What's Behind China's Recent Currency Surge?

A few days ago the Wall Street Journal published an article that said economists were dumbfounded that China’s foreign reserves rose $135.7 billion in the first quarter -- more than half the increase for all of last year. A total of $1.2 trillion USD now sits in China’s coffers and has caused pundits from Larry Summers to the guy next door to have opinions on what China should do with its money. The WSJ remarked that the jump in reserves might be due to foreign currency swaps by Chinese banks. But it and the economists it talked to cannot seem to figure out why there are tens of billions in unaccounted surpluses once exports are factored out.

Many hawks like Senator Charles Shumer will undoubtedly say that this is further cause to launch complaints to the WTO about China, as the Bush administration recently did with the piracy issue in China, and we will probably see critics of Treasury Secretary Hank Paulson calling for him to move more stridently to force China to appreciate the RMB, even though it has already gone up almost 7 percent in the last year and a half.

In reality, the answer might be much less ominous than the critics point out and should actually show to critics like Shumer that China is trying to stop the massive inflow of currency speculation which is leading to a unbalanced currency rate and thus a trade surplus.

I have been thinking about the conundrum for a couple of days now. I have a hunch that there are two main reasons for the huge jump in currency reserves that most economists and pundits have failed to see.

Personal Currency Exchange

The first one is that China’s Government recently made it much more difficult for individuals to trade foreign currency into RMB. Before, individuals could exchange up to $50,000 USD per month into RMB. Citibank (C) bankers started calling their clients just before Chinese New Year to warn them that the new rules would allow each individual to exchange only $50,000 USD per year into RMB. This is obviously a huge difference and caused many people to exchange $50,000 USD worth of currency into RMB immediately before the new laws were enacted.

Many families got creative in their currency exchange. In some cases parents had their children, even two year olds, exchange money before the deadline to get around the upcoming, onerous exchange laws so that they could take part in China’s currency appreciation.

I believe that personal foreign exchange trading is a major reason for the huge uptick in foreign currency reserves in China for Q1.

Tax Breaks

There has also been a movement in China to level the tax code between big multi-national firms and domestic Chinese firms to 25%. A substantial number of foreign firms receive a plethora of tax breaks which the Chinese Government originally enacted before China was red hot in order to attract foreign investment. Many domestic Chinese companies have called the tax breaks to foreign firms unfair and the Government is in the process of reforming the tax codes while allowing companies to get grandfathered in before the Spring.

Thus, my hunch is that the number of companies setting up shop in China increased this year in order to get grandfathered in for the tax breaks. And for companies already here, they are increasing certain investments. This has also caused more money to flow into China, often through personal accounts of Country Heads, especially before the new currency laws were enacted.

Is Q1 Indicative of the Foreign Currency Growth Problem?

There are some take-aways from this increase in foreign reserves. The first is that the shocking jump in currency reserves is due to attempts by China’s government to reduce the issue and will bear fruit in the coming months. The effort by China’s government should result in much smaller inflows next quarter.

The second is that if Citibank and other foreign banks like HSBC (HBC) and Standard Chartered can continue such great service, then the Chinese banks like Bank of China, ICBC and Bank of Communications have a lot to fear because of their ghastly customer service. Based on my terrible experiences with Bank of China especially over the last decade, the domestic banks certainly would never call any of their clients to let them know of changing laws that can have a material impact on their client’s financial well-being. I cannot even see a teller without waiting for over an hour!

Comments

[WebWatcher]

Shaun, the story is a nice read, but without support of actual data. This is particular true with your cause #1, which doesn't seem to be a factor in the same magnitude as others. It's simple, if we simply calculate the number of foreigners and alike and the % of them exchanging for RMB, ...., it's still insignificant to the huge number in terms of gap in foreign currency reserve.
I enjoyed most of your posts, but this one, "after thinking for several days", is not convincing. ;-)

[ChinaMarketResearchGroup]

Thanks for the comment Alex and nice words... at least about my previous articles. I am not sure that the #s are that insignificant for this one however. Let's do some back on the envelope calculations. The BBC estimates that 1.5 million Taiwanese live in China. If only 10% of them exchanged $50,000 USD in a rush to take advantage of the increasingly currency rates, that would total $7.5 bil USD. Now, this would not include the # of Taiwanese who had families visit them here at some point before the new currency conversion laws went into effect and who would have exchanged money (i.e. wives and kids) nor does it include the Taiwanese who travel here on business but have bank accounts here.

We also can factor in the number of HK people who regularly exchange money in the same way as well as foreigners from America and Europe. The numbers of foreigners working legally in Shanghai # only about 60,000, but a much larger # come in on short-term work visas who also have banking accounts. You can see the real estate speculation to get an idea that a lot of foreigners have been sending money into China -- so much that the Govt now makes people live in China legally for one year or open a Chinese company in order to invest in order to curb real estate speculation.

I did a very unscientific survey by asking friends and at least 10 changed the money. I also asked a couple of other businessmen who said that their companies (set up as rep offices here) were worried about having problems with RMB since they cannot bill here to get more RMB and did not want to go through the hassle of getting currency approval for the companies -- they have for years exchanged money through the personal accounts of their foreign executives.

Now, based on this, it is realistic that $10 bil. USD extra was brought into China, especially when you consider that the RMB rates have steadily been increasingly over the last few months. My hunch still is that the # was higher than that and that this is a conservative #.

Accountants have also been saying that a lot of money has been coming in to take advantage of the current tax code and to get grandfathered in. i am not an accountant but word on the street has been that they have been real busy with this.

The business capital inflow would also be fairly significant and perhaps, as you pointed out, higher than the personal conversion amounts. It is possible then that we have $20 bil. USD on the fairly conservative side. I would reckon that a sizeably number of people from HK exchange money too, perhaps on a level as high as the Taiwanese which would add more than the $2 bil. USD or so I estimated before.

Anyway, thanks for the note, and I certainly welcome comments and debate on my articles. I certainly got a lot of hate mail for my article on the difficulties Japanese car manufacturers have in China because of political and historical tensions -- by the way for those folks, I just bought a Toyota.

[ChinaMarketResearchGroup]

Thanks for the comment Alex and nice words... at least about my previous articles. I am not sure that the #s are that insignificant for this one however. Let's do some back on the envelope calculations. The BBC estimates that 1.5 million Taiwanese live in China. If only 10% of them exchanged $50,000 USD in a rush to take advantage of the increasingly currency rates, that would total $7.5 bil USD. Now, this would not include the # of Taiwanese who had families visit them here at some point before the new currency conversion laws went into effect and who would have exchanged money (i.e. wives and kids) nor does it include the Taiwanese who travel here on business but have bank accounts here.

We also can factor in the number of HK people who regularly exchange money in the same way as well as foreigners from America and Europe. The numbers of foreigners working legally in Shanghai # only about 60,000, but a much larger # come in on short-term work visas who also have banking accounts. You can see the real estate speculation to get an idea that a lot of foreigners have been sending money into China -- so much that the Govt now makes people live in China legally for one year or open a Chinese company in order to invest in order to curb real estate speculation.

I did a very unscientific survey by asking friends and at least 10 changed the money. I also asked a couple of other businessmen who said that their companies (set up as rep offices here) were worried about having problems with RMB since they cannot bill here to get more RMB and did not want to go through the hassle of getting currency approval for the companies -- they have for years exchanged money through the personal accounts of their foreign executives.

Now, based on this, it is realistic that $10 bil. USD extra was brought into China, especially when you consider that the RMB rates have steadily been increasingly over the last few months. My hunch still is that the # was higher than that and that this is a conservative #.

Accountants have also been saying that a lot of money has been coming in to take advantage of the current tax code and to get grandfathered in. i am not an accountant but word on the street has been that they have been real busy with this.

The business capital inflow would also be fairly significant and perhaps, as you pointed out, higher than the personal conversion amounts. It is possible then that we have $20 bil. USD on the fairly conservative side. I would reckon that a sizeably number of people from HK exchange money too, perhaps on a level as high as the Taiwanese which would add more than the $2 bil. USD or so I estimated before.

Anyway, thanks for the note, and I certainly welcome comments and debate on my articles. I certainly got a lot of hate mail for my article on the difficulties Japanese car manufacturers have in China because of political and historical tensions -- by the way for those folks, I just bought a Toyota.

Cheers,

Shaun Rein
researchcmr.com

[WebWatcher]

Shaun, thanks for the good reply. Your math does make sense, though I am not fully convinced; I hope that soon we will have a clearer picture as what has happened. This is probably a relatively rare case, not only the amount of reserve is huge, it has also severe political implications, not just an interesting case for our small debate. Again, i commented because i read quite some of your previous posts; keep them coming! :-)
btw: Toyota build really good cars, enjoy the ride; but I am not a fan of Japanese business practice.