External Surpluses Root Cause of China's Inflation Problem

External Surpluses Root Cause of China's Inflation Problem

By AARON BACK

BEIJING—China's large external imbalances, combined with its interventions in the foreign -exchange market, are the "root cause" of the country's current inflation problem, Yi Gang, vice governor of the People's Bank of China, said Saturday.

China should increase the flexibility of the yuan exchange rate and undertake a number of internal structural changes to reduce its trade surplus, Mr. Yi said, adding that China's focus should be on boosting imports rather than suppressing exports.

In a wide-ranging lecture at a university in Beijing, Mr. Yi also rejected many criticisms often heard in China of the central bank and its investment of foreign exchange reserves, saying it would be difficult to diversify the reserves into commodities or other alternative assets.

China's large "twin surpluses" in the current account and capital account have created massive inflows of foreign currency. The PBOC buys up those inflows by issuing newly minted yuan, thus swelling the money supply and adding to inflation pressures, Mr. Yi said.

"Why do we have so much base money? Why is the money supply relatively loose? A major reason is that our surpluses are too large," Mr. Yi said. "To maintain the basic stability of the yuan exchange rate, the central bank buys up foreign exchange inflows. If it didn't, the yuan wouldn't be so stable."

In addition to boosting the flexibility of the yuan exchange rate, China also should adjust resource prices to address imbalances, he said, as many resources are still traded in China at below their natural prices. China also should boost wages and social benefits to lift consumption, step up its enforcement of environment regulations and undertake other structural reforms to address imbalances.

After the PBOC buys up foreign exchange inflows, it attempts to "sterilize" or offset the newly created money supply by ordering banks to hold more funds in reserve and by issuing central bank bills. But Mr. Yi said such sterilization operations have costs to the central bank, as it must pay interest to banks on the bills and the reserve funds that they park with the central bank.

"We have been undertaking sterilization efforts to lock up excessive liquidity and maintain price stability," Mr. Yi said. "But all these actions have costs. We have to take into account the marginal costs and benefits if this state of affairs persists."

Many in China argue that inflows of "hot money," short-term capital that seeks to benefit from yuan appreciation and interest-rate arbitrage, are also a main factor behind China's foreign reserve accumulation and a source of imported inflation pressures.

However, estimates released last week by the State Administration of Foreign Exchange--a unit of the central bank that Mr. Yi also heads--showed such hot money inflows to be relatively limited, with just $35.5 billion of net inflows last year. Mr. Yi said the figures demonstrate that hot money inflows account for a small part of total reserve accumulation and that China's current and capital account surpluses are the main factor.

Some analysts inside and outside of China said SAFE's figures likely underestimate the true level of hot money inflows, as many such inflows are deliberately disguised as ordinary current account transactions. Mr. Yi acknowledged that this takes place to a certain degree but defended the overall accuracy of SAFE's estimates. Estimates by foreign countries such as the U.S. of their deficits with China are even greater than China's estimates, he said, indicating that China's estimates can't be significantly understated.

Many Chinese critics of the central bank argue that China should diversify its foreign exchange reserves away from sovereign debt--U.S. Treasury bonds in particular--and toward other assets such as commodities or even land. Mr. Yi said it is difficult for China to diversity into such assets without having a large impact on their market price.

Write to Aaron Back at aaron.back@dowjones.com