China Lets Loose

China's stock markets are smoking, and smart money is flooding into the country; last year foreign direct investment reached nearly $70 billion. Add to that a 2006 trade surplus of $177.5 billion, up 74 percent from the year before, and a tidal wave of hot money (or short-term speculative investments). Together, this ocean of cash has produced enormous reserves of foreign exchange within China--more than $1 trillion, a fat target for critics who say China's voracious appetites threaten the world economy.

Until recently, largely all that money was stuck in the Middle Kingdom. For decades, communist China didn't allow money to go abroad, because it had so little at home. Once it opened up in the early 1980s, China was afraid volatile capital flows would turn its accelerating economic growth into a wild roller-coaster ride. And when Beijing saw capital flight undermine neighboring economies during the Asian financial crisis of 1997, it came to believe even more strongly in controlling outward money flows, and in resisting pressure to make its currency fully convertible. But now that its cash hoard is stirring global controversy, and providing too much money for investment in a dangerously hot domestic economy, China is changing course. "If foreign-exchange reserves keep growing ... China's economy will overheat," says Huang Yanfen, a fi-nancial expert at Renmin University. So in recent months, Beijing has moved to free its homebound capital, allowing both institutions and individuals to move money abroad in unprecedented amounts.

Foreigners can expect a big wave of Chinese cash headed their way sometime soon. Adding together its different sources of capital, controlled by pension funds, insurance firms and wealthy private investors, China could have as much as $75 billion to invest overseas in the next two years, says Shanghai-based senior economist Stephen Green of Standard Chartered Bank. Assuming that Chinese bureaucrats are able to implement the directives from on high, this could mean some $5 billion a month heading out of China over the next year or so. And if Beijing keeps liberalizing its investment rules, those sums could increase.

There are already signs of change, both large and small. Just last week, regulations went into force that raised the amount of local currency individual Chinese can convert into foreign money from $20,000 to $50,000. While the impact of this change on the big picture will be modest, says economist Xia Yeliang at Peking University, the move was intended to inspire ordinary Chinese to start investing abroad, as well as traveling to and even living in other countries, which China hopes will improve bilateral ties and address awkward trade surpluses.

The reforms are all based on Beijing's commitment to allow the renminbi to trade freely--in gradual steps. Meanwhile, it has made other changes, including the implementation of a scheme last year that granted about a dozen banks quotas worth more than $12 billion to invest overseas. And a year earlier, Beijing authorized certain insurance companies, such as industry leader Ping An, to move some funds offshore. Green says China's insurance sector is flush with cash, with an estimated $200 billion in investable assets: "If they took one fifth of [this total] offshore ... that would be $44 billion worth of outflow."

Then there's the National Social Security Fund. Founded in 2000, the NSSF represents Beijing's strategic reserve, formed to help stave off a looming pension crisis. It recently awarded its first mandates to international fund managers, channeling about $1 billion into foreign stocks and bonds. That's a modest sum, but the NSSF's assets are slated to grow exponentially. Stirling Finance, a firm that has been consulted by the Chinese government on pension issues, estimates that the NSSF's capital, combined with provincial pension pools under NSSF management, could represent an additional $17 billion to $22 billion in outflow this year and next.

Why are Chinese investors so eager to move their money offshore? It's a good question, considering how well Chinese stocks have done of late; in 2006, the country's markets rose by 130 percent. But that very volatility, and the government's penchant for deflating bubbles before they burst--last week Beijing announced measures to curb market speculation, causing the Shanghai and Shenzhen 300 Index to drop 7 percent--have driven some Chinese to look for opportunities overseas.

This does not mean, however, that China has completely dismantled the barriers to outgoing investment. Many of its new policies still have to be translated into practice, and in the meantime red tape restrains some of the outward-bound capital. Ping An, for example, must still wait for new rules to take effect before it can take full advantage of its $2 billion overseas investment quota. China's liberalization is not likely to keep pace with the cash that's likely to flow into the country this year or next. Foreign-exchange reserves are thus likely to keep on growing, meaning Beijing will need new ways to grapple with its embarrassment of riches.