China FX reserves soar past $3 trillion, add to inflation

By Kevin Yao and Langi Chiang Kevin Yao And Langi Chiang Thu Apr 14, 7:15 am ET

BEIJING (Reuters) – China’s foreign exchange reserves soared to a record of more than $3 trillion by end-March, while its money supply growth blew past forecasts, threatening to aggravate the nation’s inflation woes and trigger more policy tightening.

Chinese banks extended 679.4 billion yuan ($104 billion) in new local currency loans in March, while the broad M2 measure of money supply rose 16.6 percent from a year earlier, both above market expectations.

Tapping the brakes on money and lending growth has been a crucial part of Beijing’s campaign to rein in inflation, which probably hit a 32-month high of 5.4 percent in the year to March, according to local media reports.

After making progress at the start of the year in mopping up excess cash, the People’s Bank of China appeared to lose some ground in March.

“The latest numbers show that it is still too early for China to ease monetary tightening. China still needs to keep tightening policy at the current pace in coming months,” said Qu Hongbin, chief China economist with HSBC.


Looking at the first quarter as a whole, the central bank has had some success in controlling loan issuance, said Liu Hongke, economist with CCB International Securities in Beijing.

She noted that the 2.24 trillion yuan in new loans in the first three months of the year was about 30 percent of the government’s full-year target, exactly in line with where it wanted to be at this stage.

“It shows the central bank is doing a good job,” Liu said. But she added that China would need to raise banks’ required reserves again very soon to absorb excess liquidity.

China’s inflation accelerated to as fast as 5.4 percent in March from a year earlier, Hong Kong media said on Thursday, reinforcing the government’s vow to rein in price rises.

Economists polled by Reuters had expected annual inflation in March to be 5.2 percent, up from February’s 4.9 percent.

The website of Hong Kong’s Phoenix TV, citing an unidentified source, said annual inflation in March was likely to be 5.3-5.4 percent, a 32-month high. Official data will be released on Friday morning.

China has raised benchmark interest rates four times since last October and has required the country’s big banks to lock up a record high of 20.0 percent of their deposits as reserves.

Economists polled by Reuters last week said that China was heading for a pause in its half-year cycle of monetary tightening, forecasting that it would raise interest rates just once more this year.


A measure of the difficulties faced by China in taming inflation came in the first quarter’s nearly $200 billion increase in its foreign exchange reserves, already the world’s biggest, to $3.05 trillion.

The rapid reserve build-up could indicate hefty capital inflows given that China had a $1.02 billion trade deficit in the first quarter– the first quarterly deficit since 2004 — which could complicate the government’s fight against inflation.

“It could be a sign of strong capital inflows, which implies that there will be room for more reserve requirement ratio hikes and stricter credit control measures,” said Connie Tse, economist at Forecast Pte in Singapore.

Also, the dollar’s broad weakening against major currencies in recent months meant that the value of China’s existing reserves, which is expressed in dollars, was bound to increase.

The dollar hit a fresh 16-month low against a basket of currencies on Thursday as expectations grew that the Federal Reserve would keep monetary policy loose for some time.

China’s vast forex reserves are often seen as a sign of the strength of its economy, stemming in large part from its vast trade surplus, but the rapid growth translates into money creation and additional inflationary pressures at home.

“There have been stronger expectations of yuan appreciation and faster hot money inflows in the first quarter,” said Li Jie, head of China forex reserves research center at the Central Universify of Finance and Economics in Beijing.


This looks like the Mundell-Fleming Policy Trilemma at work. China has been trying to control rising inflation using restrictive monetary policy (raising bank reserve requirement ratio to curb lending). However, with its trade surplus and strong capital inflows, there is upward pressure on its exchange rate. To keep the yuan from appreciating, the Chinese government has to sell yuan in exchange for foreign currencies, hence resulting in its growing foreign exchange reserves. The increased supply of yuan filters back into the financial system as increased liquidity. This makes the restrictive monetary policy less effective, as the central bank once again has to tighten credit to mop up excess liquidity. If China wants to continue controlling its exchange rate and have control over its monetary policy, it will have to tighten restriction on capital flows ie it cannot have independent monetary policy, exchange rate control and capital mobility at the same time.


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