At the end of 2005, China’s foreign exchange surplus totaled $818.87 billion, a leap of $208.9 billion over the previous year and an amount that is expected to have topped Japan’s to become the world’s largest.

A nation’s foreign exchange reserves are usually amassed from a surplus in the current and capital accounts. Since the 1990s, China has seen surpluses both the current and capital accounts for more than 10 consecutive years, resulting in the decade-long sustained growth of forex reserves.

As of last year, the current account surplus reached an unprecedented level of $101.9 billion. In line with China’s present compulsory settlements of the foreign exchange system, the trade surplus eventually winds up in the forex reserves, increasing the amount.

Meanwhile, increasing pressure for renminbi appreciation since 2002 has attracted a noticeable influx of hot money into the Chinese currency market. Normally, hot money looking for gains through the floating exchange rate should be included in capital accounts. However, because the Chinese market isn’t fully open and there is continuing control of such accounts, speculative funds that are betting on yuan appreciation flow into the Chinese market disguised in the current account. While it is difficult to put an exact dollar amount on this influx, experts consider it to be in the range of billions of dollars.

Every coin has two sides, and this is the case for China’s expanding forex reserves. Their size also shows that China has managed to fulfill its forex reserve needs-something plaguing most developing countries. Before the end of 1981, China’s reserves had not yet reached $1 billion.

By the end of 1981, the country’s forex reserves had reached as high as $2.7 billion. In 1990, the amount broke through the threshold of $10 billion for the first time, skyrocketing to $105 billion, whereas in 2005 alone, China’s forex reserves swelled by $200 billion.

Meanwhile, the strengthened currency capacity stabilizes China’s economy, meaning that China’s highly improved international payments capacity can better guard against debt crisis or possible inflation caused by speculation. Though expectations for appreciation of the renminbi continue to intensify, speculation on a depreciation of the home currency seem farfetched. The highly strained depreciation of the renminbi that followed the Asian financial crisis continues to remind most Chinese of the capricious market climate.

Downside to rapid growth

However, negative effects are also seen in China’s skyrocketing foreign exchange reserves. First, the overheated forex reserves may cause the country to lose its control of its fiscal policies. Funds outstanding for foreign exchange have been China’s main channel of basic currency distribution. The supply of money is piling up faster than expected, despite a target for the annual M2 (broad money supply) increase set at 15 percent by the People’s Bank of China, the central bank. The actual rate has reached 17.57 percent, an increase of 2.94 percentage points compared with 2004.

Second, hefty forex reserves put more pressure on the appreciation of the renminbi, plunging China into the dilemma of how to ease such pressures while further controlling the supply of money. To reduce the negative influence of funds outstanding for foreign exchange in the domestic market, the central bank has to tighten its withdrawal of currency from circulation, or raise the interest rate, which will in turn elevate the appreciation pressure. But if we continue to increase the supply of money or reduce the interest rate, the too-loose currency policies will only help inflate the swelling bubble existing in the capital market.

Third, a relatively low rate of return on reserve assets will lead to a capital imbalance. There is usually a more satisfactory investment return from developing countries than developed countries. During the period from 1994 to 2003, the investment returns for Latin America, East Asia (except Japan) and other developing countries stood at 12.9 percent, 14.7 percent and 11.3 percent respectively, yet those of G7 countries averaged 7.8 percent, with that of the United States standing at 9.9 percent.

Currently, China’s current account surplus excessively turns into forex reserves, and also results in an influx of foreign direct investment. All of this contributes to China’s replacing its domestic capital, with potential high returns, with low-profit overseas capital. While it may be more profitable for China to invest overseas, right now it has to save for its foreign reserves. Because of this sacrifice of national consumption as well as missing out on potentially better investment opportunities, China’s low efficiency of investment has become a public concern.