The People's Bank fo China continues to amass huge levels of foreign currency reserves with little attention paid. Those reserves totaled $2.4 trillion as of December 2009, which is larger than the GDP of Italy, the world's 7th largest economy. China's reserves are growing at about $400 billion per year, roughly adding Norway's economy to their reserve surplus every year.



These reserves are generated from structural imbalances in the world economy, with China running huge trade surpluses which are exacerbated by China's currency peg. To keep the currency within a narrow range, China is forced to buy foreign currency that comes into the country. The Yuan it spends to buy foreign cash is added to the funds sloshing around China's banking system. In addition, the foreign currency that the Bank of China holds is then reinvested, mostly in low yielding investments like US Treasury Bonds. In fact, China is the largest holder of US Treasuries. The Yuan flowing around the banking system is causing some to wonder about inflation and asset bubbles. Some market participants are taking notice of bank loan growth and Urban real estate markets. Chinese officials have taken steps recently to slow loan growth and to potentially slow inflationary pressures. We've seen the market respond with the Hang Seng Index falling over 11% over the last month.

Source: Bloomberg
China's huge arsenal of reserves is increasingly troublesome. William Pesek of Bloomberg has called it a "massive and growing pyramid scheme." China is essentially trapped in its current arrangement; as it buys more US Treasuries, it becomes harder to sell them without causing huge capital losses.

A stream of bad news from China means my pessimism on the country in the short-term will not be assuaged today.

China’s banking regulator announced Thursday that if the price of homes in Shanghai drops by ten percent, the bad loan ratio for banks there would triple. This adds further weight to my warnings about playing China by using an ETF such as Claymore/AlphaShares China Real Estate ETF (TAO) or iShares FTSE/Xinhua China 25 Index (FXI).

China has been an economic hot spot over the past few years. Even as the global economy grew weaker last year, the country remained on track and kept backward momentum to a minimum. Now that a global recovery is in the offing, keep an eye on China’s ETFs.

While the world economy shrank 0.8% last year, China’s economy grew 8.7% in 2009 and 10.7% in the the fourth quarter alone. As China’s economy continues to grow and strengthen, there are benefits in store for the rest of us, reports Tony Sagami for Uncommon Wisdom.