PRICEY PROPERTY: International hot money is considered an important driver of the Chinese real estate market in major cities (ZHANG MING)

Hot money can cause serious problems for a country's financial stability. Though analysts have controversial opinions about how hot money winds its way into China, most of them acknowledge that fast inflows and outflows of hot money have become an issue to be reckoned with. Their influences have been felt in capital and property markets as well as the overall macro-economic performance. Earlier this month, Economic Information Daily published an article about how the government tracks hot money flows and supervises them. Excerpts follow.

How much?

The latest statistics indicate that in the first quarter the country's foreign exchange reserves stood at $153.9 billion, while the aggregate value of the trade surplus and paid-in foreign direct investment (FDI) for the same quarter was approximately $70 billion. Many analysts conclude that the difference between the foreign reserves and the above-mentioned aggregate amount is the scale of international hot money in the first quarter.

But Zhao Qingming, a senior research manager at China Construction Bank, said the amount of hot money simply could not be determined in such a way. Zhao said the appreciation of non-U.S. dollar assets in China's foreign reserves contributed to the fast growth of its foreign reserve value.

Mei Xinyu, a researcher at the Chinese Academy of International Trade and Economic Cooperation under the Ministry of Commerce, agrees that the amount of hot money is not that large. The continuous devaluation of the U.S. dollar has increased China's non-U.S. dollar reserves, he said. The income from investing foreign reserve money as well as the settlement of domestic companies' foreign exchange swaps also have contributed greatly to the increase in the country's foreign reserves, he said.

Why China?

Why does international hot money favor China? Li Yang, a financial researcher at the Chinese Academy of Social Sciences (CASS), said the interest rate gap between the United States and China and the foreign exchange arbitrage brought about by renminbi appreciation both have triggered a greater influx of international speculative money.

Li believes that simple speculation such as interest rate arbitrage and foreign exchange arbitrage could bring speculators profits of more than 10 percent.

The surge of international hot money has been caused in part by U.S. interest rate cuts in the wake of the subprime mortgage crisis. The U.S. Federal Reserve has cut its key federal funds rate seven times since last September from 5.25 percent to the current 2 percent. In the meantime, the Chinese central bank started its sixth round of interest rate hikes since last year. At present, the benchmark one-year deposit interest rate was raised to 4.14 percent from the previous 2.52 percent. The opposite action of the two nations has further lured the influx of the overseas speculative money, Li said.

The continuous devaluation of the U.S. dollar has forced hot money to find a way out, with emerging markets becoming its destination. Some of the hot money holders were tempted by the fast appreciation of the Chinese currency. In the first quarter, the renminbi rose more than 4 percent against the U.S. dollar, the fastest quarterly appreciation since the currency reform of 2005.

Zhang Ming, a financial expert at CASS, said he believes the robust growth of the mainland property and capital markets was another important reason for the huge inflow of hot money.

How did it enter?

Zhang said hot money has entered China through three different ways-the capital account, current account and the underground money bank.

Items under China's capital account such as FDI, securities investment, trade credit and loans, might also be channels where hot money sneaks in, Zhang said. Hot money can enter China under the name of FDI, and after being changed into renminbi, speculators can invest it in the stock and real estate markets, he said.

"China has a strict control over the capital account, thus making it costlier for hot money to enter the country than other emerging markets," Zhang said.

In terms of the current account, Zhang said domestic foreign trade companies could bring in hot money by reporting low import quotations and high export quotations or registering sales revenue received in advance and deferred payments. Some foreign trade dealers have forged fake trade documents, enabling them to collect payment although no goods have been exported, he said. He added that fake trade has been the most convenient channel for hot money to enter the country.

Zhang cited a case in Guangdong Province where an importer signed a contract with a domestic foreign trade dealer to pay him three months in advance in U.S. dollars. Three months after the contract was signed, the Chinese dealer asked the foreign side to postpone the payment date for another three months. After the next three months passed, the Chinese dealer required the importer to raise the price of the goods because of the price surge of raw materials. After two months of negotiations, they cancelled the contract, and the Chinese side was fined 10 percent of the money it had received in advance.

In this dispute, the two companies manipulated international trade conventions by successfully keeping the importer's money in China for eight months. The Chinese dealer could use the money he received in advance to invest in the mainland capital and property markets. Therefore, in addition to the currency appreciation during the eight months, the importer got 10-percent investment revenue from the Chinese side.

Hot money also can enter China through underground money banks, Zhang said. Such banks have not been authorized by the government, are not subject to government regulations and handle deposits and loans illegally.

In these cases, foreigners usually deposit money in an overseas account at a Chinese underground bank. After changing the dollars into renminbi, the banks deduct relevant trading fees and then deposit the money into the renminbi account of the foreigners, he said.

How to contain hot money?

The frequent inflow and outflow of hot money would undoubtedly cause economic uncertainties in the mainland markets, said Zhao Qingming of China Construction Bank.

"The excessive influx of hot money will expand market liquidity, cause excessive money supply, and will eventually push up inflation," he said. "The hot money inflow also poses more pressure for renminbi appreciation. It can also create bubbles in the property and stock markets."

The large amount of hot money also has negative impact on currency policy, Zhao said.

Mei Xinyu of the Chinese Academy of International Trade and Economic Cooperation agrees. "Worse still, if the money is pulled out of China all of a sudden, the normal operation of mainland financial system will be disrupted," he said.

As a means of containing hot money, Zhao suggested that the government "reasonably control the renminbi appreciation expectation, strengthen efforts in trade investigation and sanctions and maintain asset prices at a reasonable level."

The State Administration of Foreign Exchange (SAFE) should cooperate with the Customs agency to crack down on fake trades, Zhang said. He also suggested keeping the China-U.S. interest rate difference at a reasonable level to curb arbitrage.

SAFE had stated earlier that it would strictly control foreign exchange collections and settlements, tighten its supervision and investigations of commodity and service trades, strengthen the management of the bank's short-term foreign debt quotas and improve foreign-invested companies' management of foreign debt. It also vowed to strengthen its efforts in checking cross-border capital flows and cracking down on underground banks and illegal foreign exchange trades.

Worries of a pullout

Mei warned of the financial uncertainties of a sudden pullout of hot money.

"The outflow of hot money could bring enormous disaster to the domestic financial system," he said.

Mei said the risk would come from two factors-the U.S. subprime crisis contagion and a perception that mainland renminbi appreciation and capital market gains had reached a peak. Should this happen, hot money would "quickly get the arbitrage and pull out," he said.

Mei also said the U.S. subprime mortgage crisis is worsening. If foreign-invested companies and foreign institutional investors wanted to cover losses in their home countries, they would sell off their assets in China and switch the capital into their home countries to fuel the liquidity-hungry economies, he said.

"If that happens, the renminbi will be forced to drop sharply," Mei said.

Collective irrational actions are common in financial markets, Mei said. In the long run, he believes the renminbi will keep appreciating. But if some speculators expect a downward trend in the currency's value, they would quickly retreat, prompting an overall fear of renminbi depreciation, which would in turn stir other speculators who may follow suit, he said.

"That is the scary part," Mei said. He suggested that China reject a fast and substantial appreciation of the renminbi and keep its appreciation speed at a slow and incremental level.