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With its Jump to a Record $1.68 Trillion, China's Foreign Currency Reserves Spawn Major Inflationary Fears

By William Patalon III
Executive Editor
Money Morning/The Money Map Report

China's foreign currency reserves soared to a world-leading $1.68 trillion at the end of March, and that has the government scrambling for ways to keep the torrents of incoming money from stoking an inflation rate that's already at its highest in more than a decade.

Assets advanced a record $153.9 billion in the first three months of the year, after an increase of $94.6 billion increase during the fourth quarter. Currency holdings are 40% above where they were at this time last year, the People's Bank of China said Friday.

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"The rapid accumulation in foreign-exchange reserves is making it very difficult for China to control money supply and inflation," Morgan Stanley (MS) Hong Kong Chief Economist Wang Qing told Bloomberg News.

Consumer prices in China jumped 8.7% in February after the worst snowstorms in half a century caused major disruptions in transportation and food deliveries. It's not a small problem: Chinese policymakers – including Premier Wen Jiabao – have labeled inflation and economic overheating as the two single-biggest obstacles to ongoing growth that the country faces this year.

According to a recent report from Money Morning, meat prices had risen more than 50% from the year before. Eggs and dairy products have spiked, too, making some of these once daily staples more of a "one-in-awhile" treat for families on blue-collar worker salaries. And, unlike in the United States, there are no social programs to help families navigate such rough waters. Indeed, according to one recent account, families of hourly workers are being forced to spend one third of their monthly income – or even more – on groceries.

The record snowstorm only exacerbating the country's inflationary woes.

Now the world's fourth-largest economy, China expanded at a rate of 11.9% in 2007, its fastest advance in 13 years.

But here's the problem. China's currency gained 7% against the dollar last year and has surged another 4.3% already this year. The strength of the economy and in the yuan have opened the spigot on inflows of "hot money" – speculative capital – which is what caused the massive growth in China's currency reserves.

In an effort to tamp down on liquidity, China's central bank has cranked up the required reserve ratio for lenders to a record 15.5%. However, China has held off on raising interest rates after six increases last year, waiting to see if the rate-cutting campaign being waged by the U.S. Federal Reserve ends up having the desired, offsetting effect.

By boosting interest rates, China's central bank "will only attract more money into China," said Morgan Stanley's Wang, explaining that the fast-rising yuan to crank down on a trade surplus that pumped up the financial system by additional $41 billion during the year's first three months.

A rising currency makes exports more expensive. Tighter control of foreign-exchange inflows, higher-reserve requirements and more bond sales to soak up capital all are strategies China may turn to as a way of offsetting the growth in speculative capital inflows.

Here's another point: The falling dollar has played a role in the surge in China's foreign currency reserves. The reason: Since China's reserve assets are quoted in U.S. dollar terms, the mere fact that the dollar is weakening against the yuan means that as the dollar falls the value of reserves held in other currencies will increase.

"The onset of the credit crisis and the crumbling of the U.S. housing bubble precipitated a significant sell-off of the dollar," Jonathan Anderson, a UBS AG (UBS) economist, told Bloomberg. "A sizeable portion, 35% to 40% of China's foreign-exchange reserves, is held in European and Japanese assets."

This big jump in foreign reserves in many countries has led to the creation of a number of big "sovereign wealth funds," government-run investment pools that are making major investments in high-visibility assets all around the world – and particularly in the United States, where the financial-services sector has permitted sovereign funds from Asia to the Middle East to get a foothold in some top-tier companies.

China Investment Corp., a $200 billion government-run venture fund, has acquired stakes in such firms as The Blackstone Group LP (BX) and Morgan Stanley. The Blackstone investment as resulted in a major loss for China's sovereign fund.

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning. With his latest project, Private Briefing, Bill takes you "behind the scenes" of his established investment news website for a closer look at the action. Members get all the expert analysis and exclusive scoops he can't publish... and some of the most valuable picks that turn up in Bill's closed-door sessions with editors and experts.

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