Historic financial milestone was reached regarding  Chinese currency, the new Renminbi. National foreign reserve holdings exceeded the $2 trillion mark, as money pours back into China to take advantage of faster economic growth. Swiftly inflating asset prices are also cited as a reason. The second quarter gross domestic product figures are expected to record strong growth, of about 8% for the last three months. The People’s Bank of China, nations central bank, announced on its website that foreign reserves reached $2,132 billion at the end of June following massive accumulation of funds in the second quarter.

In spite of views to the contrary, oversized foreign reserves are a serious headache. For example, in order to keep the Renminbi stable,the central bank buys US dollars and other foreign currencies coming into China, and then holds the funds on its balance sheet. This creates a de facto “peg” of Renminbi to US dollar. The latest figures also represent an abrupt reversal of an emerging trend of the previous two quarters.

The influx of funds is certain to renew pressure from trading partners for a revaluation of the Renminbi. Timing is not very challenging, since the government and domestic business are focused on financial stability. It appears that Beijing is finding itself in a squeeze not unlike the one that earlier in the decade, with a flood of hot money trying to force the authorities hand on the currency issue. The same expectations of Renminbi appreciation will start to surface again soon and possibly become a focal point going forward.

China maintained a virtual US dollar peg for more than a decade until mid-2005, prompting complaints from its major trading partners that Chinese exporters held an unfair pricing advantage. Beijing’s move to a slightly more flexible exchange rate in mid-2005 and, relieved much of the political pressure. Result was a 20% appreciation against the US Dollar over the following three years. Since mid-2008, however, the Renminbi has barely moved against the greenback as Chinese exporters’ sales overseas have dropped sharply because of the global economic downturn. It is almost certain that Chinese central bank returned to policy of controlled exchange rate.

The reserve build-up in the second quarter was over $170 billion, including a new monthly record in May of $80.6bn.The quarterly figure overtakes China’s trade surplus by large margin, as well as direct foreign investment over the same stretch. Some see is as proof that the accumulation of funds inside the country is being caused by other factors. One of them is hoarding of domestic assets in expectation of currency appreciation.

Foreign reserves increased just $7.7bn in the first three months of the year, and $40 billion in the fourth quarter of 2008, as foreign firms sent profits home and banks demanded repayment of loans. Some financial analysts calculated that after taking account various factors like foreign investment, trade surplus and impact of changes in currency changes, about $70 billion of this money money came into China in the second quarter. This is in contrast to preceding quarter, when about $65 billion was extracted.

With world economy showing recovery, it is certain that question of Renminbi valuation will become politically charged again. Chinese financial authorities will be pressured into more freedom in currency movement. More likely than not, they will relent. Question is, just how tight the bounds are, with a repeat of 2005-2008 policy being probable. At the moment we can’t reasonably expect fully free floating currency, even though it will have to happen eventually.

Mike K.