From "How much more FX reserves can China accumulate?" by Wang Tao, UBS senior China economist, January 18
It is the current account surplus and FDI, not hot money flows, that accounted for the bulk of the increase in FX reserves. For 2009 as a whole, we estimate that trade surplus and interest earnings from China’s large stock of reserves accounted for 75% of the total reserve increase, while other capital flows accounted for less than 10% of the increase … Dealing with the persistent large FX inflows in the coming year will be challenging on at least two fronts: the need to sterilize the large inflow to maintain appropriate monetary conditions; and the challenge to allocate the ever-rising FX assets properly in a more uncertain global financial market. As foreign exchange comes in, China’s government has to buy it with RMB to keep the RMB from appreciating, thus increasing base money supply. To keep monetary conditions from becoming too loose, the central bank has to sterilize the purchase of FX by either issuing central bank bills or raising the reserve requirements of banks. We believe the recent 50 basis point hike in RRR (reserve requirement ratio) was mainly intended to withdraw liquidity that had been created from the FX inflows. If large FX inflows persist, as we expect, the PBoC will need to issue more central bank bills and/or raise RRR again.
From "China Macro View: The Beginning of Exit and Its Possible Path" by Shen Minggao, Ken Peng and Ben Wei, Citi economists, January 18
The beginning of policy exit will probably lead to earlier rather than later renminbi appreciation. The pace of renminbi revaluation was highly correlated with policy rate changes over the past years. Capital inflows will likely mount on the expectation of further policy tightening even before the PBoC raises lending rates. We continue to expect the renminbi will de-peg to the dollar in the first half of the year. A new regime, e.g., pegging to a basket of currencies, could be introduced. The real debate would be whether policy tightening would be effective. If yes, the worry over inflation and asset price bubbles should ease, and if not, prices may surge to an unsustainable level. Assuming authorities are able to manage credit growth within its targeted RMB7.5 trillion [US$ 1.1 trillion] by year-end, it would help slow price increases in the asset market. Credit tightening will likely slow domestic demand and thus import growth … This will likely happen again in the near future. If the tightening means the end of the stimulus … domestic demand could drop sharply.