Lex is a premium daily commentary service from the Financial Times. It helps readers make better investment decisions by highlighting key emerging risks and opportunities.
China was grappling with capital flight last October. Uncertainty in the run-up to the country's leadership transition rattled the nerves of the wealthy, prompting them to chase safer destinations in which to park their wealth. Now the opposite is happening, which has helped the renminbi to appreciate by 1.7 per cent against the dollar this year. But inflows of hot funds are risky, especially for China's shadow banking sector.
Interest rate disparities between Hong Kong and the mainland have played a big role. The gap can reach as much as three percentage points on three-month interbank rates. For money borrowed in Hong Kong and invested in China's shadow banking system, the differential can be much wider. The FT's China Confidential notes that U.S. or Hong Kong dollars borrowed at 2.5 per cent can yield almost 2 per cent if invested in wealth management products in China, and 6 per cent in more risky trust products. Renminbi appreciation pushes those returns up further.
Over-invoicing for exports from mainland China to Hong Kong has operated as an important channel guiding these financial flows into China. Little wonder that exports to Hong Kong have surged to the highest level since 1995 this year.
Beijing is attempting to crack down, including trying to bring the over-invoicing of exports under control. This should show through in May's trade data, to be announced on Saturday. New banking rules in China also stipulate a reduction in the ratio of foreign currency loans to deposits. To meet these targets banks are likely to buy U.S. dollars, which should weaken the renminbi.
This process could accelerate as the U.S. dollar strengthens against currencies of its other trading partners. But the risk is that those money inflows turn quickly to outflows, which could contribute to a liquidity crisis in China's already fragile shadow banking system. This is a big deal. Assets under management in Chinese wealth management products alone are over 8 trillion yuan ($1.3-trillion). Beijing should hope that investors do not make a run for it.
The Globe is launching a Streetwise and ROB Insight newsletter, with content available exclusively to Globe Unlimited subscribers. Get the best of our exclusive insight and analysis delivered straight to your inbox in a daily e-mail curated by our editors. Sign up for it and other newsletters on our newsletters and alerts page .