rise in reserves. Those who call upon China to revalue also point to its highly controlled capital account and its distorted financial markets. a good dose of deregulation, they say, would break China's mercantilist plot. But they may be overstating their case. One result of China's capital controls is that its citizens and firms cannot legally keep their money abroad but must entrust it to the country's troubled banking system. According to many China watchers, this means there is a huge pent-up demand for foreign assets Andy Xie, an economist at Morgan Stanley, points out that Hong Kong residents hold an average of $30, 000 each in foreign currency, whereas in mainland China the figure is a mere $100. If Chinese residents could hold more dollars, he argues, they would Mr Lardy says that the distribution of deposits in Chinese banks is highly skewed. A small number of rich people account for a huge share of total deposits. These richer, more sophisticated Chinese he argues, would quickly shift to dollars if they could, so that whenever China gets round to loosening its capital controls, it could see big capital outflows. The yuan might even fall, not rise In short, it is hard to determine whether the yuan is undervalued today. It is even harder to determine how far and in what direction it should move in future as china becomes more integrated into the world economy. There is a much clearer argument for making Chinas currency more flexible. A flexible exchange rate would allow the yuan to move as capital and trade conditions shifted and would give the government the monetary autonomy to deal with economic shocks And indeed, China says it is gradually moving towards a more flexible exchange-rate regime. But there are few signs that this is really happening. The government is deeply worried about the instability that might result. For some years it has derived its legitimacy such as it is, from the country's continuing economic boom. It fears that meddling with the currency could raise unemployment aggravate deflationary pressures and cause a meltdown in the banking system Many of these fears are overblown, especially those about deflation True, prices in China until recently were falling slightly but much of that has to do with huge productivity improvements and excess capacity in state-owned firms, not with overall economic stagnation. It is hard to see how an economy growing at more than 7% a year can face a Japan-style deflation problem The price of stability ed currency may bring stability but at a price-to China as well as to the world Part of that price is the returns forgone when the chinese authorities pile up mountains of reserves: they are holding low-yielding American government debt rather than investing the money more profitably at home. There is also the risk of financial distortion. As Alan Greenspan recently pointed out, Chinas accumulation of reserves will eventually distort its monetary system. As the central bank builds up reserves by buying dollars, it must pay out yuan. Either which could overheat the economy and cause financial bubbles. Domestic credit has already this growth in the money supply is sterilised -which means selling domestic bonds to mop ul the excess liquidity, an increasingly expensive process-or domestic liquidity will rise rapic been soaring(relative to GDP, it was up 38% in the first half of 2003), leading to isolated property bubbles and a string of financial scandals. The longer this continues, the higher the risk of large-scale financial bubblesrise in reserves. Those who call upon China to revalue also point to its highly controlled capital account and its distorted financial markets. A good dose of deregulation, they say, would break China's mercantilist plot. But they may be overstating their case. One result of China's capital controls is that its citizens and firms cannot legally keep their money abroad, but must entrust it to the country's troubled banking system. According to many China watchers, this means there is a huge pent-up demand for foreign assets. Andy Xie, an economist at Morgan Stanley, points out that Hong Kong residents hold an average of $30,000 each in foreign currency, whereas in mainland China the figure is a mere $100. If Chinese residents could hold more dollars, he argues, they would. Mr Lardy says that the distribution of deposits in Chinese banks is highly skewed. A small number of rich people account for a huge share of total deposits. These richer, more sophisticated Chinese, he argues, would quickly shift to dollars if they could, so that whenever China gets round to loosening its capital controls, it could see big capital outflows. The yuan might even fall, not rise. In short, it is hard to determine whether the yuan is undervalued today. It is even harder to determine how far, and in what direction, it should move in future as China becomes more integrated into the world economy. There is a much clearer argument for making China's currency more flexible. A flexible exchange rate would allow the yuan to move as capital and trade conditions shifted, and would give the government the monetary autonomy to deal with economic shocks. And indeed, China says it is gradually moving towards a more flexible exchange-rate regime. But there are few signs that this is really happening. The government is deeply worried about the instability that might result. For some years it has derived its legitimacy, such as it is, from the country's continuing economic boom. It fears that meddling with the currency could raise unemployment, aggravate deflationary pressures and cause a meltdown in the banking system. Many of these fears are overblown, especially those about deflation. True, prices in China until recently were falling slightly, but much of that has to do with huge productivity improvements and excess capacity in state-owned firms, not with overall economic stagnation. It is hard to see how an economy growing at more than 7% a year can face a Japan-style deflation problem. The price of stability A fixed currency may bring stability, but at a price—to China as well as to the world economy. Part of that price is the returns forgone when the Chinese authorities pile up mountains of reserves: they are holding low-yielding American government debt rather than investing the money more profitably at home. There is also the risk of financial distortion. As Alan Greenspan recently pointed out, China's accumulation of reserves will eventually distort its monetary system. As the central bank builds up reserves by buying dollars, it must pay out yuan. Either this growth in the money supply is sterilised—which means selling domestic bonds to mop up the excess liquidity, an increasingly expensive process—or domestic liquidity will rise rapidly, which could overheat the economy and cause financial bubbles. Domestic credit has already been soaring (relative to GDP, it was up 38% in the first half of 2003), leading to isolated property bubbles and a string of financial scandals. The longer this continues, the higher the risk of large-scale financial bubbles