Inflation will be a casualty of forex reserves juggernaut

Despite China's efforts to bring down its huge foreign-exchange reserves, they continue to hit record highs, and now exceed US$1.8 trillion. Reports say the nation is accumulating reserves at a rate of US$100 million per hour. Such a fast build-up raises a host of questions. What should or can China do? Will policymakers again be forced to carry out a one-off revaluation of the yuan? Are excessively large reserves stoking domestic inflation?

China's foreign reserves need to be put into perspective. First, they would have been even larger had the government not spent a portion on recapitalising state-owned banks before their overseas listings and to create the China Investment Corp (CIC), the country's US$200 billion sovereign wealth fund.

Second, the reserves can now pay for about 18 months' worth of imports. In general, economists recommend a country to maintain enough reserves to pay for only three to six months of imported goods and services. Third, China's foreign debts - US$347 billion at the end of last year - are less than 20 per cent of its reserves. By any measure, the foreign reserves are needlessly large.

It is also clear that China's existing strategies to slow the accumulation of reserves have been ineffective. Cuts in export subsidies have not conspicuously shrunk the massive trade surplus or export earnings. The 16 per cent appreciation of the yuan against the US dollar in the past three years has not made much of a dent, either. For the past couple of years, the government has been encouraging domestic firms and citizens to go abroad to acquire foreign assets or to travel and study, but the reserves' upwards march has continued.

In the absence of more drastic action, it seems certain that China's foreign reserves will top US$2 trillion this year. The trade surplus is likely to persist, and reserve assets, after all, are generating interest income. The key concern for Chinese policymakers is the impact of foreign-currency inflows on domestic inflation.

So far, the People's Bank of China has succeeded in largely sterilising increases in reserves and in maintaining relatively strict capital controls. But, as the money keeps gushing in, these efforts are becoming less effective. To contain excessive money supply, the People's Bank has also raised the bank reserve-requirement ratio 16 times in the past two years. There is a limit, though, to how much this can curb bank lending or stop some of the reserves seeping into the domestic economy.