The yuan climbed to a record post-revaluation high against the US dollar yesterday (see the first chart).
After its recent gains, the Chinese currency has now appreciated by 1 per cent against the US dollar so far this year.
That might not sound much. But in today's low-yielding yet volatile environment, a steady annualised 3 per cent foreign exchange market gain is not to be sniffed at, especially when you can earn a nice interest rate premium for holding the yuan instead of US dollars.
Even better, plenty of people believe that the yuan is a one-way bet, and that it is going to go on strengthening for the foreseeable future. As a result, money is pouring into yuan-denominated investments. Last month the value of yuan deposits in Hong Kong hit a record 652 billion yuan (HK$812 billion).
At the same time, international capital is pouring into the mainland's onshore financial system. Yesterday, Beijing announced a capital account surplus for the first quarter of the year of US$102 billion, up from US$56 billion for the same period last year.
Such heavy inflows present China's policymakers with a problem. If they stand back and let the money flood in, the yuan will soar in value. Those gains will encourage more inflows, accelerating the appreciation and undermining the international competitiveness of Chinese-made goods.
On the other hand, if the central bank steps in and buys up the foreign currency inflows to hold down the value of the yuan, it will release vast quantities of liquidity into the domestic financial system, where M2 money supply is already around 200 per cent of gross domestic product.
Such an excess of liquidity would threaten to push up consumer inflation, and would very likely exacerbate property price rises that the authorities are already struggling to control.
To prevent this inflationary impulse, it is likely the central bank would choose to soak up much of the liquidity it releases when it sells yuan for foreign currencies, either borrowing the liquidity back from the banking system by issuing short-term debt or by raising bank reserve requirements.
But this tactic, too, causes problems. It weakens the financial system by eroding bank returns. And the combination of intervention and so-called sterilisation of inflows would massively inflate the size of the central bank's balance sheet.
That would create a huge mismatch between the central bank's foreign exchange assets and its local currency liabilities. Any future appreciation of the yuan would inflict massive, and potentially embarrassing, paper losses on the central bank.
Caught between a rock and a hard place, the authorities have compromised. Over the first three months of the year, the value of China's foreign exchange reserves leapt by US$128 billion.
That jump signals that the central bank has still been intervening heavily in the foreign exchange market to slow the yuan's appreciation, even as it has allowed the currency to climb to record levels.
Most observers believe the central bank will continue along its current path, possibly widening the yuan's permitted trading band to give itself a little more wriggle room.
But that's not a foregone conclusion. It's just possible policymakers may choose to step up their intervention to halt, or even push down the yuan.
That would temporarily set back the cause of currency liberalisation. But it would also discourage further inflows.
And it would take some of the pressure off China's struggling corporate sector. Since the yuan's 2005 revaluation, the Chinese currency has appreciated almost 40 per cent in real effective terms. Meanwhile the currencies of China's main competitors have fallen by between 15 and 20 per cent (see the second chart).
That's been painful. Perhaps yet not painful enough to prompt a policy response, but in the foreign exchange market there is never any certainty behind a one-way bet.