There is a worry shared by policy makers in China and investors: greater FX flexibility would attract a flood of speculative inflows.
Granted inflows would pick up, but let’s put it in perspective please – the current account is the main source of FX reserves. Check out the graph below:
Chinese balance of payments (US$bn)
In most years capital inflows are relatively small, and even negative. They are most probably driven by the fundamentals of expectations in GDP growth as well as current asset prices. (I do acknowledge that capital mobility into China is limited by regulations; nonetheless the current account is bar FAR the largest factor here).
The market’s rational for capital flows in and out of China is economics 101: Investors will favor Chinese assets when the Chinese interest rate plus the expected appreciation against the US$ is greater than the US interest rate.
So having said all this, one would expect Chinese reserve accumulation to contract somewhat over the coming years. Why?
- Smaller FDI – firstly the property sector looks set to slow thanks to recent cooling measures (see Regulation vs. Speculation https://ravendragon.wordpress.com/2010/04/18/regulation-vs-speculation/). In addition Chinese investment abroad is on the up. In my day-job, by way of example, I’ve been following the story of Chinese interest in Belarusian potash assets).
- Cyclical upturn in the rest of the world over the coming years will reduce the impetus for capital inflows to Chinas
- Appreciation of trade weighted exchange rate to date
- Likelihood of a small near term FX appreciation – I expect moves to wider trading bands, and a focus on a basket of currencies within the coming years.