China's `Hot Money' Crackdown Won't Halt Yuan Buying

By Kim Kyoungwha and Judy Chen

July 23 (Bloomberg) -- China's efforts to stem the flow of funds betting on yuan gains will do little to dull the allure of the nation's currency, Roth Capital Partners LLC said.

Illegal inflows, the dominant source of China's record $1.8 trillion foreign-exchange reserves, 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 tightened scrutiny of foreign direct investment to prevent ``fake'' ventures that the government said are acting as channels for speculative capital and pose a risk to the economy. Cash flooding into China has helped keep inflation above 7 percent throughout the first half of this year, a level last seen more than a decade ago.

China needs to better manage its exchange rate to curb accelerating inflows of speculative money, 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 said in a report published by Xinhua News Agency today.

More Gains Expected

Motives for yuan purchases such as currency gains, the fastest growth among the world's major economies, and weak global markets ``will win out'' despite China's crackdown on cross-border money trades, Straszheim said. The yuan has risen 21 percent since China scrapped a decade-long link to the dollar in July 2005.

The currency traded at 6.8284 a dollar in Shanghai as of 1:24 p.m., compared with 6.8217 yesterday. It advanced 7 percent this year, the best performance among the 10 most-active currencies in Asia outside of Japan, and non-deliverable forward contracts show traders are betting the currency will climb 5.8 percent to 6.4565 per dollar in the next 12 months. The contracts, settled in dollars, allow investors to bet on the future value of the yuan.

An interest-rate differential in China's favor coupled with the strengthening of its currency, Asia's best performer this year, have yielded a 14 percent return on the yuan over the past year, Straszheim said. China's foreign-exchange reserves, the world's largest, soared 36 percent in the year ended June 30.

Government Clampdown

Sham joint ventures and shell companies are among the conduits used to bring funds into the country, the National Development and Reform Commission, said in a statement last week. The commission is China's top economic planning body.

To stem the flows, the government has adopted rules that require closer monitoring of trade payments, registration of foreign-currency incomes and controls on cross-border payments for services.

``These are positive steps, but it is unrealistic to expect new, widespread compliance understanding the history of abuse,'' Straszheim said. ``With the currency still likely to be managed up by Beijing in 2009, albeit more slowly, these flows are likely to remain into China, not out of China.''

To contact the reporters on this story: Kim Kyoungwha in Beijing at kkim19@bloomberg.net; Judy Chen in Shanghai at xchen45@bloomberg.net;