China's foreign-exchange reserves had inflows of only US$28 billion in the third quarter, despite a US$96 billion trade surplus.

In the absence of strong net direct investment inflows, the only way to explain the disparity is a large forex outflow via the "everything else" category. Many assume this indicates substantial "hot money" [Offshore Company Incorporation]outflows. Is this really what is going on?

Overall, we accept the idea that some "hot money" is leaving China, but we have been cautious about its scale. We have shown that there are other things going on in the "everything else" category, including changes in trade finance and forex deposits and loans. Much of this will become clearer when China releases its quarterly balance-of-payments data.

We also think the forex transactions conducted by exporters and importers are very important to what happens with the Chinese yuan and the forex reserves. If importers buy fewer US dollars or exporters wait to sell their dollars, this makes a big impact on yuan spot, and on the need for the People's Bank of China to suck up the excess dollars. Again, such actions are pretty normal.

US dollar deposits

Over the summer, we spotted a big increase in US dollar deposits at China's commercial banks, suggesting that corporates and households were keeping dollar receivables and/or converting more yuan into dollars.

The forex conversion ratio of importers - that is, their US dollar buying against China's total import bill - rose to 60 percent to 70 percent in the first half, from 50 percent to 60 percent in 2011. We calculate the ratio as importers' US dollar buying for goods and services against the import bill three months earlier, to take account of the timing of payments. We then estimate a three-month moving average. This shift in the forex behavior of importers has been the most important reason for the failure of forex reserves to rise, even as the trade balance has returned to surplus.

Firms and corporates also converted some of the yuan they were holding into dollars. Under the income and transfer lines of the current account, it is legal for foreign workers in China to remit their incomes back home, or for companies to move profits across borders. There has been a key shift in activity here in the last few months. Usually these lines of the current account show far more US dollar [HongKong Richful  - Hong Kong Company Formation, Offshore Company Incorporation]sales than purchases, but activity is balanced this year.

As a result, forex deposits sitting in China's commercial bank accounts rose by a huge US$120 billion in the first half. Onshore dollar funding costs fell dramatically in July, and are now barely above offshore Libor rates.

This forex deposit growth is more than enough to explain the negative "everything else" flows in the first half. We estimate US$42 billion of "unexplained" outflows for the period.

Instead of the People's Bank of China absorbing these dollars into the forex reserves, China firms and households apparently absorbed them into their "reserves." Money moving out of yuan into US dollar and staying in China is not quite the same as capital flight.

That said, the timing of these flows suggests that there may have been large forex outflows in the third quarter. China's forex deposits grew by only US$9 billion in the quarter and actually fell by US$1 billion in September.

At the same time, "everything else" outflows totalled US$80 billion. This is certainly more suggestive of capital flight since it is easier to send or carry US dollars out of the country than yuan.

We are not too worried, however. Several quarters in recent history have had "unexplained" forex outflows without Armageddon breaking out in the domestic economy or in the onshore forex market.

Indeed, after continuous forex inflows from 2005-11, limited forex outflows are surely to be welcomed.

It would take significant outflows to cause a significant decline in China's forex reserves, and even if they did, the central bank has ample room to cut reserve requirements in order to boost onshore liquidity.

We recognise that some think this is the tip of a huge iceberg, but we think such worries miss the important point.

In our view, we may be witnessing the healthiest of all situations: some of the short dollar positions of recent years are reversing but with very limited broader influence.

Faith in yuan

We have kept faith in the yuan. Even in the summer, we expected the trade surplus to come back in the second half and US dollar-selling pressure to reassert itself in the onshore market.

In September, net forex purchases by banks and the People's Bank of China again turned positive at about US$23 billion, as the system as a whole went back to buying dollars. The adjusted trade surplus in September was US$34 billion.

At times when the yuan was trading weakly over the summer, we were also convinced of the central bank's willingness to intervene to prevent significant yuan weakness. QE3 has also caused ever-greater scepticism towards the US dollar in China.

The leveling-off of growth in US dollar deposits is another hint that the global risk-aversion dynamics triggered by the European debt crisis have begun to ease.

Powerful moves by the European Central Bank have cut tail risks, while ample liquidity conditions are helping to drive a broader re-leveraging dynamic among international investors. Over time, this will likely create favorable conditions for further yuan appreciation.