Libertarian Jackass

"Life is short, but truth works far and lives long; let us speak truth." -- Schopenhauer

Monday, July 11, 2005


Anticipating a revaluation, speculators are sending hordes of money to China. The other financial bubble: China and the RMB. How do they maintain the currency peg in light of the increasing demand?

Here's how sterilization works: Chinese companies that earn export earnings in dollars and other foreign currencies usually have their banks exchange them for yuan. A company with $100 million in export earnings could wind up with some 800 million yuan in its bank account. Foreign investors also ship dollars into China by the truckload to spend on new plants and securities. This money is converted into yuan deposits, too, giving China's banks huge wads of yuan to lend. In the past the banks had a bad habit of recklessly lending this money for construction of steel plants and other industrial enterprises. To keep a lid on such lending, the PBOC has been selling short-term bills to the banks, taking excess yuan out of circulation.

Right now the cost of neutralizing the flows is low. The PBOC can sell its short-term central bank bills to Chinese banks for 1.5% and reinvest that cash in longer-range domestic and foreign bonds at higher returns. Yet if the government bumps up interest rates to cool China's economy, this mopping-up process could get expensive, driving up the already sizable liabilities of the Chinese government. The other risk is that China's foreign exchange stockpile -- already equal to about 40% of gross domestic product and parked mostly in U.S. Treasuries -- could face a valuation hit if the yuan appreciates. "The more accumulated [reserves], the greater the losses," says Frank F.X. Gong, chief China economist at JPMorgan Chase & Co. (JPM ) in Hong Kong.
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