In the 2004 Blue Book of Finance -China: Banking and Financial Markets Development, compiled by the Institute of Financial Research under the Chinese Academy of Social Sciences and published late last year, researchers at the institute give their view of this situation.

Underground financial activities between Shenzhen - in south China's Guangdong Province - and Hong Kong have been very active in recent years, and the scale of these - mainly conversions between the renminbi and the Hong Kong dollar - have been tremendous.

The flow of renminbi and Hong Kong dollars between Shenzhen and Hong Kong has basically exceeded capital account restrictions.

According to the Shenzhen Public Security Bureau, the underground financial activities between the city and Hong Kong are facilitated by fairly developed networks, featuring highly professional standards.

Underground financial organizations typically set up companies in Shenzhen and then open bank accounts there. They then team up with money changers in Hong Kong, and open many foreign currency bank accounts.

Underground financial activities in Shenzhen

In our field work, we found that the major characteristic of such underground financial activities is cash transaction. The purpose of using cash is not only to evade financial supervision -which is the common feature of all forms of the underground economy - but, more importantly, to transport Hong Kong dollars or renminbi banknotes between the two places.

Before the mid-1990s, the capital flow was a one-way traffic: mainly Hong Kong dollars flowing into Shenzhen. After the mid-1990s, the flow started to go both ways, with not only Hong Kong dollars entering the mainland, but renminbi going to Hong Kong.

The purpose of this is to facilitate spending by a growing number of Hong Kong residents on the mainland.

According to statistics, Shenzhen recorded net cash withdrawals of renminbi from 1990 to 1997. Its net cash withdrawals started to fall in 1996, reversed to a net release in 1998, and has been reporting the biggest net cash release among all Chinese cities since 2001.

That starkly contrasts with the nationwide situation with the implementation of the State's macro-economic management measures, inflation came under control in 1995, starting a period of relatively stable cash release for the banking system.

We can make several observations by looking at the statistics.

First, Shenzhen's net cash release became positive in 1998.

Second, Guangdong accounted for more than half of the nation's total cash release starting 1999.

Third, since 2003, cash release in Shenzhen was approximately equal to that in Guangdong, excluding Shenzhen.

The huge proportions of net cash release in Shenzhen cannot be explained by regular factors. There are two reasons for this. First, although Shenzhen's gross domestic product is smaller than that of Beijing, Shanghai and Guangzhou, none of the three cities had such a massive net cash release after 1998. Second, Shenzhen's huge net cash release was mainly through the one channel, the Bank of Communications.

Although the Shenzhen branch of the Bank of Communications held a mere 5 percent share in the local deposits market in 2000, its cash release accounted for more than 70 percent of the city's total.

Its share hit 90.1 percent in the first half of 2002 in terms of cash release. And even after a supervisory notice from the central bank in July, the share for the entire 2002 stood at 70.5 percent.

Investigations found that the cash withdrawals at the Bank of Communications were mostly enabled by the non-issuing city cash withdrawal function of its Pacific card. The reason could be very simple: only the Bank of Communications allows free non-issuing city withdrawals. Other banks charge a certain amount of commission when card holders withdraw cash in cities other than the city where the cards are issued.

And that turned out to be the case. According to the People's Bank of China's Shenzhen branch, cash withdrawals through the Bank of Communication's Pacific cards in cities other than the issuing city totaled a staggering 17.9 billion yuan (US$2.2 billion) in 2002.

Insiders told us that the underground banks in Shenzhen transferred nearly all their renminbi derived from the transactions to Hong Kong. By comparing purchasing power and recent cash release statistics, we think what they said was basically true.

Based on that presumption, the renminbi funds transferred to Hong Kong via underground channels in recent years could amount to tens of billions of yuan annually. That is not far from the unofficial estimates.

It is worth noting that this is not only happening between Shenzhen and Hong Kong.

Net cash releases are also reported in other cities of Guangdong. Similarly, we can conclude that the majority of the renminbi funds there also flowed into Hong Kong.

Therefore, the annual inflow of renminbi to Hong Kong far exceeds the above mentioned estimates.

Functions of the money

Many may equal the net renminbi release in Shenzhen and other parts of Guangdong with renminbi funds flowing from the mainland to Hong Kong. That has led to estimates that is 40-100 billion yuan (US$4.8-12 billion) of renminbi circulating in the Hong Kong market.

That reasoning is far too simplistic. Theoretically, there are at least three possible functions for the massive renminbi cash released in Guangdong. First, mainland residents carry renminbi to Hong Kong, convert it into Hong Kong dollars and either spend or invest them.

Second, to meet Hong Kong residents' consumption and investment needs in Guangdong - Hong Kong residents carry Hong Kong dollars to the mainland, convert them into renminbi and spend or invest the money.

Third, the massive cash release may also reflect renminbi conversions between mainland residents and residents of Southeast Asia or other regions, which can be normal trade of commodities and services or international smuggling or other types of cross-border crime.

Sources of demand

Why is there huge demand for renminbi in Hong Kong? We believe there are five major reasons.

First, the upward pressure on the renminbi started to build in 2000. The softening of the US dollar, starting at the end of 2002, reinforced the trend.

That trend prompted speculative funds to convert into renminbi through underground channels for arbitrage purposes.

Second, the stability of the renminbi exchange rate and the wide use of the currency in neighbouring regions.

After the Asian financial crisis in 1997, the currencies of most Southeast Asian countries depreciated to different extents, while the renminbi has remained stable in a highly volatile international environment.

Nowadays, the renminbi not only maintains its stability, but boasts growing purchasing power, gaining broad recognition among institutions and individuals in both Hong Kong and other neighboring regions.

Third, renminbi interest rates remained stable after a string of cuts in the late 1990s, while developed nations including the US repeatedly lowered rates to stimulate economic growth, bringing renminbi interest rates far above levels in the United States, European Union and Japan.

That makes increasing renminbi holdings an option for many investors. With little room provided for legitimate channels given China's capital account controls, underground channels become the natural choice.

Fourth, the interest rate cuts on the renminbi after 1998 significantly reduced the cost of renminbi-denominated investment, increasing the acceptance of renminbi among Hong Kong investors as they invest on the mainland.

Fifth, with the economic integration as well as increased convenience of traveling between Hong Kong and the mainland, the ties between the two sides increased in recent years. Given the huge differences in the commodities and services available on both sides, more Hongkongers are travelling northward for sightseeing, shopping, purchasing properties and others items.

Then, why is there huge demand for foreign exchange on the mainland? As we found in the investigations, there are two major reasons: One, to invest in mainland's B-share market or the H-share market in Hong Kong; two, to transfer ill-gotten money out of the mainland via money laundering. Due to the complexity of the issue of money laundering, here we only discuss the relationships between forex transactions and the capital markets.

On February 19, 2001, the China Securities Regulatory Commission announced that the B-share markets in Shenzhen and Shanghai were opened to domestic investors, triggering a bull run unseen since the B-share markets were established. During that period, many people converted their renminbi into Hong Kong dollars to purchase the B shares, leading to a rapid expansion in transactions between renminbi and Hong Kong dollars. As the renminbi was not convertible under the capital account, the demand for Hong Kong dollars could only be satiated through illegal channels.

This is demonstrated in net cash release in Shenzhen. In the first half of 2001, the net cash release of renminbi rose by 260 percent year-on-year. As the B-share market stabilized in May, underground conversions started to reside, subsequently bringing cash release back to normal.

Conclusions and recommendations

Statistics indicate that there was a huge cash amount released in Shenzhen and the whole Guangdong Province, which neighbours Hong Kong. The huge cash release suggests that there are huge amounts of renminbi circulating between Hong Kong and Shenzhen.

Regulators have noticed the trend, and some domestic scholars have also done a lot of research on this phenomenon. In this report, we tried to move forward in a few areas:

First, we elaborated on the process of currency circulation and conversions between Hong Kong and Shenzhen. We believe that, due to the existence of that conversion mechanism, capital account controls on renminbi convertibility are, to a large extent, invalid.

Second, we pointed out that the huge conversions with renminbi have led to a gradual de facto marginalization of the Hong Kong dollar.

Third, we provided an in-depth analysis of the three major purposes of conversions. We pointed out that before the signing of Closer Economic Partnership Agreement between the mainland and Hong Kong, the main purpose of converting Hong Kong dollars into renminbi was to buy the lower-price commodities and services and enter the mainland's financial markets. The reason for mainland residents to hold Hong Kong dollars was mainly for consumption, or investment, in Hong Kong.

The above analysis shows that there exists a mechanism for the conversion of renminbi and Hong Kong dollars between Hong Kong and the mainland. This judgment carries a further implication - through the underground channels, the renminbi has become somewhat convertible under the capital account. In other words, renminbi and Hong Kong dollar are close to forming a common currency zone.

Given the current exchange rate systems of renminbi and the Hong Kong dollar, such close interactions have not yet had any significant impact on the mainland's economic, financial and monetary policies. But we may face very complicated situations should the exchange rate systems change. We need to get prepared for this.

(China Daily February 7, 2005)