Monday, China’s $586 billion dollar stimulus plan appears to have positively reverberated around the world’s stock markets. China’s own indicies were up more than 7 percent, while major indexes in Asia were up 2 to 5 percent on Monday. Even Europe got in on the fun, with its major indexes up 1 to 2 percent. Is the world going Keynesian again, returning to 70s era deficit spending? Will a huge financial spending package in China be enough to mollify stock markets, ending their bear runs?

I am not normally one to attribute rhyme or reason to the movements of stock market indexes. In most cases, only a fool would say how a market is going to move on any given day. Yet today, with the news from China’s central government that it would encourage its domestic market to invest and consume more, it appears to have moved markets in a straight-forward correlation. Certainly, Chinese investors have come to expect the government to step in to prop up stock markets. Last week, it was a rumored $50 billion ‘buffer fund’ that prompted China investors to rally.

US investors are not so easy to impress. The Chinese spending package was not enough to dent the malaise over the US markets, which today were hit by the new of the bankruptcy filing of a major electronics retailer, Circuit City, and layoffs at the US subsidiary of DHL. Finally, the spectre of a slew of possibly negative economic data to be released later this week, including the trade balance, may be prompting caution.

But, back to China, the relatively huge gains in China and other Asian markets indicates, to me at least, that China’s economic news does have the power to help stimulate regional stock markets. But will the package, as China’s leaders claimed, actually help stabilize the world economy? Put another way, can China’s economy save the world’s?

To elaborate on that point, one must not imagine that China will quickly start spending its half trillion dollars to ramp up imports, thereby helping its trading partners. The main effects of this package will be to further push China’s economy toward domestically-fueled expansion via consumption and investment.  It is China’s biggest package ever, the equivalent a $2 trillion package for the US economy, but it will do little to help the world economy, other than encouraging a stable China.

China can afford the package without running a huge deficit, but is there any other cost? Inflation, possibly. One thing is clear, China is most definately now a Keynesian. I hope it can avoid the fate of Japan of the 90s, which tried, and is still trying, to spend its way out of the economic doldrums. Nobody wants to see another lost decade.

For those wondering how China would plug the many holes in its supposedly-airtight capital account (allowing a record amount of hot money to flow into China in the past six months), part of the answer was revealed on July 2 via the website of China’s State Administration of Foreign Exchange: A new policy to verify that export invoices are valid and not over-billed for the purposes of transferring more foreign currency into China.

Here at China Supertrends, foreign reserves and hot money are an endless curiosity, having achieved in China never-before-seen volumes, anywhere, in the history of mankind (Perhaps the Romans had a proportionally large foreign reserve, but should that count?).

In a July 3 report from Xinhua, a SAFE official appears to have confirmed the much-speculated figure of US$1.797 trillion in foreign reserves as of the end of May, increasing about US$115 billion in just two months from the last officially-released figure of US$1.682 trillion. From the Xinhua article:

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

As Brad Setser mentioned recently (and in this older post), there is likely an under-stating of the true amount of the increase in foreign reserves due to internal transfers to the state investment funds Hujin / China Investment Corporation; Chinese banks holding more foreign reserves as the reserve ratio continues to increase (up an additional one percent in June to reach 17.5 percent at present); and revaluations of China’s non-US currency holdings. As well, I’d point out the significant amounts of capital entering the market via the Hong Kong / Shenzhen corridor’s frequent travelers, black market currency traders throughout China, and people such as the Atlantic’s James Fallows withdrawing as much RMB from their foreign bank account as the limits will allow.

Back to the July 2 press release from SAFE, a Financial Times story on July 2 translates some important details:

Exporters will now be required to provide documentary evidence that their invoices are based on genuine transactions if they wish to change dollars into renminbi. The regulator said the new computer system for checking invoices would be introduced on August 4. A trial period begins on July 14.

This is serious news for exporters, and will create additional paperwork and possibly delays for many legitimate transactions. Still, this is what the hot money problem has come to: Reserve ratio increases can soak up liquidity but this is merely treating the symptoms rather than curing the disease.

If the trial proves feasible (and considering the volume of trade, it may not) this will be another problem, in addition to the rise in transportation costs, for China’s exporters (foreign and domestic companies alike) and possibly cause export growth to slow. Not good news for trade, perhaps, but a step in the right direction to reduce hot money.

UPDATE JULY 4: From the Wishful Thinking department, CBS MarketWatch reports SAFE has “limited” foreign tourists to exchanging a maximum of US$50,000 during their stay for the Olympics from July 8 to October 17:

The regulator said the quota would provide tourists with enough spending money while also helping to limit foreign exchange inflows during the games.

With an estimated 500,000 foreign visitors (that’s assuming they can get visas), what’s another US$25 billion of foreign exchange between friends?

Related information:

h/t to China Herald for the excellent Olympic-related news coverage.

An article from Reuters on the foreign exchange issue, relating to the previously-unofficial May 2008 increase.