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The trillion-dollar high of China's central bank

Section: Daily Dispatches

From Agence France-Presse
via Yahoo News
Sunday, November 5, 2006

SHANGHAI -- China will announce any day now that its forex reserves have shot past one trillion dollars in a relentless rise described as the stimulating but risky financial equivalent of mainlining drugs.

The unprecedented financial high will come as no surprise to economists and traders, who widely estimate that Beijing's foreign reserves holdings already hit one trillion dollars late last month.

The nation's forex holdings reached $987.9 billion at the end of September and have been expanding at a rate of $18.8 billion a month this year. At the end of 2000, China's forex reserves stood at $165.6 billion.

At current levels, China accounts for nearly 20 percent of the world's foreign exchange with about 70 percent of its holdings in dollars, according to the latest note to clients from Brad Setser, head of research at Roubini Global Economics in New York.

Like being a multi-millionaire, or in the case of China's central bank, a trillionaire, hoarding such huge amounts of money has benefits but also nasty side-effects.

Among the positives are it provides security in times of economic trouble and helps defend against financial speculators, as many Asian countries learned the hard way during the financial crisis in 1997 and 1998.

But a fast rise in forex can also overstimulate the economy, experts warn.

"It doesn't really matter how big a country's foreign reserves are because obviously the more you have the more stable you are in a crisis," said Stephen Green, a senior economist at Standard Chartered in Shanghai. "The problems come when they rise at a very fast rate. It's kind of like shooting cocaine into the veins of the economy. It's a stimulant."

Amid considerable efforts to curb breakneck growth, the ballooning reserves continue to raise questions about regulators' ability to execute China's gradual currency reforms and administer effective economic policy.

China's economy, the world's fourth-largest, is growing at a formidable rate. It expanded by 10.7 percent in the first three quarters, while in 2005 it grew by 10.2 percent, according to official statistics.

In its latest move to cool the economy, the central bank Friday for the third time this year ordered a 0.5 percentage point hike in commercial lenders deposit reserve ratio to nine percent.

China has also raised interest rates twice this year aiming to brake the surge in bank lending, already well past the 2.5 trillion-dollar annual target.

Mainland banks are swimming in cash because of the huge foreign direct investment flows entering China, while its factories are earning dollars for exports on everything from plastics to electronics.

At the same time tens of billions more in speculative cash betting on a currency revaluation and economic growth flood the country annually, adding even more to country's foreign exchange pot.

The problem is the accumulation puts massive upward pressure on the yuan, but China, keen to ensure that its exchange rate rises only gradually, prefers to force the central bank to buy the forex, weighing its books with more dollars.

When the People's Bank of China purchases the forex inflows, it must do so with yuan, inadvertently pumping cash or liquidity back into the financial system, which then gets loaned out by the banks.

Too many loans lead to indiscriminate investment, which potentially gives way to overproduction and eventually a deflationary crisis develops resulting in financial meltdown.

Standard and Chartered's Green said inflation is the greatest risk China faces, but so far, with the rate running under 2 percent a year, the inflationary consequences of all these inflows has been avoided.

"The strange thing about China at the moment is that we have low, pretty stable inflation, even if you doubt the government's inflation statistics," Green said.

While strong inflation may have yet to surface in China, the overgrown reserves open up Beijing to a further risk, greater currency exposure.

Experts worry that China could suffer huge losses if the dollar depreciates or US treasury yields fall, as the dollar-denominated assets are by far the largest portion of the reserve portfolio.

With China also politically committed to its trading partners to letting the yuan strengthen, albeit slowly, the more the currency rises the bigger the losses on the central bank's yuan-denominated liabilities against its US dollar assets.

"It's a big challenge to manage the money," said Ha Jiming, chief economist with China International Capital Corp. in Hong Kong. "The key will be to slow down the reserves growth but it takes time."

Traders say that Beijing is already secretly doing its best to diversify its US holdings, a tricky task because the slightest whiff that China's central bank intends to divest assets sends shivers through the markets.

"If any central bank that has most of their reserves in dollars -- and that is most Asian central banks -- sells a large amount of dollars as a percentage of their reserves, two things are going to happen: One, the dollar is going to collapse, and two, they're going to hurt themselves," said Callum Henderson, head of forex strategy at Standard Chartered in Singapore

"No one is going to offload half their reserves; it's the stuff of Michael Crichton" novels.

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