In the first article of this series (How does China ?save?? Story of the circuitous journey of a US$), we showed you how the US$ leaked out of America from its current account deficit, streamed into China, showed up as monetary inflation of the Chinese currency and then flowed back into America as investment. In the previous article, we showed you how China opened up an avenue to slow down the never-ending flow of US$ into China. Today, we will explain to you another step that China is going to take to reduce the US$ inflow.

First, let?s take a look at steps 3 to 6of the process in our first article,

• The remaining US$3 ends up in a factory in southern China. The deal between Oral-B and the Chinese manufacturer is denominated in US$ (i.e. the Chinese manufacturer is paid in US$). But US$ cannot be used in China because the RMB is the currency of China. So, what happens next?
• The Chinese manufacturer will present the US$ to a local Chinese bank (say, the Shenzhen Development Bank). He has to show the receipts to the Shenzhen Development Bank (SDB) to prove that the US$ is earned by trade and not through speculation.
• The Shenzhen Development Bank (SDB) will take the US$3 in exchange for RMB.
• In China, the SDB has to surrender all of its US$ to the PBOC for RMB at whatever the official exchange rate.

Basically, US$ is like contraband in China- banks have to surrender all of them to the State. But things are changing…

Our long time readers may recall that back in October 2007, we wrote China considers leaking money to overseas stock. Back then, the Chinese government was toying with the idea of allowing private investors to punt in the overseas stock market. It was a pilot project back then.

From August 1, a new change will take into effect. As this official Chinese news report said,

China’s foreign exchange regulator said Wednesday it would loosen its controls on overseas investment procedures and foreign exchange management of domestic companies to boost outbound investment.

In other words, the Chinese government is making it easier for US$ to flow out of China as investments by the private sector. This will mean less pressure on the burgeoning official forex reserve.

Along with this new capital freedom, we expect the next logical step will be towards the eventual float of the RMB. This is because capital freedom and currency peg can be a dangerous powder-keg combination. To understand why, you may want to read this article that we wrote back in October 2007. But be warned, a float of the RMB will not happen tomorrow. The Chinese government will take their time reach that eventual destination.