The People’s Bank of China will welcome the news that China’s foreign exchange reserves dipped for the first time in a decade in the final quarter of 2011.
A more serious problem for China has been the need to cancel out the domestic inflationary effect of the reserve accumulation.
The root cause of the growth in currency reserves has been Beijing’s policy of keeping the renminbi in a managed float against the dollar. The semi-pegged currency obliges the Chinese central bank to buy most of the foreign exchange coming into the country, injecting fresh renminbi into the financial system in return.
To prevent that newly created money from pushing prices higher, the People’s Bank of China must constantly engage in what are known as “sterilisation operations”. It issues bills to banks or forces them to set aside a portion of their deposits as required reserves to mop up the excess liquidity.