Despite China's efforts to bring down its huge foreign-exchange reserves, they have hit another record high of US$1.76trn at the end of April. News reports say China is now accumulating reserves at a rate of US$100m per hour. Such a fast build-up raises a host of questions. What should or can China do about the skyrocketing reserves? Will policymakers again be forced to carry out a one-off revaluation of the renminbi? Are excessively large reserves stoking domestic inflation?

Before tackling these questions, China's foreign reserves must first be put into perspective. First, the reserves would have been even larger had the government not spent a portion of them to recapitalise state-owned banks before their overseas listings and to create the China Investment Corp (CIC), the country's US$200bn sovereign wealth fund. Second, at present levels the reserves can pay for about a year and half's worth of China's imports. In general, economists recommend a country to maintain enough reserves to pay for only 3-6 months of imported goods and services. Third, China's foreign debts—US$347bn as of the end of 2007—are less than 20% of its reserves. The country's foreign reserves, by any measure, are needlessly large.

Ineffective strategies

It is also clear that China's existing strategies to slow reserves accumulation have been ineffective. Cuts in export subsidies have not conspicuously shrunk China's massive trade surplus or export earnings so far. The appreciation of the renminbi against the US dollar in the past three years has not made much of a dent either. For the past couple of years the Chinese government has also been actively encouraging domestic firms and citizens to go abroad to acquire foreign assets or to travel and study, but the reserves' upwards march has continued.

In the absence of more drastic actions, it seems certain China's foreign reserves will top US$2trn within this year. The trade surplus is likely to persist, and reserve assets, after all, are generating interest incomes. The key concern for Chinese policymakers is the impact of foreign-currency inflows on domestic inflation. So far, the People's Bank of China (PBC, the central bank) has succeeded in largely sterilising increases in reserves and in maintaining relatively strict capital controls. However, as money keeps gushing into the country, these efforts are becoming more challenging. To contain excessive money supply, the PBC has also hiked banks' reserve-requirement ratio 16 times over the past two years. But in the end there is a limit to how much the PBC can curb bank lending or prevent some of the reserves from seeping into the domestic economy.

The early travails of the CIC are further evidence of the difficulty of managing such large foreign reserves. The need to diversify their holdings away from US Treasuries and other Western governments' debt was the key motive for forming China's first sovereign wealth fund. But the CIC's headline-grabbing but so far loss-making investments in the Blackstone Group, a US private-equity fund, and Morgan Stanley, a US investment bank, have drawn a flood of criticism in China. While the CIC's timing of these two transactions may have been plain bad luck, few Chinese have faith in its ability to generate a decent rate of return consistently. (It has not escaped people's notice that most key positions at the CIC are filled by political appointees, not investment professionals.)

China seems to have only two options if it seriously wants to reduce the level of foreign reserves. It can either accelerate the renminbi's appreciation or relax capital controls more. The latter action is unlikely this year. The plunge in China's stockmarket has made any policy that would encourage capital outflows politically untenable. China may adopt a much stronger renminbi policy. Some policymakers, though, apparently also want to reintroduce export subsidies for sectors most hurt by the currency appreciation that has already taken place. For example, to redress widespread textile-job losses, the government may allow a 2% increase in export-tax rebates for the industry. But then, it makes little sense to accelerate currency appreciation while giving exporters a helping hand. The reality is that China has run out of politically feasible means to bring down its reserves.

Consequently, China will face higher inflation. Indeed, as the speed of reserves accumulation shows no sign of slowing, the Chinese government may be tempted to mobilise some of the money for social purposes. For instance, it may give more subsidies to the poor to counter the inevitable (upwards) adjustment in state-regulated petrol and electricity prices. If so, the government must be extra careful as to not throw all fiscal prudence out the window. Otherwise, its tolerance level for inflation will be even more sorely tested in the coming months.