The latest data shows that as of the end of September 2004, China's foreign exchange reserves came to US$514.5 billion, hitting a record high. From January to September, foreign exchange reserves increased US$111.3 billion. So what exactly do the foreign exchange reserves mean?

Experts say that China's increasing foreign exchange reserves not merely show that this nation's overall strength has grown, but also cause internal and external pressure for the country. Externally, China faces the pressure for the appreciation of its currency; internally, there is a need to raise interest rate on deposits, and indirect debts are mounting.

China's growing foreign exchange reserves do not mean a wealth that is disposable at any time. On the contrary, it is a sizable indirect debt. Take this yea for example. From January to September, China's trade surplus was only US$3.9 billion. In other words, it only had a slight current account surplus. In addition, the amount of direct investment contracts was US$107.4 billion, with US$48.7 billion foreign investments being actually utilized. However, in the nine months China's foreign exchange reserves increased US$111.3 billion. After trade surplus and direct investment in regular channels are deducted, there are still funds of US$58.7 billion not accounted for. In fact, the US$58.7 billion is hot money; it sneaked into China under the guise of current accounts.
 
The most immediate function of foreign exchange reserves is international payment. However, it has to be a nation's own wealth. For example, Japan's foreign exchange reserves hit US$830 billion at the end of September 2004. Thus, it became the world's number one nation with foreign exchange reserves. However, Japan's foreign exchange reserves mainly come from huge trade surplus. Foreign direct investment accounts for merely 0.25 percent or so of Japan's GDP, and thus it is not a major contributor to the increase in its foreign exchange reserves. The large amounts of foreign exchange reserves are a huge wealth that is disposable at any time for Japan. The foreign exchange reserves are commensurate with Japan's economic strength.

Such is not the case with China. The colossal foreign exchange reserves are not generated by trade but come from increased foreign direct investment. If China purchases large quantities of foreign products with the foreign exchanges in hand without earning foreign exchanges to make up for the spending, and international hot money pulls out of this country at the same time, then price will soar in China. Moreover, sharp increase in foreign exchange reserves takes up large amounts of base money in China. Thus, once foreign investments are withdrawn, China's central bank will come under the pressure for issuing excessive currency to recover foreign exchanges. Now, the US$58.7 billion of hot money is actually a sword hung over China's central bank. Lessons show that financial crisis in a country is often triggered by hot money.

On the one hand, the growing foreign exchange reserves shows that China offers flexible policy toward foreign investment, and it is very tempting to international capital. At the same time, it indicates that as the nation's overall strength improves, international forces have higher and higher expectations for Renminbi. They hope that the currency will grow strong and undertake more international responsibilities. It is under such circumstances that international hot money dares to get into the Chinese capital market.

In addition, the Federal Reserve raised interest rate twice until it came to 1.5 percent, which is roughly the same as the after-tax interest rate on one-year Renminbi deposits Thus, domestic and foreign economists cry out for a raise in the interest rate on Renminbi deposits, as if no delay is permitted. In addition, as the issue of negative interest rate is becoming increasing prominent in China, people call for higher interest rates to compensate depositors' losses. In terms of the trend of price in China, there is growing pressure for inflation. Thus, increasing interest rate becomes an important strong tool for protecting achievements of macroeconomic control.

However, the reason why China's central bank has not raised interest rate is that considering that the Chinese economy has become an important part of the world economy, if China raises the interest rate hastily, it will trigger a new wave of hot money speculation (that foreign institutions claim that Renminbi exchange rate is expected to rise 7 percent is actually a smoke grenades used to help speculators to make profit through hot money), which will make it harder to address the mounting pressure for inflation.