China Must Improve Yuan Management to Curb Hot Money

By Zhang Dingmin

July 23 (Bloomberg) -- China needs to better manage its exchange rate to curb accelerating inflows of ``hot money'' that pose a threat to the economy, the finance and economic committee of the nation's legislature said.

The country needs to counter expectations for the yuan to keep rising, the committee's economic office said in a report published by the state-run Xinhua News Agency today.

Inflows of speculative capital may stoke inflation and destabilize the financial system in the event of sudden outflows. The government said July 18 that it was tightening scrutiny of foreign investment in the world's fourth-biggest economy as part of a crackdown on channels for so-called hot money.

``The government needs to control expectations that the yuan will continue to appreciate at a steady pace,'' said Sherman Chan, an economist at Moody's Economy.com in Sydney. ``One way would be to revalue the currency.''

The yuan has climbed 7 percent against the dollar this year, the best performer among Asian currencies. It fell 0.1 percent to 6.8290 as of 2:01 p.m. in Shanghai. The currency has gained 21 percent since a fixed exchange rate was scrapped in 2005.

Short-term international capital may take advantage of weaknesses in China's economy and financial system and ``cause turmoil'' in its markets, the report said. It didn't say what better management of the yuan would consist of.

Illegal Money

Illegal inflows are expected to total $120 billion in the second half after reaching $162 billion in the first, according to Donald Straszheim, vice chairman of Roth Capital, a U.S. investment bank specializing in emerging markets.

``As long as the perceived profitability of this illicit activity remains high, it is not about to be stopped,'' Straszheim wrote in a report yesterday. ``Only a perception that the profit-loss calculation has reversed will turn these hot money inflows into outflows.''

China's foreign-exchange reserves, the world's largest, soared 36 percent to $1.81 trillion as of June 30 from a year earlier. Sham joint ventures and shell companies are among the conduits used to bring funds into the country, the National Development and Reform Commission, said last week.

The report added to a debate in China on how much the government should do to help exporters as the global economy slows and demand weakens. China's overseas shipments grew 17.6 percent in June, the slowest pace in four months.

`Excessive Impact'

Trade policies should be tilted in favor of labor-intensive industries such as toys and textiles, the report said. The government should delay measures that may have an ``excessive impact'' on manufacturers that process imported materials for export, it said.

The Ministry of Commerce has urged China's cabinet, the State Council, to rein in currency gains and increase some export rebates, a ministry official said July 14, speaking on condition of anonymity.

China's economic expansion will continue to slow steadily in the second half, as growth in exports, investment and consumption moderates, today's report said. Second-half fixed-asset investment may grow by 15 percent excluding inflation, it said.

China should expand bond issuance, including selling local- government and earthquake-reconstruction debt, the legislative committee said. It also recommended raising the threshold for personal income tax, reducing a tax on bank interest income, loosening price controls on resources such as energy and water, and paying attention to the risk of a property slump.

The Chinese economy grew 10.1 percent in the second quarter, after expanding 10.6 percent in the previous three months. Growth of 10 percent this year would be in line with government targets, the report said.

Consumer prices rose 7.1 percent in June, down from a 12- year high of 8.7 percent in February.

To contact the reporter for this story: Zhang Dingmin in Beijing at Dzhang14@bloomberg.net