Why China Is Becoming The 'Black Hole' Of Global Markets

Is China the financial equivalent of the scariest celestial body in the universe? In a new report that crunches Beijing's opaque numbers, analysts at Standard Chartered Bank in Hong Kong argue that the country's foreign reserves "seem to have turned into some kind of massive black hole for the world's liquidity." They calculate that China drew in a staggering $324 billion during the first four months of 2008, of which $119 billion was "unexplained" by either the country's yawning trade surplus or the inflow of legitimate foreign investment. The unexplained part—a sum just shy of Singapore's gross national income last year—is both mysterious and dangerous. The bank's widely respected head of research in China, Stephen Green, says a "hot-money vortex" is forming that could be capable of ravaging China's economy.

Asians know well that hot money (typically invested by high-flying speculators searching the solar system for big, fast returns) can be a highly destabilizing force. When it rushed out of regional economies in the late 1990s, it caused a devastating currency crisis. Today funds surging into China have boosted liquidity, undermined Beijing's efforts to tamp down inflation and contributed to consumer prices that are now running at a 12-year high. Speculators, betting that the yuan will appreciate, are buying it with weakening greenbacks. Most hot money enters China masked as trade settlements or legitimate investment funding, though Green estimates that so far in 2008, as much as $15 billion has flowed across the border from Hong Kong, where residents can convert HK$20,000 per day into yuan and remit it into mainland accounts.

Controlling hot-money flows is never easy. In China's case, doing so with harsh administrative measures could crimp legitimate trade and investment. Already, Beijing's policy of slow yuan appreciation is an open invitation for speculators to pour ever more money into Chinese assets, priced in steadily rising yuan. There's no clear-cut fix. Repegging the yuan to the falling dollar would likely amplify Western complaints that China manipulates its currency. Engineering a fast upward revaluation would quell expectations of future rises and reduce the spiraling cost of imported oil and other commodities, but would make export factories less competitive. And too sharp a rise in the yuan could send hot money coursing out of the country. Yet waiting only allows the problem to grow, analysts argue. "There are not many things that can overwhelm an economy as large as China's," warns Green. "But these apparent inflows are rapidly turning into one of them."