Harry Potter’s invisibility cloak, the boy wizard’s fashion accessory in many an adventure, seems to have left the Hogwarts campus for its new home in China.
Two separate reports last week—by Standard & Poor’s (S&P) and JPMorgan Chase & Co.—showed that large chunks of capital may be entering and exiting China hidden from public view.
S&P analyst Kim Eng Tan says a growing discrepancy in China’s gross domestic product (GDP) data may be an indication of unrecorded capital inflows.
GDP, computed by adding up domestic consumption, investments and net exports, was 5.3% higher last year than GDP measured as the sum of the value-added in agriculture, manufacturing and services.
In other words, some $139 billion (Rs6.39 trillion then) more of China-made goods got consumed last year worldwide than was produced there. That’s nothing short of magic.
While the two methods of calculating GDP never really produce identical results in any country, the divergence is large even when compared with China’s own recent past. According to my calculations, the difference between expenditure-and-production-side GDP averaged 0.2% from 1999 to 2004.
The gap began widening thereafter, in line with a spurt in China’s trade surplus.
The two may be connected.
“One way to explain the abrupt increase in China’s trade surplus, and the associated increasing disparity in national income measures, is that exporters have been over-billing foreign sales to disguise capital inflows,” Tan says.
Chinese exporters may be bringing speculative capital into the country by manipulating the transfer price at which they sell goods to related parties overseas.
“They have a number of reasons for doing this—the most obvious being that the renminbi is almost guaranteed to appreciate,” Tan explains. “Chinese interest rates are also heading up to further boost their returns, while fast rising asset prices in China also attract new investments.”
This isn’t the first time an analyst has raised the possibility of serious over-invoicing of exports.
Stephen Green, a Standard Chartered Plc. economist in Shanghai, has estimated that as much as $67 billion of capital may have come into China concealed as exports in 2005, making up a big part of the trade surplus that more than tripled that year.
Even if China’s real trade surplus isn’t as high as reported in the official data, it doesn’t mean the case for quicker yuan appreciation is weak.
The economic argument for yuan appreciation hinges on the potentially destabilizing impact of more-than-abundant liquidity on money supply and asset prices. It doesn’t really matter whether the liquidity is introduced through genuine trade or through capital inflows disguised as exports.
The yuan needs to stop being a one-way bet. Until that happens, interest rates, which were again raised late last week, won’t have much of a sobering effect on an economy growing at its fastest pace in 12 years.
Misclassified inflows aren’t the only problem. It seems even the money that’s going out of China—being recycled into US treasuries through official channels—isn’t showing up in the statistics. And that may mean the US dollar is even more vulnerable than traders anticipate.
A 17 July report showed foreign buying of US financial assets climbed to a record. Yet, Paul Meggyesi, a currency strategist at JPMorgan in London, finds it odd that only $11 billion of the $163 billion of purchases was attributed to central banks. The data show the People’s Bank of China sold US treasuries in May even as its reserves rose by $46 billion.
Something doesn’t quite add up in the US Treasury’s International Capital System statistics, or TIC data. Why, for instance, did UK investors begin buying US securities just as the People’s Bank of China started increasing its pace of reserve accumulation in 2004?
“Is this more than a coincidence? I believe it is,” Meggyesi says. For the past three years, the reserve build-up in Russia, China and the rest of Asia has overshot the recorded official purchases of US securities.
And the growing difference between the two has moved in lockstep with the reported purchases by UK investors, “providing very strong evidence that much of this reserve accumulation is being channelled via the UK, and is in the process being incorrectly recorded in the TIC data as a private rather than official inflow”, Meggyesi says.
The distinction may be important.
“That the US is seemingly still reliant on official financing suggests it is still struggling to compete for profit-maximizing private investors,” the JPMorgan analyst says.
Actually, the invisibility cloak may not be an appropriate analogy for what’s going on here. Capital is moving into China looking like merchandise trade, and perhaps moving out of China and into US securities looking like British money.
Such temporary transformation of form, every Harry Potter fan knows, is very simple to achieve. All you need is a cauldron full of polyjuice potion.
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