By staff intern Li Zengxin

China's leading government and finance officials huddled in late April to discuss what had appeared to many as a mysterious infusion of US＄ 85.1 billion that, without clear explanation, poured into the nation's already huge foreign exchange reserves during the first quarter 2008.

Did those attending the meeting at the behest of the State Council learn the origin of the unexplained money, or where it went? Maybe, maybe not.

Sources told Caijing that the meeting of top officials from the People's Bank of China, the Ministry of Finance (MOF), the National Development and Reform Commission and the State Administration of Foreign Exchange (SAFE) ended without the kind of policy change recommendations that may have shed at least a pinpoint of light on the cash, which represented well over half the US＄ 153.9 billion, first-quarter increase in China's foreign reserves, raising the stash to more than US＄ 1.6 trillion.

But not everyone is baffled. Some experts say a hefty portion of the mysterious cash, if not all, was hot money from short-term investors -- with eyes on China's appreciating currency, real estate boom, credit market and other moneymaking options -- who found ways to squeeze through cracks in China's strictly regulated market.

Zhang Ming, a professor at the Chinese Academy of Social Science (CASS), said the nation's economy may have absorbed more than US＄ 476 billion in hot money between 2003 and '07, if the calculation includes forex swaps, forex preparation funds and the government's capital injection into a sovereign wealth fund called China Investment Corp. (CIC). And if cash from phony trade transactions is likewise added to the equation, Zhang said, the figure could be more than US＄ 800 billion.

The US＄ 85.1 billion figure is what remains after subtracting China's officially posted trade surplus and foreign-direct investment (FDI) for the first quarter -- a combined US＄ 68.8 billion -- from the reported US＄ 153.9 billion increase in foreign reserves.

Tracing the Heat

Based on this simple calculation, a CASS report said the amount of hot money entering China was US＄ 37.8 billion in 2003, US＄ 114.1 billion in '04, US＄ 46.6 billion in '05, US＄ 600 million in '06, and US＄ 117 billion last year.

This methodology supposes that neither the nation's trade surplus nor FDI figures included hidden hot money. But experts say this can't be. Hot money can slip into China through false contract pricing, ghost transactions, shell companies, or registered capital deposits masked as surplus trade or FDI.

National trade surplus statistics leave plenty of room for hiding. After China reformed its foreign exchange system in 2005, the trade surplus swelled to US＄ 102 billion from US＄ 30.4 billion the previous year. It jumped to US＄ 177.5 billion in 2006, and last year's figure was an astounding US＄ 262.1 billion.

“There might be some hot money” that's being counted as trade surplus, said Zhang.

Management of the government's forex reserves also raises suspicions. The official figure for new forex reserves was US＄ 461.9 billion in 2007 -- the year MOF issued special treasury bonds to buy some forex reserves, some US＄ 200 billion of which was then injected into the CIC fund for investment projects. Details of this money-moving operation have yet to be disclosed to the public.

Experts also say calculating hot money is a mission impossible because of the obscurity surrounding official statistics on forex swap operations, CIC capital injections, the composition of forex reserves, accounting procedures and forex settlements. SAFE officials know these statistical details but are reluctant to share.

The strengthening of China's currency has also encouraged hot money. Morgan Stanley's Asia chief economist for China, Wang Qing, says the yuan's appreciation accelerated the influx of hot money. Ongoing financial turbulence around the world has lured investors to seek a safety net in Chinese currency, he added.

Hot Money Targets

Hot money may have contributed to drastic fluctuations in the domestic stock market over the past year, said Bank of China analyst Tan Yaling. The Shanghai Composite Index doubled last year, soaring to more than 6,000 points in the fall, but plummeted to near 3,000 early this year. Tan noted that, while the index swung dramatically, China's macroeconomic conditions, the yuan's appreciation speed, and earnings of listed companies were generally stable.

Not all agree with Tan. For example, China International Capital Corp. chief economist Ha Jiming thinks the unexplained cash probably flowed into tangible sectors of the economy, such as real estate development.

Borrowers also may have attracted speculative cash. Since the government tightly controls credit, companies have had an incentive to borrow on the international market. Low interest rates globally have created “an abundant capital supply” for Chinese borrowers, Ha said. 

Hot money also may have been used for production projects and transactions, said Gao Shanwen, chief economist with Essence Securities. He said the central bank may be encouraging the influx by enforcing credit control targets set in late 2007 that may be obsolete. China's nominal GDP growth is more than 20 percent, Gao noted, and the capital demands of small entities are substantial.

Inflation also must be taken into consideration when assessing hot money, said Xie Guozhong, a Caijing guest economist. Because speculative capital lacks patience, Xie supports increasing savings deposit interest rates above inflation levels to make long-term savings more profitable. He also thinks capital account controls should be strengthened.

Guessing on the Yuan

But among all the explanations for China's phenomenal cash inflow, the lure of currency trades stands out. Hot money is betting on the appreciation of the yuan, whose value rose more than 4 percent against the U.S. dollar in the first quarter.

As dollar-denominated international commodity prices drive up China's prices for energy, agricultural products and food, some economists have suggested a speedier or even one-time increase in the yuan's exchange rate to kill speculation surrounding the currency's gradual appreciation. But others have raised questions about how far to go.

Ha has suggested a “policy shock,” such as an adjustment to the yuan's exchange rate for certain periods on a trial-and-error basis. Monetary policies that are anticipated and then imposed are less effective than bold moves, he said.

Ha's idea of a shock is a possible 10 percent to 15 percent increase in the yuan, followed by a fixed exchange rate for one year. The move could help reduce uncertainties for companies that must price their goods, he said, as well as stem the flow of hot money.

Zhang suggested SAFE allow the yuan's exchange rate to be set entirely by market forces for some time. Only when the currency swings go beyond the range of non-deliverable forward fluctuations should SAFE step in again, he said.

The yuan's appreciation slowed in April. Nevertheless, the government has found it difficult to convince international speculators that the yuan's exchange rate, after years of rising against the dollar, has reached a plateau, said Paul Cavey, China research director at Macquarie Securities. Apparently, the US＄ 85.1 billion mystery is not so mysterious after all.