After peaking in 2009-10, China's foreign exchange (FX) accumulation has been on a downward trend, driven by a lower current account surplus and less net foreign direct investment (FDI). Net financial capital flows (hot money) and valuation effects are less important for the trend but can cause large short-term swings in FX reserves, as in the second quarter.

Since the start of the surge in FX reserves in 2004, the current account surplus has been the most important factor, contributing more than two-thirds of the FX reserve accumulation in 2005-11. However, after peaking at more than $400bn in 2008, the current account surplus has trended down because of weak global demand, continued solid import growth in China and exchange rate appreciation. The decline-from 10 percent of GDP in 2005 to 2.8 percent of GDP in 2011-has helped reduce global imbalances and shift views on the valuation of China's exchange rate and reduced FX reserves accumulation.

Net FDI, the other major contributor, peaked in 2010. It is still distinctly positive, as inward FDI continues to exceed outward FDI. Outward FDI has been lower than expected by many observers a few years ago. But last year and this year inward FDI has recently again been affected by global financial turmoil.

Net financial capital flows-called "hot money" in China-have on the whole not been as large as their prominence in discussions on financial and monetary issues suggests.

Some analysts and policymakers think that "hot money" has been a key factor in driving China's property and other asset markets. However, I think that is unlikely. China still has capital controls on most financial flows. These controls are not perfect but they do discourage flows. Net flows have in the past 10 years never exceeded 4 percent of new domestic liquidity creation. Moreover, with net inflows alternating with net outflows, during 2006-11 inflows and outflows roughly balanced out.

However, such net other capital flows can trigger substantial short-term swings in FX reserves, and this is also the case for valuation effects. The second quarter of 2012 saw a net outflow of more than $100bn in our estimation, reflecting in part a shift in exchange rate expectations. Valuation effects, the fourth item, were negative $50bn on account of a weakening of the US dollar against other major currencies during the second quarter.

The changes in FX reserve accumulation have some implications but are no cause for concern. The trend moderation in FX reserves accumulation, and the fact that it has largely been driven by a lower current account surplus, suggests that yuan is closer to equilibrium.

The moderation also has implications for monetary policy. For several years, with massive foreign inflows, managing domestic liquidity was fairly straightforward-ensuring that enough liquidity was mopped up. The PBoC combined open market operations with higher reserve requirements to do this. With trend inflows now lower, monetary policy needs to be more agile. Short-term shifts can at times tilt net foreign inflows in negative territory, requiring the PBoC to inject substantial amounts of liquidity rather than withdraw it. This has happened a few times recently.

The lower pace of FX accumulation also suggests some progress, on an incremental basis, with reducing the mismatch of China's foreign assets and liabilities.

Traditionally, China's international assets are denominated in US dollars whereas a large part of its international liabilities is denominated in yuan. This exposes China's overall to exchange-rate risks. Lower FX accumulation, especially when combined with lower net FDI, reduces this mismatch.

There is no need to worry about occasional declines in FX reserves such as in the second quarter. At more than $3.2trn, China's FX reserves provide a massive cushion against external shocks. Moreover, steady deposit inflows into the domestic banking system and the controls on financial capital flows reduce the scope for financial turmoil. In any case, I expect the current account surplus to remain decidedly positive and do not foresee prolonged declines in FX reserves in the years ahead.

The author is chief China economist at RBS. The views expressed here are entirely his own.

(HK Edition 10/09/2012 page2)