Europe may send hot money to China

Expert says Chinese officials should stick to their guns on currency liberalization

Dramatic monetary policies in Europe have lots of potential to create a new surge of hot money inflow into China, says Simon Derrick, chief currency strategist at the Bank of New York Mellon.

Hot money is speculative money that flows quickly between markets as investors cast about for high interest rates and returns. It can create distortions in sufficient quantity.

This impact is similar to the impact that quantitative easing by the US Federal Reserve had for China in 2009, when excess money created was looking for a home in a high growth economy and found China, Derrick says.

As China experiences this inflow of hot money, it is tempting to introduce exchange rate controls similar to a repeg of the yuan to the US dollar, he says, but such measures are not advantageous for the longer term.

"The temptation is to step in and intervene, but the problem is that you'd simply end up with the same old reserve policies and reserve problem that characterize the currency war for the last 25 years," says Derrick.

Instead, the brave thing for China is to decide that it has committed to liberalizing the currency, so it should use monetary policy to control inflationary pressures, he says.

"I hope that will happen, as it shows that the People's Bank of China, and more generally the Chinese government, has had faith in what they were doing. I really do believe what's happened over the last 18 months is an important step and I'd like to see it continue to happen," says Derrick.

The two events in Europe that Derrick made reference to are the European Central Bank's intention to execute quantitative easing in March and the introduction of a negative interest rate by the Swiss National Bank.

According to European Central Bank announcements in January, at least 1.1 trillion euros will be injected into the ailing eurozone economy, and the program is expected to start in March.

The measure was decided upon to address problems in the eurozone after it was revealed in December that the eurozone had fallen into deflation for the first time in more than five years.

Meanwhile, in January, the Swiss National Bank introduced a negative interest rate of -0.25 percent on commercial bank deposits in order to stem the rise of the Swiss franc against the euro.

Derrick says the QE in the eurozone is on a magnitude similar to that of the QE introduced by the US Federal Reserve in 2009, leading to the potential for a big flow of hot money into China on a similar scale.

The negative interest rate of the Swiss Franc will encourage borrowing, and China then will become an obvious location for this extra money to be invested, he says.

"People are being paid to borrow Swiss francs, so a significant amount of this money borrowed will go into hard assets, like oil, gold and London property; secondly, high yielding currencies; and thirdly, economies that are doing well, like China," Derrick says.

Put into a historical perspective, such major monetary adjustments globally will create a real test for the Chinese government on how to keep its exchange rate under control.

Starting in 1994, the Chinese yuan was pegged to the US dollar because China was in the process of opening its economy to foreign competition, and also the dominance of its export sector meant that the government needed to manage the currency to benefit exporters.

This situation changed in 2005 as China liberalized its currency, moving the peg to a managed float against a basket of major currencies. This enabled the yuan to appreciate by about 20 percent over the next three years against the dollar.

However, the global financial crisis in 2008 hurt worldwide demand for Chinese products and China halted appreciation of the yuan, which resumed only in 2010.

Meanwhile, rounds of QE executed by the Federal Reserve drove a large amount of hot money into China following the financial crisis, and this led to China's further accumulation of foreign reserves.

This battle between China and the United States has long been labeled a key element of the global currency war, and Derrick says it is very destructive for the global economy, especially if China finds itself on the losing side of the game.

For the US, which effectively created extra money through QE, and used the extra money to buy products from China, its economy and consumers gained. But China accumulated large amounts of foreign reserves over the years, which increasingly lost value as the Federal Reserve executed its QE.

"China ended up with 4 trillion dollars of foreign reserves, effectively lent money to the US at low interest rates, and experienced intermittent spikes of inflation when the US introduced each round of inflation," Derrick says.

Perhaps for this reason, each new US treasury secretary threatened to label China as a currency manipulator but never actually did so, having realized the benefits that China's currency controls have given to the US.

The interesting phenomenon over the past two years is a reversal of this trend, Derrick says, perhaps as a consequence of realizing the destructive nature of such a currency war.

The US has hinted at possibly raising its interest rates later this year, through changes to the Fed's so-called forward guidance on rates and fresh economic projections, which could lead to an appreciation of the US dollar.

China, meanwhile, has further liberalized its currency to allow freer trade and investment flows into and out of China, rather than regulating it tightly to keep the exchange rate under control. Most economists agree that the yuan-dollar exchange rate has now reached equilibrium despite the yuan's lack of full convertibility, an assessment with which Derrick agrees.

"The dollar has appreciated in the last nine months, and far from complaining, the US government has embraced it. And in China, certainly from November 2013 onwards, China decided that they have ended up with a level of reserves the government has considered to be doing more harm than good," Derrick says.

He points out that measures like the creation of the Shanghai Free Trade Zone, where currency can be freely exchanged within a confined geographical location, and other capital and current account liberalization policies, are all signs of China's foreign exchange liberalization.

Over the long term, Derrick feels extremely confident about the yuan's internationalization, given that it is now already one of the most traded currencies globally. He also thinks the Chinese government's currency liberalization policies are heading in the right direction.

Going forward, he says the Chinese government should maintain its faith in its decision to liberalize the yuan, and use monetary policy to control inflation, because the danger of any form of repegging is the likely accumulation of more foreign reserves.

"We remember what happened in August 2011 when there was a downgrade in US sovereign debt. European sovereign debt may have the same problem as well, so why would you want to earn a lot of low-yield sovereign debt," he says.

Meanwhile, Derrick says the Chinese government's policy of encouraging sovereign wealth funds to invest in high yield assets abroad, and for Chinese companies to pursue international expansion, is extremely helpful in making good use of the country's foreign reserves.

Such overseas investment will help the Chinese economy grow, help Chinese companies internationalize and support the internationalization of the Chinese currency over the long term, he says.

cecily.liu@chinadaily.com.cn