China's refusal to let market forces determine the foreign exchange value of the yuan and to liberalise capital markets has meant that the People's Bank of China must continue to accumulate foreign reserves. Official reserves now stand at more than US$514 billion, compared with less than US$350 billion only 18 months ago. With most of those reserves held in US government bonds, there is an increasing risk of substantial losses to the Chinese economy as the US dollar loses its international purchasing power. Since early 2002, the US dollar's value has fallen by 35 per cent against the euro and by 17 per cent against a broader basket of currencies on a trade-weighted basis. The slide is due to an unsustainable US current account deficit that is now about US$600 billion, nearly 6 per cent of gross domestic product. Moreover, the US is running a sizeable budget deficit, has trillions of dollars of unfunded liabilities associated with Social Security national pension system and Medicare, and has a saving rate close to zero. Given China's current-account surplus and large capital inflows, including speculative inflows in anticipation of an upward revaluation of the yuan, the People's Bank's foreign reserves are growing too fast. To keep the yuan pegged at 8.28 per US dollar, it must buy excess dollars, which can lead to inflation. The problem is that China will not be able to increase its US dollar reserves indefinitely without serious inflationary consequences, which will cause social and political instability. China's capital controls are porous, with billions of dollars flowing in through black-market channels. As those funds are converted into local currency, there will be increasing upward pressure on the yuan-dollar exchange rate - unless the central bank pumps out more and more yuan to buy the excess supply of US dollars. The fact that inflation has gone from zero to more than 4 per cent last year, and producer prices rose 8.4 per cent in October from a year earlier, means that there is too much money chasing too few goods. The recent increase in the benchmark interest rate is a clear signal that Beijing is worried about overheating. China could move to a more flexible exchange-rate regime, perhaps by first tying the yuan to a basket of other currencies, thus allowing it to move in a wider range against the US dollar, before eventually floating it. With a floating exchange rate, there is no need to hold large foreign reserves, so the People's Bank could slowly reduce its US dollar assets and its exposure to future exchange-rate losses. Floating the yuan would be a hedge against overreliance on the US dollar and would lead to a more rational use of savings. If China continues on the current course, reserves will keep growing, putting increasing pressure on the yuan-dollar peg. Expect to see further capital account liberalisation this year to relieve pressure on the yuan, and a slow movement towards widening the peg or adopting a currency basket. The central bank will then have greater freedom to focus on domestic monetary policy aimed at long-term price stability. James Dorn is a China specialist at the Cato Institute in Washington
