By closely linking the yuan with a sharply declining U.S. dollar, China is importing a highly accommodative U.S. monetary policy, which sits oddly with Chinese monetary policy considerations. On top of China’s already large, basic balance of payment surplus, speculative inflows likely have risen in recent months as yuan appreciation expectations have become entrenched. A combination of a one-off revaluation of the Chinese currency and tightened capital controls by government regulators may help break the expectation in the near term, although these steps would be highly controversial.
The speed of China’s foreign exchange reserves accumulation has been nothing short of astonishing. In a previous report (see “Country Alert China, Difficult 2008 Part I: The Speed of FX Accumulation,” March 17, 2008), we identified the influx of foreign exchange as one of the biggest challenges facing Chinese policymakers this year. Our estimate puts the actual increase of net foreign assets in 2007 at between US＄ 570 billion and US＄ 685 billion, and we are not surprised that FX reserves increased by more than US＄ 120 billion in the first two months of this year.