The curious case of rising Chinese reserves Chinese inflows are back. Wei Yao at SocGen notes on Tuesday that China's FX reserves added $163bn in the third quarter, the biggest quarterly increase since the second quarter of 2011. As she notes, however, the source of those inflows is not necessarily down to the usual suspects (our emphasis): China's FX reserves added USD 163bn in Q3, the biggest quarterly increase since Q2 2011. The FX positions of all financial institutions (including the central bank) increased by only CNY 2.8bn in the first two months of Q3. Hence, inflows probably accelerated significantly in September. We estimate that the impact of the euro appreciation on the valuation of the reserve stock should be no more than USD 40bn during the month. In addition, the trade surplus narrowed significantly to USD 15.2bn in September from USD 28.5bn in August. Even if we assume a 20% increase in FDI, that still leaves us with nearly USD 100bn of unspecified capital inflows. The Fed's September non-taper will definitely have played a part in encouraging some of these flows - not least because the yuan/USD carry trade in that context continues to make financial sense. But this does now leave the PBOC managing something of a dilemma, according to Yao: The People's Bank of China is caught up with the difficult choice again: should it sterilise inflows with high-powered money or allow the yuan appreciation? As Chinese export growth remains stuck in low gear, the PBoC seems to be opting for the former. Looking at the central bank's balance sheet data, we notice that the PBoC has significantly stepped up currency intervention since August. The PBoC's FX asset rose by nearly CNY 100bn in August, four times the increase in all financial institutions" FX positions. We expect the central bank to keep the USD/yuan rate largely stable around the current level until the end of the year, in order to alleviate the pain inflicted on the export sector. The fact they've gone for the sterilisation option represents, we'd say, an interesting sentiment shift. For one thing, it's likely that the PBOC was hesitant to go down this path before because of the impact this may have had on the country's short-term dollar shorts, as well as all those legacy carry-trade positions (where the Chinese borrow cheap in dollars and convert into RMB on the expectation that the RMB will stay strong or get stronger). But then, who cares so much about possible short-term dollar defaults when the US doesn't seem to care about default either? No surprise then, that the Chinese central bank is suddenly prepared to devalue the RMB in a bid to boost the export sector, rather than choking off trade with continued strengthening policy. In which case it's worth asking whether the sudden inflow over into the yuan represents something much more important than usual. Could it be the first sign of a shift in global reserve preferences? What with Osborne also wooing Chinese capital over to Britain on the sidelines of events in Washington, one has to wonder whether the whole US fiasco isn't unwittingly making the yuan an ever more viable global reserve alternative? There's no doubt, of course, that there are still many things standing in the yuan's way to achieving full global reserve status: the lack of a free-float, ongoing state intervention, inferior contract law and an unclear attitude to property rights. But one thing China has proven time and time again is that it is ready to take on national debt whenever the situation calls for it. And in light of the two-party chaos in the US, perhaps in the grander scheme of things capital might become attracted to the certainty associated with a one-party state. Though, as Yao points, there is one last curiosity to consider. Despite the central bank's sizeable sterilisation efforts, domestic liquidity conditions are still far from easy in China. This she says is no doubt linked to a declining money multiplier on the back of the government's attempts to rein in the shadow banking system. The irony is, if the US ever was to default, one would expect the US shadow banking sector to explode as it moved to fill the funding gap. Related links: Why China may not be over-investing - FT Alphaville Does the world really need China's rapid growth? FT Alphaville Magnus on China's investment cliff - FT Alphaville China: IMF paper warns investment rate is too high by 10 per cent of GDP - FT Beyondbrics China myths series- FT Alphaville