China locks speculators out of yuan gains

One of China's big fears about resuming yuan appreciation is that it serves as a magnet for hot money inflows. Who could pass up a one-way bet on a stronger currency? But as this chart shows, Beijing has outflanked speculators, for now at least.
The orange line measures illicit money inflows (it is obtained by subtracting trade and investment receipts from the total amount of yuan issued domestically to purchase foreign exchange). It dropped into negative territory in May, June and July, indicating speculative capital actually left China.
An uptick in August, according to data released this week, suggests just a handful of investors were positioned for the yuan's faster appreciation of the past two weeks, when it rose 1.5 percent versus the dollar. Now that investors have seen the yuan's rally, expect the orange line to rise steeply.
But this chart is also powerful evidence of why the yuan is unlikely to rise without interruption, as it did from mid-2005 to mid-2008. Hot money inflows built to a crescendo by the end of that period, giving Beijing a serious liquidity headache. Whatever China's political calculations as US pressure intensifies, a resumption of major speculative inflows would be sure to act as a break on yuan appreciation.
In fact, it would not be surprising if the yuan fell back a touch against the dollar after another few weeks of gains. The central bank has vowed to introduce two-way volatility to the exchange rate, precisely in order to wrong foot speculators. The light blue line is a measure of total net capital inflows into China.
Despite a rebound in the country's trade surplus since May, net monthly inflows have averaged 185 billion yuan ($27.6 billion) a month, considerably less than in the two years before the global financial crisis struck. Although some US critics believe the yuan is undervalued by as much as 40 percent, Chinese officials have been adamant that the currency is nearer to its equilibrium level. So long as net capital inflows - a proxy for market demand - remain relatively weak, Chinese officials will have a point and large-scale appreciation will be off the table.