX reserve accumulation is easing despite a sharply lower trade balance surplus. Hot money inflows now account for more than half of the increase in reserves.
  • Hot money inflows have become a major policy challenge. Hot money inflows will make it hard to manage a gradual appreciation of CNY, which we expect to be resumed in Q2 10. Tighter capital controls and liberalization of some capital outflows are likely policy responses.


Hot money inflows puts pressure on China

China’s FX reserves in Q4 09 increased USD127bn to a new record USD2,399bn (Consensus: 2,420bn) by the end of the December last year. The FX reserve accumulation eased slightly from USD141bn in Q3 09 according to the headline figures. However, the headline figurers are to some degree distorted by value adjustments due to changes in the exchange rate. In Q3 the USD value of China’s FX reserves was boosted by a weaker USD, while the stronger USD reduced the value of China’s FX reserves by year end. Adjusting for these value changes (assuming China’s FX reserves consist of 80% USD, 15% EUR and 5% JPY) our calculations show that China’s FX reserve accumulation continues unabated and actually picked up slightly in Q4 to about USD140bn from around USD130bn in the previous quarter (see chart).

Remarkably China’s FX reserve accumulation has accelerated, despite a sharp decline in the trade balance surplus. The main explanation is apparently that speculative “hot money” inflows have surged in 2009. We have estimated “hot money” inflows as the part of the value adjusted change in the FX reserves that cannot be explained by the trade balance surplus and Foreign Direct Investment. As seen in the chart more than half of the increase in FX reserves can currently be explained by “hot money” according to our calculations.

Implications

We see no signs that China’s reserve accumulation is easing in today’s data and it appears that speculative hot money inflows has become a major policy challenge for China. Firstly, Peoples Bank of China (PBoC) will be struggling to neutralize the liquidity impact from its massive purchase of foreign exchange. This might be one reason for PBoC raising its reserve requirement for banks earlier in the week. Secondly it underlines that despite China’s capital controls, capital flows has become more important and it has become more difficult for China to maintain an independent monetary policy, while simultaneously maintaining a quasi peg to USD.

China’s continued strong FX reserve accumulation and hot money inflows underlines that pressure is building up for policy changes in China. We expect China to resume its gradual appreciation of CNY in Q2 10, albeit we stress that this process could be very difficult to manage because it will not necessarily stem hot money inflows. We cannot rule that China will start to tighten capital controls. Finally China is likely to start liberalizing its capital flows. SAFE, China’s foreign currency regulator, has announced it will broaden channels for overseas investment, however without being more specific.