A staff member counts money at a branch of the Bank of China

In January, the Chinese central bank vice-governor said China’s stabilising foreign exchange reserves showed that the economy was increasingly well balanced. But three months after Yi Gang’s comments, that balance is at risk of coming undone.

China’s mountain of reserves reached $3.44tn – roughly the size of the German economy – in the first quarter, in an indication that the economy is once again facing heavy and unwanted capital inflows. The $128bn jump in the first quarter was the biggest quarterly increase since the second quarter of 2011.

The money washing into China has already made its impact felt by fuelling explosive credit growth in the first quarter. Total new financing in the economy increased 58 per cent to Rmb6.2tn ($1tn) compared with the first three months of 2012, according to government data released on Thursday.

The surge in credit gets to the crux of why Fitch this week cut China’s sovereign credit rating, in the first such move by a major international agency since 1999: it is worried that local governments and companies have racked up too much debt.

China Foreign exchange reserves

The best measure of this is the ratio of China’s overall credit to gross domestic product. Fitch reckons it reached 198 per cent of GDP at the end of last year, up from 125 per cent at the end of 2008.

Fitch also raised concern about the rise in shadow banking, which continued apace in the first quarter, according to the government. The increase in outstanding bank loans was moderate at 16 per cent year on year, but credit outside the formal banking system, including trust loans and corporate bonds, more than doubled.

“The rise in foreign exchange reserves is a very clear sign that capital inflows are back,” said Shen Jianguang, an economist with Mizuho Securities. “We will see more and more worries about this in the coming months because of the massive money printing in the US and Japan.”

Large bond-buying programmes by the US Federal Reserve and the Bank of Japan are expanding the money supplies in both countries, generating cash that in part could wind up in emerging markets such as China. The People’s Bank of China has stepped up liquidity withdrawals over the past two months to blunt the inflationary effect of the inflows.

Beijing has strict capital controls to prevent unwanted speculative inflows. But major discrepancies in Chinese export data published on Wednesday pointed to one of the ways in which investors have been sneaking money past the regulators.

Chinese exports to the world rose 10 per cent but those to Hong Kong rose 93 per cent in March, which analysts said was an indication of how companies have been over-billing in order to bring more money into China.

Lu Ting, an economist with Bank of America Merrill Lynch, said the strong credit figures might add to fears about inflation, government debt and shadow banking. Mr Lu said Chinese monetary policy makers are “in a tough position to balance short-term growth stability, market worries, and long-term economic health”.

China’s economic growth bottomed out at 7.4 per cent year on year in the third quarter of 2012. It rebounded to 7.9 per cent in the final three months of last year and is expected to have narrowly topped that pace in the first quarter this year. The latest growth data will be published on Monday.

The government has already started to take some actions to better control shadow banking. The banking regulator unveiled rules at the end of March that will force off-balance sheet funds into lower-risk investments, a move that will reduce yields and so potentially slow the growth of shadow financing. But it will be another month before the impact of these rules can be gauged.

The government is also acutely aware of the dangers of inflation. Consumer prices rose more slowly in March than expected but loose monetary conditions provide fertile ground for price pressures later this year. Zhou Xiaochuan, the central bank governor, said last month he was on “high alert” about inflation.

Regardless of the GDP figures, the jump in foreign exchange reserves and credit issuance in the first quarter has put pressure on the government to restore balance to the economy.

“The loose policy stance in the first quarter has increased the likelihood of more policy tightening ahead,” said Zhang Zhiwei, an economist with Nomura.

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