Is China overwhelmed by capital inflows?

The question of whether China is overwhelmed by capital inflows has been asked for quite a while now. If a question continues to be asked, there is probably a good reason for it. Whether the answer is yes or no depends on how you look at it.

Brad Setser, in his highly recommended blog at RGE Monitor, has written a lot about the drivers of capital inflows into emerging markets and how they challenge fixed exchange rate policies.

Official foreign exchange reserves have soared further in the first quarter (Q1) of 2008, indicating a record balance of payment surplus. Moreover, the external data implies that, with the current account seemingly not having increased in Q1 compared to a year ago, capital flows have indeed been very large in Q1 (there are some caveats and uncertainties, because the underlying data is difficult to extract from the data due to many one-off transactions, including some pursued to "offload" reserves to commercial banks). The surge in inflows is in part because China's interests are now signficantly higher than those internationally (US, but also nearby Hong Kong) and, more generally, because with the global economy slowing down considerably and China still going strong, the expected returns in China compare favorably with those abroad.

Have capital flows overwhelmed policy making in China?

I would say not yet if we narrowly look at whether the inflows have massively affected current domestic monetary conditions. In fact, overall money and credit growth have come down in the first 4 months, and interest rates on the interbank market--probably the best measurement of excess liquidity--have edged up. This ability of monetary policymakers to engineer what seems to me to be a monetary tightening should be counted as a success.

Looking forward, though, China's monetary and exchange rate policy remains a dilemma. The traditional reluctance to appreciate the exchange rate in line with the substantial appreciation of the equilibrium exchange rate--which occured because productivity growth has been considerably faster than wage growth for many years--and the massive external surpluses have encouraged "one way bet" inflows on the rather certain expectaction of future appreciation. The current combination of US and global weakness--leading to lower interest rates there--and so far continued strength in China has accentuated these pressures.

What would be the way out?

Several China economists who thought about the dilemma recommend some combination of tighter controls on inflows and a significant one-off upward move in the exchange rate that would reduce the remaining expected appreciation (see Brad Setser's blog  post on "What keeps Zhou Xiaochuan up at night"). Tighter controls on inflows used to be unpopular with institutions like the IMF, although they have fewer problems with them these days. They are also not universally popular in China. Vice Minister of Finance Li Yong said on Sunday at the Asian Development Bank Annual Meetings in Madrid that he does not see a large role for them. However, a significant one-off upward move in the exchange rate also does not seem to have enough support in Beijing.

The other way would be to continue with the current policy of gradual appreciation against the US dollar and keep mopping up the inflows. The problem with the latter option is that it relies on hoping that the underlying pressures will ease along the way. Ironically, pressure from exporters, who complain about cost rises, seem to have led to a slowdown in the pace of appreciation of the RMB against the US dollar at the same time as that the overall balance of payment surpluses have reached record highs. In these circumstances, China is likely to see more capital flows coming its way in the near term.