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Capital charge

27 January 2014 By John Foley

Capital is flooding into China, and central bankers are worried. It’s easy to see why: such problems aren’t supposed to happen in countries with strict capital controls. But China’s monetary magnetism is of the authorities’ own making. In trying to slow reckless lending growth, planners have created a huge arbitrage opportunity.

The net amount of foreign exchange Chinese banks bought from their clients more than tripled in 2012, to $270 billion. In other words, customers are eagerly swapping their foreign currency for yuan. No wonder: unlike most of the developed world, China has strongly positive real interest rates. The appreciating currency and economic growth add an extra thrill.


Foreign financial investors can’t easily get money into China’s fixed income markets. Export companies, though, can bring yuan into the country freely as payment for trade. That gives them a strong incentive to overstate shipments, which in turn creates statistical oddities. In a recent example, the volume of exports from China fell 17 percent in December, according to China Customs, but their value grew by 4.3 percent.

The proceeds from currency arbitrage are pretty enticing. The cost to banks of borrowing in U.S. dollars for one year is just 0.6 percent. Yet on the mainland a one-year triple-A rated corporate bond, or a wealth management product available over the counter in any Chinese bank, returns ten times as much.

The reason is that China’s central bankers have been letting some interest rates creep up, to deter reckless borrowing from non-banking “shadow lenders”. Rates in the interbank and bond markets have been going up, even though base rates for traditional bank loans have remained flat. That selective tightening may be working, but it creates an appealing arbitrage. The more the authorities tighten, the greater the incentive for those who can to sneak in money.

There are some options for taming the flows. Talk of a “Tobin tax” on financial transactions could be helpful, though it would need to be large to cancel out the spoils from lucrative cross-border arbitrage, and if applied uniformly, would also impede genuine trade transactions. Assuming China’s central bankers prefer inflows to the alternative, the yuan’s appeal should last for a while.


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