The Market's Different Reactions To the Two Inflows

The last time massive inflows were recorded was from the end of last year to early this year, resulting in similar rallies in the HKD exchange rate, the stock and property markets, as well as rise in the aggregate balance but decline in HKD interest rates. The monthly average inflows amounted to approximately HKD10.0bn then. This time, the amount was about HKD10.9bn. Although the HKMA's different pace of intervention may play a role here, the speed of the two inflows seems identical.

However, the market reactions differed markedly. In the foreign exchange market, the HKD forward discount widened by a much larger degree this time. On October 3, 2003 when the HKD spot rate was as high as 7.7020, the one year forward discount was only 350pips. But on November 5 this year when the spot rate was at the high of 7.7709, the forward discount widened to 1320pips. In the interest rate market, one month Hibor took just three weeks instead of several months during last time to decline from 1.00% to 0.10%, boosting the spread against Libor to 2.00%. Hong Kong banks acted quickly within weeks after the initial inflows to lower their interest rates, more so in term deposit rates, producing a rare phenomenon of term deposit rates lower than savings deposit rates. Such developments suggest that the suddenness of inflows caught Hong Kong markets by surprise through quick reversal from outflows to inflows. And since then, the market promptly recognized the trend and its sustainability, as reflected by the widening HKD forward discount and the speed banks cut their deposit and lending rates.

The Different Background to Inflows

The most important difference of the two inflows lies in that the economic and financial backgrounds have vastly changed, reflecting different motivations for inflows and implying different prospects for the sustainability. During the previous cycle, the surging Chinese economy and rising expectation of an RMB revaluation, combined with strong rebound of the Hong Kong economy, created tremendous incentives for inflows. The still low US interest rate environment and uncertainties concerning the rate hike cycle also pushed for inflows. Up till recent months, the market had largely digested the favorable factors such as CEPA and Hong Kong's economic recovery. Meanwhile, China's economy started to cool on macro tightening, and the US has entered a rate hike cycle, reinforced by the recent strong employment data. In view of these, the backgrounds of the two inflows differed significantly. In certain aspects, they even contradicted with each other, leaving only the RMB revaluation expectation to be the identical factor.

Judging from another angle, the interest rate spreads between Hong Kong and the US have widened to 2.00%, a level far greater than a year earlier, implying higher opportunity costs for capital inflows. Then where will the necessary higher returns come from to justify such inflows? Even if China and Hong Kong's economic fundamentals look favorable, they are within expectation. The recent weakness of the USD is used as another argument for portfolio repositioning favoring Hong Kong. And the potential returns of hedging the USD exchange rate risk are considered at par with the potential loss of spread. But under Hong Kong's peg exchange rate system, the HKD cannot be used to hedge the USD weakness. Therefore, excess returns required to justify such inflows can only come from the possible RMB revaluation. The market seems to be placing heavier bets on such an outcome, which constitutes the basic and most important reason for inflows.

Differentiate the Revaluation Expectation and Revaluation Itself

Whether the RMB revaluates or not will determine the sustainability of this round of inflows. But it must be pointed out that rising expectation for revaluation doesn't necessarily mean rising probability of such an outcome. Under China's current exchange regime, the change in RMB exchange rate is not directly linked to market expectation and behavior. We attach a far smaller chance for an imminent RMB revaluation than that embedded in the market's expectation.

First of all, China still imposes FX controls. Its capital accounts are not completely open. It is the Chinese Government who dictates the RMB exchange rate, not international hot money, as it cannot materially impact the demand and supply of RMB in the Mainland market. Even if China's recent rate hike provides a better opportunity for arbitraging the Chinese and the US interest rate differentials, the impact is relatively muted under FX controls.

Secondly, the major issue facing the RMB lies in how to reform and perfect the exchange rate forming and FX control mechanisms instead of simply adjusting the RMB exchange rate. Option one to revaluate the currency is to readjust the RMB exchange and re-peg it to a basket of currencies. But pricing the RMB by such administrative measures does not conform to the market oriented approach of reforms. Option two is to freely float the RMB, which is the ultimate goal of the exchange rate reform. But then the currency can move up or down, even if the direction is most likely to be up at the beginning of such liberalization. This is because potential risks cannot be ignored as China's banking sector and capital markets are still facing difficulties and risks. Whether China's economy can withstand significant volatilities in foreign investment and the exchange rate remains to be seen.

And thirdly, external pressures can hardly influence China's exchange rate policy as well as its reform progress. The US and other Western countries have accused China of unfair competition by undervaluing the RMB, and sought to end the Yuan's peg to the USD. The recent dollar weakness further fuelled such demands. Yet price competition only works when the underlying commodities are identical. China's concentration on low-end, labor-intensive productions contrasts with that of developed countries such as the US and Japan in high-end, capital and technology intensive productions. As the unit labor cost of the US manufacturing industry is some 50 times of that of China, price competition simply will not work. And exchange rate related price changes would unlikely alter the bilateral trade and the US trade balance fundamentally. Judging form this, the pressure exerted by the US and Japan takes on more political colors than substances. As hot money enters China, pushing up its foreign reserves and complicating monetary policies, domestic residents would rush to exchange their foreign currencies into the RMB, putting further pressure on the exchange rate. Under the circumstances, if the RMB is forced to revalue even by a small percentage, suggesting the Government is bowing to pressure brought by hot money, it may lead to even greater revaluation expectation down the road. To counter hot money, the Chinese authorities may only need to strengthen measures currently in place such as improving and enforcing banks' FX settlement, relaxing controls on capital outflows, and expediting the implementation of QDII, etc. These measures are believed to be more efficient and practical than revaluation.

Moreover, an RMB revaluation or change to the exchange rate regime may lower China's competitiveness against Southeastern Asian countries whose exports are also mostly labor intensive. This could worsen the already grim employment situation. And it may create new uncertainties to business operations, especially those of state owned enterprises and banks that are under critical reform pressures. It may also further complicate the delicate macro tightening measures and become a new and uncertain external variable. All these combined somewhat lower the probability of an imminent RMB revaluation.

Guarding Against Risks Associated With Sudden Outflows

As argued above, even if fundamentals of the local and the external economies are still respectable, when compared to earlier ones, a higher degree of speculation is detected in this round of capital inflows, as reflected by the over-reliance of investment returns on a single and uncertain RMB revaluation. Therefore, its sustainability is in doubt. Nonetheless, it contributes to the sources of risks to our financial markets because of the gap between expectation and reality.

Inflows could be reversed on two occasions. One is that the RMB revalues as expected, prompting some speculators to take profits. Currently, there is a remote chance for this to happen within a short period of time. The other one is that the Chinese Government chooses to defuse such expectation by unambiguously and openly denying any such plans in the short term, or strengthening and enforcing the current economic and administrative measures in place, toughening its stance on illegal inflows, and significantly increasing the risks and costs of such speculations. It is not a difficult task to carry out. If the revaluation expectation is successfully altered, inflows may reverse course quickly.

As a result, the market volatilities may tend to be magnified, given the characteristics of hot money. Fund companies that control most of such hot money are likely to deploy similar investment management strategies and techniques, resulting in herd mentality of investment decisions and behavior. They tend to enter or exit a market en masse, magnifying the impacts of any economic and financial changes as well as market volatilities, even distorting some market behavior. Therefore, ordinary investors need to closely monitor the sustainability of current inflows and be prepared for any market risks arising from possible reversal of capital inflows.