Ring in the old

China starts new year with old "hot money" problem

China is seeing in the new year with an old problem: hot money. Growth for 2013 came in at a reassuringly rapid 7.7 per cent. Add in an appreciating currency, new investment opportunities and low rates elsewhere, and China's appeal for investors who are able to borrow cheaply in foreign currencies and shovel the proceeds into China is all too strong.

Two factors fuel the so-called carry trade. First, China's economy has stabilised. Industrial production in 2013 was a respectable 9.7 per cent. Reforms announced in November are still on probation but have at least dispelled the worst fears of a hard landing. Second, China's currency is on an upward trend. While the yuan strengthened just 2.7 per cent against the US dollar in 2013, there is room for more. Currency appreciation is one tool China's central bank can use to tighten monetary policy, and looks more appealing than raising interest rates, given high levels of corporate debt.

The result is a lure for speculators. Investors can borrow one-year yuan in Hong Kong for less than two per cent, whereas mainland banks are offering wealth management products which pay multiples of that rate. To add to the appeal, the yuan is one of Asia's least volatile currencies. Exporters, who can circumvent China's capital controls by passing off currency flows as trade, are in a prime position to benefit.

China's planners have, if anything, encouraged these flows. For the second half of 2013, the central bank injected money into the market on a net basis, and set the daily starting value for the yuan on average 0.7 per cent below the previous day's closing price. Schemes for foreign investors have been opened up, too. Of the $508 billion increase in foreign reserves in 2013, some $95 billion was financial flows, according to RBS.

The question is where the money has gone. Property is one answer. Investment in office buildings rose 38 per cent year on year, while house prices in big cities are increasing at a 20 per cent clip. Yet, other parts of the market still seem parched - interbank rates are chronically elevated and the stock market is a serial underperformer. China's real problem may be twofold: too much capital in the wrong places and, not nearly enough elsewhere.