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A few days ago the Wall Street Journal published an article that said economists were dumbfounded that China’s foreign reserves rose $135.7 billion in the first quarter -- more than half the increase for all of last year. A total of $1.2 trillion USD now sits in China’s coffers and has caused pundits from Larry Summers to the guy next door to have opinions on what China should do with its money. The WSJ remarked that the jump in reserves might be due to foreign currency swaps by Chinese banks. But it and the economists it talked to cannot seem to figure out why there are tens of billions in unaccounted surpluses once exports are factored out.

Many hawks like Senator Charles Shumer will undoubtedly say that this is further cause to launch complaints to the WTO about China, as the Bush administration recently did with the piracy issue in China, and we will probably see critics of Treasury Secretary Hank Paulson calling for him to move more stridently to force China to appreciate the RMB, even though it has already gone up almost 7 percent in the last year and a half.

In reality, the answer might be much less ominous than the critics point out and should actually show to critics like Shumer that China is trying to stop the massive inflow of currency speculation which is leading to a unbalanced currency rate and thus a trade surplus.

I have been thinking about the conundrum for a couple of days now. I have a hunch that there are two main reasons for the huge jump in currency reserves that most economists and pundits have failed to see.

Personal Currency Exchange

The first one is that China’s Government recently made it much more difficult for individuals to trade foreign currency into RMB. Before, individuals could exchange up to $50,000 USD per month into RMB. Citibank (NYSE:C) bankers started calling their clients just before Chinese New Year to warn them that the new rules would allow each individual to exchange only $50,000 USD per year into RMB. This is obviously a huge difference and caused many people to exchange $50,000 USD worth of currency into RMB immediately before the new laws were enacted.

Many families got creative in their currency exchange. In some cases parents had their children, even two year olds, exchange money before the deadline to get around the upcoming, onerous exchange laws so that they could take part in China’s currency appreciation.

I believe that personal foreign exchange trading is a major reason for the huge uptick in foreign currency reserves in China for Q1.

Tax Breaks

There has also been a movement in China to level the tax code between big multi-national firms and domestic Chinese firms to 25%. A substantial number of foreign firms receive a plethora of tax breaks which the Chinese Government originally enacted before China was red hot in order to attract foreign investment. Many domestic Chinese companies have called the tax breaks to foreign firms unfair and the Government is in the process of reforming the tax codes while allowing companies to get grandfathered in before the Spring.

Thus, my hunch is that the number of companies setting up shop in China increased this year in order to get grandfathered in for the tax breaks. And for companies already here, they are increasing certain investments. This has also caused more money to flow into China, often through personal accounts of Country Heads, especially before the new currency laws were enacted.

Is Q1 Indicative of the Foreign Currency Growth Problem?

There are some take-aways from this increase in foreign reserves. The first is that the shocking jump in currency reserves is due to attempts by China’s government to reduce the issue and will bear fruit in the coming months. The effort by China’s government should result in much smaller inflows next quarter.

The second is that if Citibank and other foreign banks like HSBC (HBC) and Standard Chartered can continue such great service, then the Chinese banks like Bank of China, ICBC and Bank of Communications have a lot to fear because of their ghastly customer service. Based on my terrible experiences with Bank of China especially over the last decade, the domestic banks certainly would never call any of their clients to let them know of changing laws that can have a material impact on their client’s financial well-being. I cannot even see a teller without waiting for over an hour!

Source: What's Behind China's Recent Currency Surge?