Great stuff from the FT yesterday. One of the more interesting aspects of the Chinese monetary system until now has been the way in which the PBOC has benefited from its large Forex reserves. Before we get to that, there are two important things to note.

First – sterilization. When dollars flow in to China for investment and from trade, the PBOC buys them at a certain price so that the exchange rate stays where the government wants it to stay. It pays for the dollars with RMB, which has the effect of injected a huge amount of RMB, liquidity, into the economy. This is dangerous because it can lead to inflation. Therefore the PBOC sterilizes the purchases by selling bonds and therefore extracting liquidity from the economy.

Second – interest rate differentials. The PBOC has a lot of dollar denominated assets, including T-bills and other bonds. The return on these instruments fluctuates with U.S. interest rates. The return on the bonds that the PBOC sells in China when it sterilizes dollar purchases is determined by Chinese interest rates.

For some time now, U.S. rates have been higher than China's rates, so the PBOC has been in an advantageous position, in fact making money on this whole deal. However, things are changing.

First, you have the RMB appreciation, which makes the dollar reserves held by the PBOC less valuable. Second, you have U.S. rates going down and Chinese rates, because of inflation, going up. Once these converge, suddenly the PBOC stops benefiting and could actually begin to lose money.

According to the FT, the government has already anticipated the issue with respect to interest rates and is employing other ways to soak up liquidity, including raising banks' reserve requirements. Not sure if that is working all that well, but that's another story.

Why is this important? This is another huge motivation for the government to move more quickly on exchange rate policy. Things are moving along rapidly, and it seems like every day that additional reasons can be found for increased liberalization.