China trying to stop currency arbitrage.

An article in the Wall Street Journal by Terrance Poon hints at the difficulties that China is facing maintaining it's artificial undervaluation of the RMB.

"The regulator's statement, the latest on curbing such illegal fund flows in recent months, underscores the difficulties Beijing faces as the local stock market soars and foreign investors speculate on further appreciation of the yuan.

Coming after China's trade surplus widened to $26.91 billion in June and its foreign-exchange reserves rose to $1.333 trillion, the statement also highlights a dilemma for Beijing's foreign-exchange policy: a faster appreciation of the yuan could help curb growth of the trade surplus, but could also fuel the speculative inflows it is trying to stem."


Countries that allow their currency to freely float against other currencies don't have a problem with investors speculating on the value of currency. The Forex market is one of the largest, most developed world markets with millions of participating firms and individual investors trading currency daily.

China, on the other hand, DOES have a problem with speculators. The government is intentionally keeping the RMB 30-40% undervalued to help stimulate exports.

Example:

You want to buy 100,000 alternator cores for your new car. The amount of metal in the core costs $10 on world commodity markets, and it requires 2 man hours of labor and $1 of machine time to produce. Let's say that labor in India costs $0.90 an hour. Total manufacturing cost is $12.80 plus a 10% firm profit = $14.08.

Now let's say one man hour of labor in China costs 6 RMB. So you're looking at 12 RMB to produce the machine. At the undervalued rate of the RMB, labor cost is $0.79 per hour x 2 = $1.59 + $10 + $1 = $12.59 plus a 10% firm profit = $13.85

The price difference for the 100,000 cores is $23,100 US. Obviously, most sane people will chose the Chinese firm. But if the RMB were fairly valued at 30% higher for an exchange rate of 5.82 RMB / Dollar, the cost of each Chinese produced core would be $14.36 and the contract would instead go to India and along with it, 200,000 man hours of labor = 100 full time jobs for a year.

Keen investors realize that the currency is intentionally undervalued to stimulate the economy. If the RMB were openly traded on the Forex markets, investors would sell dollars/euros/etc and buy RMB at frightening speed. Supply would stay the same while demand would shoot through the roof. The government of China would be forced to burn through it's foreign currency reserves to maintain the exchange rate until eventually they run out of currency and can no longer control the price. The investors would then sell the RMB and buy the currency they sold at a 30% profit - which could all happen in as little as a few days of trading.

To prevent this, China has strict controls on the exchange of RMB with other currency. It does not allow speculation, only exchange for the purpose of legitimate trade. The "illegal fund flows" are investors trying to take advantage of the revaluation by converting foreign currency into RMB using Chinese companies to help them move money into the country. This is how it works (ignoring the exchange spread and other fees for simplicity):

1) Investor contacts Chinese firm, makes an arrangement to bring cash into the country.
2) Chinese firm "sells" a product at many times it's actual value. Say a container full of a commodity that would normally sell for $20,000 is sold for $20,000,000.
3) Chinese firm sends an invoice for $20,000,000
4) Investor wire transfers $20,000,000 into the country
5) Chinese bank converts the dollars to RMB (at the current exchange rate of 7.5821) giving 151,642,000 CNY
6) Chinese firm deposits the money to an interest bearing account (say at 2%)

After a certain period of time, say a year, they reverse the transaction. The new exchange rate is 6.7 RMB per dollar (13.17% change)

1) The bank account has grown by 3,032,840 CNY. Total balance is now 154,674,840 CNY
2) Chinese firm "buys" $20,000 of a commodity for 154,674,840 CNY
3) US investor receives $23,085,797
4) Return = $3,085,797
5) ROI = 15.429%

Not too shabby, considering that it's a fairly liquid transaction that could be unwound at any time. Obviously the transaction costs would reduce this return, but on the other hand, the money COULD be invested at a much higher rate of return in which case you get an enhanced profit above and beyond the interest since your also getting the currency appreciation the interest.

Interest - ROI
2% - 15.43%
5% - 18.82% (difference = 3.39%)
10% - 24.48% (difference = 5.66%)

Eventually, given enough of this activity, foreign investors could force the RMB to revalue faster - which would increase returns and increase interest into an avalanche of illegal speculation. At the peak limit of 0.5% per day, the RMB could reach it's true value in only 53 days of trading. This would be absolutely devestating to the Chinese economy as Chinese products jump in price and work flows to major competitors in the Pacific Rim.