Fund flows may become too hot to handle on QE2

After months of being hounded by the US over the value of its currency, it is China's turn to frown on the Americans. With the US Federal Reserve triggering a second wave of monetary stimulus in the form of quantitative easing, or QE2, amounting to $600 billion (Dh2.2 trillion), more money is likely to flow into emerging market assets, commodities and equities, especially China. The question is how will regulators deal with this hot money inflow and how will it affect its fledgling debt market.

China remains the biggest foreign holder of US Treasury bonds, after its holdings rose by $21.7 billion from July to $868.4 billion in August. Following the US Federal Reserve's announcement last week that it will pump billions of dollars into the economy, China faces the risk of its dollar-denominated assets depreciating.

Also, QE2 will cause excessive liquidity in the US and speculative money may seek high-yield investment opportunities in China. Experts warn that international speculative capital or ‘hot money' risk is high and China needs to remain highly vigilant to prevent outside liquidity from distorting its own assets market.

Adding pressure

The Fed's upcoming move may also add pressure on China to appreciate its currency. According to reports, the US bond interest rates are bottoming out and will start to rebound soon. The rebound in bond interest rates may mean a bear market. A weaker dollar, coupled with a sluggish bond market, may threaten China's colossal dollar assets.

In 2007, the People's Bank of China set up the National Association of Financial Market Institutional Investors to help develop the country's over-the-counter financial markets, which span bonds, loans, foreign exchange, commercial paper and gold. Contrary to Western financial systems, China has the leeway of being able to control every inch of the process, which it proposes to do through Hong Kong's sophisticated market and introducing credit-default swaps.

Bank analysts feel there's a lot of money coming from outside China, including Hong Kong, that is likely to be invested in the yuan because of its healthy appreciation prospects. Also, demand for yuan assets is much higher offshore.

With this in mind, International Finance Corp, the World Bank's private investment arm, plans to sell about 100 million yuan of five-year bonds in Hong Kong.

China is also encouraging domestic lenders to sell debt in Hong Kong to broaden the appeal of holding its currency overseas as it seeks to reduce reliance on the dollar for international trade and finance. Yuan deposits in Hong Kong more than doubled to a record 130 billion yuan in the first eight months of 2010.

Efforts are also underway to adopt more sophisticated instruments. Last week, China launched its first yuan-denominated credit-default swaps (CDS) with 1.84 billion yuan worth of the derivatives changing hands on the first trading day.

The introduction of this experimental derivative, called ‘credit risk mitigation' (CRM), is aimed at giving investors an instrument to hedge against risks in a fast-growing domestic corporate bond market. These are the latest financial tools in the country's relatively young financial sector, aimed at building more mature markets. However, as always regulators have been most cautious in carrying out these reforms to guard against some of the risks inherent in more complex financial products.

Chinese CRMs are based on specific bond or loan transactions and do away with speculations typical to developed markets. The first CRM deals, using bonds as underlying assets, were struck between the China Bond Insurance Co and China Everbright Bank and Industrial Bank. The underlying assets also include short-term bills, mid-term bills and bank loans, with maturities ranging from 36 days to over 26 months.

Rules

According to the stringent rules, issued in October, yuan swaps can be traded through the Shanghai interbank clearing system and can only be sold to investors holding the underlying assets and can't be used to insure high-risk securities. The value of the swaps cannot exceed five times that of the underlying debt.

The writer is a journalist in China.