Concerning foreign exchange transactions, since China does not allow offshore transactions between yuan and foreign currencies, domestic foreign exchange transactions are carried out with cross rates calculated from the exchange rate between yuan and U.S. dollar. Therefore, there can be no foreign exchange speculation in China.

A lack of interest rate and financial derivatives transactions in China also leaves no room for hot money speculation.

Most arbitrage opportunities lie in real estate, yuan appreciation and the use of foreign currencies after domestic settlement. Since real estate purchases in China require an identity card, the number of individual foreigners buying houses in China is limited, while most of the real estate investment from abroad is made by institutions. Because current risks on the real estate market have been large, the amount of hot money is altogether limited, Chen said.

Yuan appreciation presents the ideal opportunity for arbitrage. Foreign capital can enter China in large amounts, seeking the difference between deposit interest rates and exchange rates. In general, however, foreign companies won't engage in this practice because they need liquidity and won't make long-term deposits. Only foreign individuals or commercial banks are likely take this route—hence it is likely that some arbitrage capital with expectations of yuan appreciation has already made their way into China.

However, it is unnecessary to worry about arbitrage capital, because arbitrage capital is not the same as speculation capital. Speculation capital, or hot money, mainly speculates on financial products, whereas arbitrage capitals mainly make profits by investing with actual capital or currency converting. Since arbitrage is often closely related to real economic activities, it should not be considered speculation. Generally speaking, arbitrage capitals are not harmful and even if harm is done, the problems are caused by policy reasons.

"We can deem that there is currently no short-term speculation capital or hot money on a large scale in China," Chen said.

If there is no major inflow of hot money, how is the abnormal increase in China's foreign exchange reserve explained? Chen said this is caused by the structure of China's foreign exchange resources.

China's foreign exchange resources are divided into two parts: its foreign exchange reserve and foreign exchange deposits. Because of yuan appreciation expectations, people are reluctant to hold foreign currencies, while enterprises are more willing to use foreign currency loans, which leads to the increase of foreign exchange reserves. "This is the fundamental reason for the abnormal increase of China's foreign exchange reserve," Chen said.

Channels for Hot Money

False Trade

Many Sino-foreign joint ventures or wholly foreign-invested companies lose their anti-dumping cases, most of which are related to false quotations or false documents. One of the purposes for false pricing is to pay fewer taxes, but with two different contracts for customs declaration and real transactions, most hot money flows into China through this channel.

Convenience Stores

Every day, hundreds of thousands of people from Hong Kong and the mainland pass Luohu port in Shenzhen, Guangdong Province. Dozens of convenient stores sit around the immigration passageway, selling beverage, telephone cards and other things. Different from ordinary convenience stores, these stores provide another business: currency exchange. This has facilitated the entry of foreign capital into China, and is listed by many experts as one of the major channels for hot money inflows.

Where Hot Money Entered Previously

Escaping from China after gaining profits;

Bottom fishing on the Chinese stock and real estate markets;

Remaining in the banking sector and waiting for opportunities;

Being transferred to medium- or long-term investment;

An important standard to judge hot money is "fast entry and fast exit." Because of strict foreign exchange regulations in China, it is difficult for hot money to exit quickly. Some of the money has to be transferred to medium- or long-term investment where it cools down temporarily.

Entering commodities market.

Commodities—oil, iron ores and precious metals to name a few—were once a favorite for hot money. In China, the prices of these commodities have been high, leaving little room for speculation. Grain is the only kind of commodity whose prices are still low. Experts are concerned that after withdrawing from the real estate and stock markets, hot money will move to the grain sector. If huge amounts of capital enter the grain sector, grain prices will spiral out of control.

(Source: www.icxo.com)