Excessive Foreign Exchange Reserves
"Foreign exchange reserves" can help us to do an analysis. Foreign currency has two major sources: trade surplus and net inflow of foreign capital, which enters a country without the sale of goods.
Clearly, foreign exchange should be used to purchase foreign goods but not to buy domestic goods. If surplus foreign exchange is used in the country, it will create “too much money chasing too few goods,” which is inflation. If used in stock and real estate markets, foreign exchange can create bubbles in money games. The more foreign exchange reserves, the greater the bubbles are. The question is: what are the proper foreign exchange reserves for a country?
It is commonly accepted that foreign exchange reserves should increase with a country’s import value and the instability of the international balance of payment. The proper foreign exchange reserves can be estimated as equal to the 10 percent of the GDP or three to six month import value of the country. However, China now has US$1.6 trillion of foreign exchange reserves, which equals 50 percent of its GDP or 15 months of its imports.
Chinese statistics are not transparent. We can only estimate according to other agencies or observers. According to Reuter’s New Agency, China's foreign exchange reserves increased $40.3 billion in May this year, and the trade surplus plus foreign direct investment (FDI) were only $28 billion. The difference is likely to be the "hot money" used for currency arbitrage.
Inflow and Outflow of Enormous ‘Hot Money’
In recent years, the Chinese communist regime employed the so-called "macro-economic control," which has been ineffective due to lack of respect for market mechanisms. The exchange rate control is the main reason for the inflow of an enormous amount of hot money. The economic bubbles and even a tsunami of economic crises are looming over the Chinese economy.
According to Logan Wright, an analyst with Stone & McCarthy in Beijing, the amount of the hot money influx into China between January and May reached $150 to $170 billion.
It was reported that there are various channels for hot money to flow into China. Chinese officials have said that most of these channels are illegal and the most commonly seen practices are the falsification of the amount of direct investment and international trade. Confronted with an incessant influx of hot money, Chinese authorities have repeatedly intensified capital control. Now, the regime is looking for ways to further enhance the censorship of outward remittance. These control measures are not effective, and they could also increase China’s economic risk.
The Best Practice is to Liberalize the Exchange Rate of the Yuan
Sherman Chan, senior economist at Moody International Consulting Inc., believes that drastic measures are needed to adjust the exchange rate of Chinese yuan to an appropriated level.
He pointed out, “If the government still wants to maintain its existing exchange rate system, speculative capital would definitely continue to influx for arbitrage.”
Even if trading control measures are tightened; foreign capital could still flow into China through other channels, including through the falsification of foreign direct investment capital. Some banks have said that capital control may lead to an upsurge of innovative money laundering channels. As a result, it is impossible to find an effective solution.
Hot money has given China’s future economic policy more concerns. The Chinese authorities are finding it a difficult challenge to the policy-making process.
According to the South China Morning Post, though China’s GDP growth rate reached a two-digit level in the first quarter of this year, the fixed assets investment hit a new low in the past five years. The growth rate of industrial profit in the first five months dropped from previous year’s 42.1 percent to 20.9 percent. The gross profit rate of China’s business also dropped to 8.2 percent in March, which was a new low in the past four years.
On the other hand, according to the Reuter’s reports, China’s inflation rate for the first half of this year was 7.9 percent, higher than official target of 4.8 percent. As a result, when making policies, the authorities must take into consideration both economic growth and inflation.
As to whether first priority should be given to growth or inflation, in addition to two fractions within economic experts, Chinese premier Wen Jiabao regards curbing inflation is the first priority, while the CCP leader Hu Jintao thinks the first priority should be given to growth. As a result, China faces a real dilemma. It seems one can't have the cake and eat it, too.
Plainly speaking, the easiest approach to control inflation for now is to appreciate the yuan or hike the interest rate. But both of the approaches may eventually result in the quicker inflow of hot money, and may in turn hasten the worsening of inflation. As mentioned by the 1976 Nobel Laureate and economic master M. Fredman in his book entitled “Free to Choose,” Whether inflation leads to unemployment, or the temporary side effect of curbing inflation leads to the rise in unemployment. In other words, it is impossible to solve problems without any cost. Therefore, the drastic measure to deal with the problem is to let the market decide the exchange rate of the yuan. Though there will be some hot money inflowing into China in the short term, it would happen only once and will get back to normal gradually.
 Hot money, also called speedy-flow capital, refers to extremely volatile short-term capital that moves with short notice to any country providing better returns. Powerful speculators can quickly pump massive sums into a high-yield economy, giving it an artificial aura of success and propriety. But, on a mere suspicion of a downturn or other negative factor, they can (and do) withdraw it almost overnight causing a near collapse of the country's financial structure.