China has taken a series of increasingly aggressive measures in the past several months to blunt the impact of so-called "hot money," amid the explosive growth of its foreign exchange reserves, which have soared beyond what can be explained by trade and investment flows.

The inflows have been so massive as to raise alarms over the country's financial security.

According to the State Administration of Foreign Exchange (SAFE), as of the end of May, forex reserves stood at 1.797 trillion U.S. dollars.

During the first five months of 2008, forex reserves increased by 18.7 percent year-on-year, or 268.7 billion U.S. dollars, SAFE figures showed.

Where is all that money coming from, and where is it going?

HOW MUCH IS "HOT MONEY"?

What caught the attention of analysts was that forex reserves jumped at the same time as the current-account surplus and foreign direct investment (FDI) into the fixed-asset field declined year-on-year.

Set against the increased forex reserves in the first five months of this year, there was the 78.02 billion U.S. dollars represented by the trade surplus, which was down 8.6 percent year-on-year.

Another 42.78 billion U.S. dollars was connected with FDI in the first five months, which soared nearly 55 percent year-on-year. But FDI going into fixed assets (longer-term investment), actually fell 3.5 percent in the same period.

Jiang Zheng, a macro-economist at a Beijing-based securities firm, has closely tracked these figures and analyzed the data.

Deducting the trade surplus and the FDI, there was an unexplained 147.9 billion U.S. dollars in the forex reserve increase figure, which Jiang and numerous other analysts consider to be "hot money", which is usually defined as short-term global speculative funds moving among financial markets in search of the highest short-term return.

The government doesn't release official figures on this category of funds; in fact, it doesn't even use the term "hot money". So analysts can only make estimates.

Jiang said the "hot money" figures deduced by analysts might even be underestimates. "There is a tricky decline among the FDI figures, i.e. the drop of fixed-asset investment," he explained.

"Foreign direct investment in the first five months soared about 55 percent. But strangely, fixed-asset FDI in the first five months fell 3.5 percent from last year's figure," Jiang said.

Jiang said it appeared that some speculative money had managed to move into China in the guise of FDI.

But there are many other channels for "hot money" to flow into China. These include falsified international trade with over-invoiced exports and underground private banks, according to Jiang.

Jiang and other analysts maintained that as much as 600 billion U.S. dollars in "hot money" had surged into the country, most of it after 2005.

Jiang said he was somewhat surprised at the scale of "hot money" inflows in the first five months of this year. The monthly inflow of "hot money" from January-May was estimated at 35 billion U.S. dollars, more than double the 15 billion U.S. dollar figure for the same period last year, Jiang said.

In April alone, deduction showed that a record 50.2 billion U.S. dollars of "hot money" poured into China, he said.

WHY CHINA AND WHERE DO THEY INVEST?

Many will ask why such huge sums of "hot money" have been continuing to flood into China and where it is going.

Li Yang, head of the Financial Research Institution at the Chinese Academy of Social Sciences, said the disparity between Chinese and U.S. interest rates, the appreciation of the Chinese currency (the yuan) since 2005 and the profits from the Chinese capital and real estate markets were the main causes of the unstoppable "hot money" inflows.

Since the start of the global financial crisis, which surfaced last summer with problems in the U.S. subprime mortgage market, the U.S. Federal Reserve has since September cut interest rates seven times to stimulate economic growth. The Fed funds target rate has fallen from 5.25 percent to the current 2 percent.

In contrast, the People's Bank of China (PBOC, the central bank), hiked interest rates six times between March and December 2007 to cool economic growth, with the one-year deposit rate rising from 2.52 percent to the 4.14 percent.

These opposing actions created a disparity that helped to lure global speculative money to into China at an accelerated pace this year.

Another major lure for "hot money" was the continuously appreciating yuan.

In July 2005, China abandoned a decade-old peg to the U.S. dollar and allowed its currency to appreciate by 2.1 percent. Since then, the yuan has strengthened further, mostly slowly, and risen nearly 17 percent against the U.S. dollar.

The appreciation of the yuan, coupled with the simultaneous depreciation of the U.S. dollar, has also prompted "hot money" to bet on the yuan's further appreciation.

"The combination of the interest rate disparity and the yuan's appreciation will ensure a profit rate in excess of 10 percent for 'hot money'," Li Yang said.

The other major incentive for "hot money" was the chance to profit from China's markets, mostly stock and real estate.

Many economists and analysts like Jiang said that the booming Chinese stock market between 2006 and late 2007 and soaring housing prices since late 2005 were, in part, created by global speculative money.

Stock and property returns have been poor lately: share prices have plunged since peaking late last year and the real estate market has faced uncertainties since China began to impose tight macro-economic controls.

So speculative money has sought greener pastures, with some simply being deposited into banks.

Jiang said household and business deposits had grown fast in the first five months.

According to the PBOC, as of the end of May, the balance of deposits in reminbi accounts in domestic financial institutions reached 43.11 trillion yuan, up nearly 20 percent over last year's figure.

"The consumer price index has risen more than 8 percent every month on average this year, higher than the interest rate, but deposits are soaring. It is very probable that 'hot money' is flowing into banks," Jiang said.

His judgement was echoed by investors.

Wang Chenyang, who manages a 12-billion-U.S.-dollar hedge fund from Wall Street, told Xinhua that the best investment choice at present was to convert money from the U.S. dollar to the renminbi and deposit it into banks in the Chinese mainland.

Wang said his Chinese friends who work in New York had made such investments with help from their relatives in China.

Similar scenarios took place in Hong Kong, where residents traveled to neighboring Guangdong Province and converted money from the Hong Kong dollar, which has also been depreciating, into the yuan, depositing the proceeds into Chinese mainland banks.

TOO HOT TO HANDLE?

As many in China believe that "hot money", as a major factor in capital flight, was largely responsible for the financial crises in Southeast Asia in 1997 and one that began in Vietnam this year, continued speculative capital inflows had raised strong concern in China.

Mei Xinyu, an economist at the Ministry of Commerce, warned that "hot money" inflows would create problems and put pressure on China's monetary policy.

"Moreover, capital flight will disrupt the normal operation of the country's financial system and have an immense impact on China's financial order," he added.

Zhang Ming, an economist at the Chinese Academy of Social Sciences, echoed Mei's views, saying: "If there was capital flight, it would cause a significant impact on the international payments for China and would probably result in deficits in both the current and capital accounts.

"We should pull out all the stops to contain further inflows of 'hot money', and make full preparations for possible capital flight," Zhang warned.

In addition, analysts said the inflows of speculative money were partly to blame for creating excess liquidity and stoking inflationary pressure in the Chinese economy.

In the first five months of 2008, the CPI, the main gauge of inflation, rose 8.1 percent year-on-year. The CPI for February hit a 12-year high of 8.7 percent.

Amid these concerns, China is taking no chances. Various departments, particularly the PBOC, have stepped up efforts to ward off the risks of "hot money".

The central bank has since last year frequently employed two tools to curb excess liquidity -- raising commercial banks' reserve-requirement ratios (RRR) or issuing bills.

In particular, the central bank has hiked the RRR at an unprecedented frequency.

In 2007, the PBOC raised the ratio 10 times, which lifted it from 9.0 percent last January to 14.5 percent as of December. The central bank had raised the RRR only five times over six years since 2000.

This year, the central bank continued to employ this tool. The latest move was on June 9, when it raised the RRR by 0.5 percentage point (to take effect on June 15) and another 0.5 percentage points (effective on June 25).

The rise on June 25 was the sixth this year, and it brought the ratio to a record 17.5 percent. With it, the central bank said it had received 1.23 trillion yuan in required reserves from the commercial banks so far this year.

Jiang said the amount of the required reserves, along with bill issues, enabled the central bank to successfully ward off the risks created by the excess liquidity owing to "hot money" inflows.

The unprecedented measures taken by the central bank, however, created a dilemma for the Chinese economy: the PBOC was flush with liquidity while commercial banks, equities and the property market faced tight conditions, according to Jiang.

FINANCIAL SECURITY A PRIORITY

While China moved to cope with hundreds of billions of U.S. dollars of speculative money that had already poured into the country, it was taking much stricter measures to monitor the capital flows and prevent more "hot money" from flooding in.

In mid-April, the State Council, China's Cabinet, called a special meeting to discuss the seemingly unstoppable capital inflows.

The meeting was also attended by all concerned central government departments, such as the Finance Ministry, the central bank, the China Banking Regulatory Commission and SAFE.

According to the Shanghai-based China Business News, ahead of the meeting, several central governmental departments had received a special report, more than 200 pages long, about the "hot money" inflows.

On May 9, Vice Premier Wang Qishan, who was in charge of financial affairs, sounded wary when he stressed the importance of the country's financial security in the face of the speculative flood.

"Financial security deals directly with overall national economic and social stability and the fundamental interests of the people. Therefore, safeguarding financial security is the top priority among all financial affairs," Wang told an economic forum in the financial hub of Shanghai.

Wang said the government would take more measures to improve management of forex reserves, strengthen supervision of trans-border capital flows and crack down on financial crimes.

Days after Wang's remarks, on May 21, SAFE issued a notice ordering all banks in the mainland to file reports on all renminbi accounts opened by non-resident individuals and non-resident institutions.

SAFE said the measure was meant to "improve statistics on international payments".

According to SAFE, a new system that enables real-time monitoring of the flow of foreign exchange is in the pipeline. The system is mainly an Internet-based data exchange mechanism among SAFE, banks, enterprises and accounting firms.

SAFE also said it was actively seeking to strengthen administration of foreign exchange receipts and trade settlements.

Hu Xiaolian, SAFE administrator, said recently that it was necessary to check the authenticity of foreign investments and trading activities. By doing so, SAFE aimed to prevent inflows of "hot money" in the guise of FDI or trade.

China faced with a bigger challenge of guarding against the impact of short-term global speculative funds, Hu added, alluding to "hot money".