Hot Money Poses Risks to China’s Stability

Michael Pettis and Logan Wright reports in the Financial Times:

In 2006 China shocked the world by adding $247bn to what was already the largest hoard of foreign currency reserves. In 2007, if correctly counted, China took in more than twice that amount. So far this year it is on track to double yet again.

It is increasingly clear that this level of reserve accumulation is not sustainable. Besides the strains it places on the global balance of payments, the biggest problem it causes is within China itself. The People’s Bank of China, China’s central bank, has to purchase these soaring reserves by issuing a combination of local currency and central bank bills. The ensuing monetary creation is fuelling rising inflation, systematic overinvestment and an overextended banking system.

But while vast and growing reserves have been an issue for China for several years, in the past few months something new and highly destabilising has been added to the process. The source of reserve accumulation has become much more volatile and perhaps intensely procyclical (exaggerating the swings of the economic cycle).

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