China's Foreign-Exchange Reserves Top $2 Trillion (Update2)

By Bloomberg News

July 15 (Bloomberg) -- China's foreign-exchange reserves, the world's biggest, 
topped $2 trillion for the first time as overseas investors became more 
confident that the nation's economy is recovering.

The reserves rose a record $178 billion in the second quarter to $2.132 
trillion, the People's Bank of China said today on its Web site. That dwarfs a 
$7.7 billion gain in the previous three months.

The World Bank, BNP Paribas SA and Standard Chartered Bank have raised 
estimates for China's growth and the Shanghai Composite Index has surged 74 
percent this year as record lending and surging investment counter a slump in 
exports. The increase in the reserves highlights China's concern that its 
$763.5 billion of Treasury holdings may fall in value as the U.S. sells record 
amounts of debt to fund stimulus spending.

"China has the strongest prospects out of all major economies, so it is not 
surprising that hot money is flowing back," said Sherman Chan, an economist 
with Moody's in Sydney. "China has certainly recovered from the 
downturn, and it is on a strong footing now."

M2, the broadest measure of money supply, rose a record 28.5 percent in June 
from a year earlier, the central bank said, after a 25.7 percent gain in May. 
Outstanding yuan loans rose 34.4 percent to 37.74 trillion yuan ($5.5 trillion) 
at the end of June from a year earlier. The central bank also confirmed June's 
new lending of 1.53 trillion yuan.

`More Momentum'

"The capital inflows have driven up stock and property prices," said Yang 
Shengkun, a currency analyst in Beijing at China Citic Bank Co. "Speculators 
are favoring China because the government's stimulus package is working quite 
well, which will help the country to be the first to recover globally."

Economic growth rebounded to 7.8 percent in the second quarter, according to a 
Bloomberg News survey of economists. That number will be released tomorrow.

The yuan traded at 6.8333 against the dollar as of 10:00 a.m. in Shanghai, from 
6.8329 yesterday.

Central bank Governor Zhou Xiaochuan ruled out any sudden change in the 
management of the reserves last month after proposing that governments 
investigate setting up a supranational currency.

"It's inevitable that China will continue investing in Treasuries because of 
the sheer scale of its reserves," said Ken Peng, an economist with Citigroup 
Inc. in Beijing. "Diversification will happen at a slow pace, with commodities 
the favored alternative."

Record Lending

This year's record lending is stoking concern that the nation risks bad loans, 
asset bubbles and resurgent inflation. The government failed to attract enough 
bidders at two debt sales last week because of investors' concern that the 
central bank will tighten monetary policy.

China's reserves more than doubled in two and a half years as the trade surplus 
pumped cash into the economy, fueling claims that the nation's currency is kept 
artificially low to help exporters. The International Monetary Fund may 
describe the yuan as "substantially undervalued" in a pending report, according 
to a person who has seen the draft.

The reserves are double those of Japan, the country with the second-largest 
holdings, and account for 29 percent of the global total, according to 
Bloomberg data before today's announcement.

Speculative Capital

The bigger gain in China's reserves was probably driven by higher valuations 
for non-dollar assets because of the U.S. currency's weakness, and inflows of 
speculative capital, or so- called "hot money," said Dariusz Kowalczyk, chief 
investment strategist at SJS Markets Ltd. in Hong Kong.

The nation's trade surplus was smaller in the second quarter than the first and 
foreign direct investment in China has slowed this year.

About 65 percent of China's reserves are in dollar assets, with the rest mostly 
in euros, yen and sterling, estimates Wang Tao, an economist with UBS AG in 
Beijing. It is "difficult to stop buying U.S. Treasuries when markets for most 
other assets are too small and too illiquid," she said in a report last month.

For China to hold 5 percent of its reserves in gold, it would need to buy more 
than 3,000 tons of the metal, the equivalent of about a year's global 
production, Wang said.

Japan should consider diversifying its foreign reserves away from the dollar 
and buying IMF bonds, the top finance official in the opposition party said.

`Economic Turbulence'

"In the medium to long term, we need to do what we can to avoid the risk of 
currency losses or economic turbulence that could result if the dollar were to 
swing," Masaharu Nakagawa, the shadow finance minister in the Democratic Party 
of Japan, said in an interview in Tokyo on July 9.

Demand for U.S. Treasuries is rising on expectations that the world's biggest 
economy may recover at a slower pace. The yield on the benchmark 10-year note 
fell 20 basis points, or 0.2 percentage point, last week to 3.30 percent in New 
York, according to BGCantor Market Data, as an auction of $19 billion of the 
securities drew the most demand ever.

China will continue to buy Treasuries because alternatives are too risky or 
won't soak up enough money, Kowalczyk said. He also highlighted political 
opposition around the world to direct Chinese investment, citing miner Rio 
Tinto Group's rejection of Aluminum Corp. of China's proposed $19.5 billion 
investment. The scrapping of the deal was followed by Chinese allegations that 
Rio staff stole state secrets.

China Petrochemical Corp. is spending $7 billion to acquire Geneva-based Addax 
Petroleum Corp. and secure oil reserves in Iraq's Kurdistan region and West 
Africa. China's sovereign wealth fund, meanwhile, has lost money on investments 
in Blackstone Group LP and Morgan Stanley.

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