China Monetary Policy in Focus as Reserves and Lending Surge

China's foreign-exchange reserves climbed to a world record $2.85 trillion last quarter as bank lending continued to exceed the government's annual target, putting more pressure on the central bank to increase borrowing costs to dampen down liquidity and tame inflation.

China's foreign reserves jumped by $199 billion in the fourth quarter, a much larger increase than economists expected. The People's Bank of China (PBOC) may need to raise benchmark interest rates, boost reserve requirements for lenders and allow faster yuan appreciation, as a result, according to economists from Standard Chartered Plc and Credit Agricole CIB.

"All eyes are going to be on what new policies the central bank can bring to the table,"Jinny Yan, a Shanghai-based economist at Standard Chartered told Bloomberg News. "But there's still going to be a lot of excess liquidity in the market in the first half of the year."

The Chinese government has been buying record amounts of foreign currencies including the dollar and the euro, which are pouring into the country through trade surpluses and foreign investment.
The numbers suggest that China had about doubled its intervention in currency markets to about $2 billion a day in an effort to hold down the value of the yuan, according to The New York Times.

The yuan strengthened by 0.3% in Shanghai yesterday (Tuesday), the biggest jump since Dec. 30, amid speculation that the central bank will allow gains ahead of President Hu Jintao's visit to the United States next week.

President Barack Obama is expected to pepper Hu with questions about how an undervalued yuan has led to gains in China's currency holdings, underscoring global economic imbalances.

Just last week, Brazil's new President Dilma Rousseff joined the chorus of foreign policymakers calling for the Chinese government to allow the yuan to appreciate against other currencies and improve trade imbalances.

The yuan hit an 18-year high against the dollar shortly after Rousseff's plea, and a report by the state China Securities Journal cited unnamed industry sources as saying China's currency could appreciate 5% against the U.S. dollar this year.

The yuan has climbed about 3% against the dollar since last June after officials removed a peg that had been in place since the global financial crisis.

The PBOC has been battling inflation since it pumped $686 billion in stimulus into the Chinese banking system to keep the economy growing through the global financial crisis.

Inflation in China hit a 28-month high of 5.1% in November, according to government data. However, many Chinese economists say that understates the true extent of inflation, because it excludes soaring costs for owner-occupied housing and is based heavily on the prices of an outdated list of consumer products that are no longer popular, The Times reported.

Now Beijing is struggling to rein in its lenders, which continue to stoke the fires of the economy with easy capital. Banking regulators have repeatedly ordered banks to slow their lending, with limited effect. Yuan-denominated lending last year hit 7.95 trillion yuan ($1.2 trillion) compared with the government's stated target of 7.5 trillion yuan ($1.13 trillion).

The PBOC raised the share of bank assets that banks must keep on deposit at the central bank six times last year. But banks have exploited loopholes in those controls by securitizing assets and moving loans off their balance sheets.

Investors around the world have also been sending huge amounts of "hot money,"or speculative capital, into Chinese real estate, bank accounts and other investments despite efforts by the Chinese government to discourage these capital inflows.

"Liquidity in the banking system will be more than abundant and the central bank needs to tighten more aggressively," Dariusz Kowalczyk, a Hong Kong-based economist at Credit Agricole told Bloomberg.

Standard Charter's Yan forecasts three interest-rate increases this year with the first this quarter. Citigroup Inc. (NYSE: C) said yesterday that the central bank may announce rate and reserve-requirement increases to take effect after the Lunar New Year holiday, which starts Feb. 2.

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