CHINA'S yuan down, foreign reserves down, trade deficit worsening. These were the forecasts of most broking houses at the beginning of the year. The facts so far: the yuan is up, foreign reserves are up, the trade gap has narrowed, and broking houses are being forced to revise forecasts for their clients. Why has China managed to defy initial predictions? There are three reasons. The most obvious is the dramatic turnaround in the balance of trade. After posting a deficit of US$12.2 billion last year - its first in four years - the country is finally rolling back the red ink. The question now is: will it be a $1 billion deficit or surplus? Whatever the outcome, the drastic reduction in the deficit has meant an improvement in China's foreign reserves. More significantly, however, capital inflows show little sign of abating, despite rising costs of doing business in China. The drop in contracted investment to $62.58 billion notwithstanding, actual investment in the first 10 months climbed 44 per cent to $25.23 billion, demonstrating foreign investors' long-term confidence. That is a ratio of 40 per cent - probably the highest recorded since China's open-door policy was initiated in 1979 - thanks to the past few years of high contracted investments. Last year China attracted $110 billion in contracted investment, equal to the total for the past 14 years. The final reason for the impressive record is the foreign exchange reforms initiated earlier this year, under which state enterprises are required to turn over their foreign exchange earnings to state-designated banks, thereby boosting the supply of hard currencies. Foreign exchange reserves also rise with increased foreign investment. Coupled with the credit squeeze and the demand for yuan by foreign investors to cover local expenses, the yuan naturally appreciates. If anything, the People's Bank of China, the central bank, feels the appreciation is too strong for its liking and has stepped in to buy up foreign currencies. An indication of its strength is that the yuan now trades within the 8.50-8.51 margin against the greenback, compared with 8.7 when the exchange reforms were initiated on January 1. The robust capital inflows, better-than-expected trade performance, and exchange reforms have added up to a doubling of foreign reserves to $43.7 billion in the first 10 months. The growing reserves will bolster the central bank's confidence in doing away with the swap centres and allowing foreign enterprises to join the inter-bank foreign exchange system. But inside the silver lining is a dark cloud, which the People's Bank has to consider with great caution. The rise in foreign reserves implies an increase in 'base money' - or the liquidity of the local currency. By buying up foreign currencies, the bank raises the liquidity of the yuan. At a time when inflation stays stubbornly at about 25 per cent, the higher money supply will only stoke the fire of runaway prices. The bank should resort to more debt instruments to achieve what economists call the 'sterilisation effect' _ soaking up the increased yuan supply due to higher reserves _ or it risks spoiling the country's impressive record.