Liu Wei, director-general of the General Affairs Department of the State Administration of Foreign Exchange, in an interview with Century Weekly, recently responded to questions concerning hot money? The interview, published in Century Weekly (no. 2, 2011) and on www.caing.com, is presented as follows.
The Cure for Hot Money?
Hot money has become a hot topic in the emerging economies.
At the upcoming meeting to be convened by central banks from Southeast Asia to talk about regulation of cross-border capital flows, the prevention of hot money is bound to come up as a key issue. This is the first time after the outbreak of the 1997 Asian financial crisis that East Asian nations have once again put priority on this topic.
The background for this latest development involves loose monetary policies and a series of economic stimulus measures taken by the major developed economies, such as the U.S., Japan, and Europe, in an effort to combat the 2008 international financial crisis, resulting in tremendous liquidity in the market.
As for the emerging markets, due to their steady economic growth, interest rate spreads between the home currency and foreign currencies, and expectations for an RMB appreciation, China has become a magnet for international capital. According to the State Administration of Foreign Exchange (hereafter referred to as the SAFE), the banks foreign exchange settlements and sales have recovered to their highest level, with USD2.12 trillion for the first eleven months of 2010, 4% higher than that at the 2008 peak level during the same period; the surplus of the banks foreign exchange settlements and sales for that same period stood at USD351.5 billion, registering year-on-year growth of 48%.
This shows that people prefer to have their capital held in RMB instead of foreign currencies, and this directly results in a further surge in China's foreign exchange reserves. As of the end of September 2010, the balance of China's foreign exchange reserves amounted to USD2.65 trillion, an increase of USD249.1 billion from year-end 2009. This amount is more than twice that of the runner-up, Japan, which had USD1 trillion in its foreign exchange pool.
However, to the unprofessional eye, the inflow of Hot money to China is as complicated in nature as it is difficult to understand. As Liu Wei, director-general of the SAFE General Affairs Department, answered questions concerning hot money in an interview with our journalist, she offered insights into the categorization, inflow channels, regulation targets, and policy measures for hot money, as well as provided an up-close introduction to its high-voltage crackdown.
Results of Quantitative Easing
Caing-Century Weekly: What can China expect this year in terms of cross-border capital flows? Why?
Liu Wei: Since 2010, the combination of the slow recovery of the global economy and the strong momentum on the domestic front has exerted more pressure on the net inflows of foreign exchange into China. This is mainly because: first, a new round of quantitative easing policies adopted by the major developed countries added to the rise of global liquidity, resulting in the emerging economies facing the impacts of currency revaluations and capital flows. Second, China's good economic fundamentals continued to attract inflows of foreign capital. Third, affected by changes in the domestic and international macroeconomic environments, Chinese market entities, including businesses and individuals, were more willing to settle accounts in foreign currencies but less inclined to buy foreign exchange. Domestic market entities actively adjusted their asset-liability structures in domestic and foreign currencies, for example by taking large USD loans to replace foreign exchange purchases. Banks also avoided overseas capital maneuvers as much as possible, and instead be brought the capital back to the home market, which also indirectly led to more net inflows of foreign exchange. Moreover, there is the possibility that arbitrage capital infiltrated through legal channels or instruments.
Caing-Century Weekly: How do you interpret the impacts of the quantitative easing policies adopted by the Federal Reserve?
Liu Wei: In the short term, America's QE policies might weaken the dollar, keep its interest rate down, and to a certain extent stimulate the U.S. economy. But in the medium and long term, this policy might fuel inflation and asset bubbles around the world, and making a global economic recovery more uncertain. First, it might aggravate the deteriorating economies of some European economies. Second, emerging markets will have to deal with more inflows of speculative funds, leading to appreciation pressures and aggravation by the already high inflation level. Third, global expectations of a USD depreciation will grow, forcing some countries to adopt measures to slow their currency appreciation, or even to devalue their currency, which will likely result in another round of global protectionism. Fourth, the large supplies of US dollars will trigger asset bubbles in sectors such as commodities, stocks, and the real estate markets. Fifth, as an international reserve currency, an increased supply of dollars might contribute to the export of America's inflation to other parts of the world.
In a word, the QE policies of the U.S. are accompanied by complicated and profound implications that we should closely follow, carefully evaluate, and cope with promptly.
Caing-Century Weekly: You mentioned America's QE policies have aggravated inflation and capital inflow pressures in the emerging markets. Do you think the surge in Chinese banks? foreign exchange settlements and sales is a sign of the influx of Hot money?
Liu Wei: I feel the need to clarify two matters: first, a massive foreign exchange net inflow does not mean there is a large inflow of foreign exchange. Generally, the differences of banks foreign exchange settlements and sales can be used to gauge the cross-border flows of foreign currencies. A foreign exchange net inflow means there is a surplus in the banks foreign exchange settlements and sales, created either by an increase in the sale of foreign exchange or by a decrease in the purchase of foreign exchange, or by a combination of both.
China's increased surplus in foreign exchange this year can mainly be attributed to the weakened inclination of market entities to purchase foreign exchange. Market entities prefer to raise capital in foreign currencies or settle payments in RMB, thereby substantially lowering the amount of the banks foreign exchange settlements and sales.
Second, not all incoming capital falls into the category of hot money. While continuously trying to facilitate trade and investment, China still keeps an eye on capital controls and has put in place a series of policy measures to curb the inflow of short-term speculative arbitrage funds. Therefore, there is no room for legal inflows of hot money in China.
Addressing the Root Cause
Caing-Century Weekly: What on earth is hot money Given the many current arguments, what do you think is a more reasonable way to assess the scale of hot money inflows?
Liu Wei: Indeed, no consensus has yet been reached on a definition of hot money.? In reality, long-term capital and short-term capital are interchangeable, and it is difficult to draw a line between investment and speculation. In economies with free flows of capital, Hot money generally refers to capital moving rapidly in and out of the country for the purpose of short-term speculative profits. Due to China's capital account management, short-term capital is not allowed free entry or exit; therefore, the key to determining whether some capital is Hot money is to find out whether the capital flows are for real and legitimate trade or investment purposes.
A popular way in China to assess the amount of Hot money is newly added funds outstanding for foreign exchange trade surplus actually utilized foreign capital = hot money. Personally, I do not think that this is a recommended method because it fails to reflect the reality of the cross-border capital flows.
First, this formula omits important trading items. Aside from trade and actually utilized foreign capital, there are other trading items that generate cross-border capital flows, such as services, profits, current transfers, securities investments, and other investments. According to this method, all other international payments are labeled hot money, and this obviously is unreasonable. In addition, some hot money flows in the guise of trade and investment, so this method runs the risk of either overestimating or underestimating the amount of hot money.
Second, this method of evaluation brings together the two different concepts of funds outstanding for foreign exchange and international trade without explaining the mechanism for the formation of funds outstanding for foreign exchange or identifying its components. This involves a gross overgeneralization and fails to consider the time lag between goods flows and capital flows.
We need to fully reflect the reality when evaluating the true volume of hot money. Since hot money is usually disguised as legal capital inflows, a simple formulaic calculation can hardly reveal the full extent of hot money. In contrast, daily supervision and investigation of hot money can offer some evidence of the scale of the hot money inflows. For example, starting from February 2010, the SAFE has been carrying out a hot money crackdown campaign, and by the end of October 2010, it had exposed 197 cases of foreign-exchange violations involving a total of USD7.34 billion.
Caing-Century Weekly: Has the SAFE observed more inflows of hot money?
Liu Wei: In this year's hot money crackdown campaign, we have not seen a massive organized cross-border inflow of hot money into China. Violators of hot money regulations mainly include Chinese-foreign equity joint financial institutions, Chinese-funded enterprises, foreign-funded enterprises, and entities that receive foreign exchange from overseas ties and commercial transactions. As for large multinational financial agencies, given the legal risks they face under the capital controls, they are seldom found to be involved in illegal hot money operations.
In addition, as the market awareness of businesses and individuals is strengthened, they become more sensitive to the changes in price signals, such as interest rates and foreign exchange rates. In order to avoid risks and maximize profits, some market entities have adjusted their domestic and overseas asset arrangements and financial management. In international trade settlements, if companies advance or delay their payments to take advantage of foreign exchange fluctuations, they will intensify the volatility of cross-border capital flows and will need to be regulated, though the capital involved cannot be categorized as hot money.
Taken together, the cross-border capital inflows this year are mostly the result of real trade and investment. We cannot rule out the possibility of arbitrage purposes, but those are not the mainstream. We should not overestimate or exaggerate the scope of hot money.
Caing-Century Weekly: Since China maintains an appropriate level of capital controls, in principle there should be no way for hot money to flow in. Then, from the perspective of the SAFE, what channels are responsible for the inflows of Hot money?
Liu Wei: The hot money that manages to enter China for speculative purposes and without a real trade or investment background usually takes advantage of the highly open and channels with minimal procedures, such as cargo trade, service trade, and direct investment. The violators cover up their illegal purposes with seemingly legal transactions, breaking or sidestepping the regulations in their chameleon ways. Typical practices include: trade processing companies directing into China more funds than they need or earlier than is necessary in order to make profits from the sale of foreign exchange; some foreign exchange funds being disguised as foreign direct investment, but after falsifying the capital settlement, they flow into the property or stock markets or are used for other investment purposes; some speculative funds are split into smaller amounts and remitted into China by individuals who want to avoid the annual quota management for the settlement and sale of foreign exchange.
It is especially important to note that when dealing with the settlement and sale of foreign exchange, some designated banks fail to strictly check whether some foreign exchange settlement applications are for real trade purposes, thus allowing the inflow of hot money. Some banks even dodge foreign exchange management regulations by promoting arbitrage-oriented trade financing products. On the surface, they might achieve a win-win? solution for both the bank and the business, but in fact they increase the pressures on foreign exchange net inflows and affect the balance of international payments by avoiding or delaying purchases of foreign exchange.
Therefore, the hot money in China shares the following common features: First, it comes in under disguise. Because hot money is not allowed to flow freely, its entry and exit is usually achieved by violating or bypassing the laws and regulations under the pretense of legal trade or investment or other available means of disguise. Second, it is very complicated. Some aim to gain the differences between domestic and foreign interest rates or exchange rates in the short term, whereas others are more interested in the short-to-medium term profits from asset price increases. Third, it comes in diverse forms, making it difficult to determine the true nature of the underlying transactions. But the movements of hot money leave behind traces that can be used as clues to track down its whereabouts and to reveal its disguise.
High-Voltage Crackdown
Caing-Century Weekly: Since there are traces left by the hot money, has the Chinese government discovered any clues about the inflows of hot money? Have any countermeasures been adopted?
Liu Wei: The massive inflows of cross-border capital have many detrimental effects in China, such as inflation pressures, asset bubbles, as well as increased pressures on monetary policy operations and foreign exchange reserve management. As a result, since 2010, the Chinese government has employed various policy instruments to control the inflows of hot money.
First of all, we have strengthened the management of cross-border capital flows. Since February 2010, we have launched hot money crackdown campaigns in provinces and municipalities with large volumes of foreign exchange. In a series of five announcements, the names of the banks, businesses, and individuals violating the foreign exchange regulations have been released to the public. Our continuous high-voltage crackdown has effectively deterred further increases in the inflows of hot money. Recently, the SAFE developed and strengthened foreign exchange management measures and guided cross-border capital flows by introducing temporary policy adjustments with respect to the banks positions in foreign exchange settlements and sales, collection of payments and settlement of exchange for exports, short-term external debts, foreign direct investments, overseas listings, return investments, and penalties for violations of foreign exchange regulations. Since the launch of these policies, initial progress has been made, producing positive regulatory effects on the cross-border capital inflows during certain periods and in certain areas.
Second, we have reinforced interdepartmental coordination and stepped up joint regulation. In 2010, for example, the SAFE joined the Ministry of Housing and Urban-Rural Development in issuing a document to reiterate that individuals overseas can only purchase one house in China for their own residence, and overseas agencies can only purchase non-residential housing in the city of registration to be used as offices. These principles help curb the influx of foreign capital into China's property market.
Third, we have made full use of monetary policy measures and intensified macro prudential regulations. We do this mainly by allowing price mechanisms such as foreign exchange rates and interest rates to act as guidance, comprehensively using quantity-based hedging instruments such as the reserve requirement ratio and central bank bills, and stepping up prudential regulation over financial institutions. We have also provided banks with more guidance in terms of foreign exchange risks and have strengthened the banks awareness of legal operations.
Caing-Century Weekly: The SAFE has repeatedly mentioned a high-voltage crackdown on hot money. How should we interpret the word high-voltage?
Liu Wei: As China's foreign exchange resources shift from a shortage to a relative surplus, the major functions of foreign exchange management should go beyond merely ensuring the acquisition and administration of foreign exchange resources to also covering the balanced management of capital entry and exit, the prevention of abnormal risks in cross-border capital flows, and the security of the national economy and finance. Recent developments at home and abroad have resulted in potential increases in cross-border capital net inflows; therefore, combating hot money and preventing risks have become important measures to ensure steady and healthy economic development, thus they are part of our current priorities. As for the term high-voltage, I will offer the following interpretations:
First, we should intensify the investigation and punishment of entities with illegal capital by identifying the key channels, links, targets for hot money inflows, dealing pinpointed blows, and increasing inspection efficiency, thereby effectively preventing and curbing the inflows of hot money.
Second, we should further improve the relevant systems and standardize management by reinforcing system building, adopting effective control measures, and preventing market entities from taking advantage of legal loopholes.
Third, we should strengthen cooperation with other regulatory authorities to achieve a synergy. Inbound movements of hot money involve many links and multiple entities, such as banks and enterprises, so the SAFE should cooperate with the relevant departments to carry out joint administration. Taking cross-border transactions as the starting point, the related authorities should assume responsibility for the corresponding businesses, identify suspicious conduct, and eliminate arbitrage behavior under the guise of legal facades.
It is especially worth mentioning that the persistent high-voltage crackdown on hot money does not mean that we will control or restrain the legal foreign exchange transactions of banks, enterprises, and individuals. This campaign will be conducted without adding extra costs for market entities and we will take active measures to facilitate trade and investment.
Caing-Century Weekly: From the end of October 2010 up until the present, the SAFE has issued a series of penalty announcements, making public the foreign exchange violations committed by commercial banks, enterprises, individuals, illegal private banks, and online entities. But given the RMB appreciation expectations and the increases in domestic asset prices, are these measures intended to deter future offenders really effective?
Liu Wei: First, these public announcements are made in order to warn and educate the offenders, to urge the entities involved to strengthen internal management and carry out careful rectification. Second, in this way, we can reveal the typical channels and operational models o the hot money inflows, so that market entities can learn from these lessons and refrain from breaking the laws and regulations. Third, we can strengthen compliance awareness by market entities, urge them to assume their social responsibilities, and to strictly comply with the various policies for foreign exchange management. On the whole, these announcements have produced positive social effects, and have been conducive to pooling the strength of society in the fight against hot money, and to enhancing the effectiveness of the hot money crackdown campaign.
The speculative nature of hot money determines that it is always in hot pursuit of profits, wherever they are, and to follow the extent of profits, the violation of the laws is only a small price to pay. The SAFE must strengthen investigation and regulation according to the law. For bank offenders, we should impose punishments such as fines, suspension of operations, public criticisms, and hold executives with direct responsibilities accountable. For enterprises and other market entities that have violated the relevant regulations, punishments will be followed by public announcements to deter future offenders.
Caing-Century Weekly: You just mentioned the SAFE has adopted a series of measures to curb the inflows of hot money and these have has achieved initial results. Can you elaborate on that point?
Liu Wei: On November 9, 2010, the Circular of the State Administration of Foreign Exchange on Issues Relevant to Strengthening the Administration of Foreign Exchange Businesses was issued to further standardize cross-border capital flows through channels such as trade, foreign direct investment, return investment, and overseas listings, and in particular to strengthen management of the banks positions in foreign exchange settlements and sales, and short-term external debts, and to reinforce the banks obligations to verify the authenticity when dealing with foreign exchange businesses.
According to foreign exchange statistics since November 2010, due to the above-mentioned foreign exchange policies, net inflows of foreign exchange have dropped: the surplus of banks spot foreign exchange settlements and sales has been lowered, especially the surplus in the settlement of foreign exchange capital for foreign-funded companies and foreign exchange settlement and sales for individuals; banks are more cautious when providing forward foreign exchange settlement services, resulting in an obvious reduction in the volume of settlements; banks cash basis positions have increased after the launch of the relevant measures, demonstrating the initial effects of the measures to regulate the foreign exchange market.
Meanwhile, expectations that the RMB will appreciate have weakened both at home and abroad. On December 29, 2010, the one-year forward exchange rates of RMB/USD in the home market and the overseas market were respectively 6.5807 and 6.4890, with the RMB appreciation expectation standing at 0.7% and 2.1%, down by 1.5 and 1.6 percentage points compared with the end of October.
Of course, considering the complicated and uncertain prospects in the foreign exchange markets, we must remain vigilant, and closely watch and actively cope with the latest developments.
Caing-Century Weekly: Going forward, what steps will the SAFE take to tackle hot money?
Liu Wei: To prevent and combat hot money, we must adopt a two-pronged approach. While robustly promoting the facilitation of trade and investment, we must strengthen our monitoring and early-warning of capital flows, adopt measures to stop cross-border arbitrage activities, prevent the devastating impacts of fluctuations in domestic asset prices and the aggravated financial risks caused by the massive entry or exit of hot money.
First, we will maintain our high-voltage stance toward the inflows of hot money and other illegal capital. We will focus on banks and other key channels, continue to carry out special inspections of hot money inflows, step up efforts for foreign exchange examination, and severely crack down on illegal private banks and other foreign exchange crimes.
Second, we will improve the methods for foreign exchange regulation and will optimize management of cross-border capital inflows. We will strengthen trade-based foreign exchange administration, improve management of foreign exchange registration and capital settlement of foreign-invested enterprises, and explore follow-up examination and regulation of money after exchange settlement. We will also strengthen management of banks short-term external debts and reinforce the regulation of banks off-balance-sheet financing.
Third, we will promote the process of opening up China's capital market and boost capital outflows. We will encourage the relevant companies to set up overseas operations, allow more types of institutions to engage in QDII businesses, and while ensuring risk controllability, accelerate the process of capital account convertibility selectively and in order of priority.
Last and most importantly, we must bring into full play the basic functions of the market mechanisms, provide proper guidance by using price mechanisms such as foreign exchange rates and interest rates, eliminate arbitrage opportunities that are likely to be exploited by hot money, and take concrete measures to maintain an enabling foreign exchange policy environment for the sustainable development of foreign-related businesses.
