China considers leaking money to overseas stock

October 4th, 2007

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Today, we caught hold of this article in the news media: China may look to buy shares in BHP, Rio Tinto:

Chinese authorities are looking to loosen outward investment restrictions to reduce pressure on inflation, asset prices and the pegged yuan.

Recall that in our earlier article, Why is China printing so much money?, China has to print money in order to maintain the value of its currency (the RMB) against foreign currencies within a band. This ballooning of money supply is causing the current priceĀ  inflation problems in China (see Cause of inflation: Shanghai bubble case study). The Chinese authorities are thinking of this new scheme in an attempt to control domestic price inflation. Below is a highly simplified example of how it works on the level of an individual:

  1. Let’s say you are a local Chinese investor with excess RMB to invest in. Let’s say you decide to invest in Australian stocks.
  2. With your excess RMB, you buy US dollars from the Chinese central bank.
  3. Given that the Chinese central bank is awashed with excess US dollars (see Awash with cash?what to do with it?, it exchanges your RMB for US dollars.
  4. With the US dollars that you had just acquired, you buy up Australian dollars.
  5. With these Australian dollars, you buy Australian stocks (e.g. BHP, Rio Tinto).

So, as you can see, this results in less RMB circulating in the Chinese economy, which reduces price inflation pressures. Isn’t this a good idea?

Well, there is a risk with this that can end up in disaster. Indeed, as the article said,

Yu Yongding, an economist who stepped down from the central bank’s monetary policy committee last year, recently warned Chinese officials that they could court disaster by opening outward investment channels before introducing a more flexible currency regime.

“Capital controls are China’s last line of defence and cannot be eased until China’s financial reforms are complete,” he said.

“Growth is cyclical and a sudden change in China’s situation could prompt massive capital flight. If there are no restrictions to ease the blow at that point, the effects on China’s economy will be disastrous.”

Why is it possible that this may result in disaster? Stay tuned!