By Karen Yeung and Lu Jianxin
SHANGHAI, Dec 10 (Reuters) - For years, billions of dollars of speculative capital poured into China every month. Now those flows may be reversing, complicating the central bank's efforts to push down market interest rates to aid the economy.
Cushioned by huge foreign exchange reserves, China is not likely to face a balance of payments crunch. But to prevent outflows of money from pushing up interest rates, it may be forced to flood the banking system with funds.
"The economic challenge that China is facing is unprecedented -- it's global, not just regional as it was during the Asian crisis in the late 1990s," said Jin Dehuan, senior economist at Shanghai Securities and Futures Institute.
"With economic conditions worsening both at home and abroad, capital outflows will become a real threat, and authorities will have to take strong steps to prevent them."
Foreign reserves shot up to $1.906 trillion at the end of the third quarter from $711 billion in mid-2005. Much of the rise was due to "hot money" -- funds betting on an appreciating yuan and booming stock and property markets.
(For a graphic on China's foreign exchange reserves, click https://customers.reuters.com/d/graphics/CN_MNY1208.gif )
Official data is not available, but economists think hot money inflows totalled hundreds of billions of dollars; Royal Bank of Scotland estimates them at $460 billion since 2006.
Now the global financial crisis and China's economic slowdown threaten to send that money flowing out of the country as quickly as it poured in. China could face the first significant fall in its foreign reserves since the Asian crisis of 1997/98.
"There is a real danger of a possible fall in FX reserves prompting a self-fulfilling cycle of outflows in the coming months," HSBC said in a research report last week.
HOT MONEY
One by one, many of the factors luring hot money to China have faded. The stock market has been slumping since late last year; a decline of real estate prices in major cities has accelerated in the last few months.
Interest rate cuts by China have narrowed its rate premium;
the spread of the one-year Chinese central bank bill yield
Most importantly, the yuan
"The yuan may depreciate about 2 percent against the dollar in 2009 because of a globally strong dollar and a correction of the yuan's previous appreciation. So net capital inflows will continue slowing next year or even reverse," said Xing Ziqiang, analyst at China International Capital Corp.
Some analysts think flows have already reversed. Shi Lei at Bank of China estimates that excluding the trade surplus, a net $20-30 billion may have left China every month since September.
In 1998, when China had about $140 billion of foreign reserves, capital outflows cut the reserves during several months, prompting speculation that Beijing might have to devalue the yuan to rescue the balance of payments. Ultimately, it managed to avoid doing so.
This time, the country has much bigger reserves to cope with an exodus of funds, so a yuan freefall remains very unlikely.
But analysts think foreign reserves might nevertheless drop sharply -- by as much as $300 billion, according to Royal Bank of Scotland, which said China might find it more difficult to control the current crisis because its economy had become more market-driven over the past decade.
POLICY
The mere spectacle of a big drop in foreign reserves could alarm China's fragile asset markets, increasing downward pressure on the yuan and encouraging more capital outflows.
The central bank would have to supply dollars to the foreign exchange market to satisfy increased demand, as it did in small amounts last week during a burst of speculation about yuan depreciation, traders say.
That would absorb yuan from the market, making it harder to push down interest rates. This threat was apparently behind the central bank's decision in the past two weeks to conduct its biggest easing of quantitative monetary policy in a decade, and it may prompt even more aggressive easing in the months ahead.
The proportion of commercial banks' money that must be kept at the central bank was slashed by between 1 and 2 percentage points; analysts believe it may be cut by a further five percentage points or more next year.
The central bank also suspended its issues of one-year bills; it may halt three-month issues as soon as this month and let an estimated 2.2 trillion yuan ($320 billion) of bills mature in 2009 without absorbing any of that money through fresh bills.
And some traders think the central bank could actually start injecting funds into the money market via short-term bond repurchase agreements next year, after several years in which it absorbed large amounts through such operations. (Editing by Andrew Torchia)