Real and financial imbalances are currently building up in China. They are linked to major capital inflows that have only been partly sterilised by the central bank. Contrary to conventional wisdom, these inflows stem not just from current account operations or FDI. Apart from illegal foreign currency inflows, there is another channel which makes the financial account more permeable to capital inflows than is usually thought. Under these circumstances, a rise in Chinese interest rates aimed at reducing credit growth risks fuelling forex inflows. Higher interest rates would therefore not seem to be compatible with maintaining a fixed exchange rate. In the wake of the expected rise of US rates in 2004, international financial conditions will provide a window of opportunity that could permit scrapping China's currency peg, with only limited risks of the forex markets over-reacting.
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