Firstly, inflows of hot money may adversely affect the development of the Chinese economy, and preventive measures should be taken. Secondly, other factors contributing to China's rapid increase in foreign exchange reserves should be scrutinized.

An excess of hot money will inflate liquidity in the country, thereby intensifying inflationary pressure as it is invested in the stock and real estate markets. China's economic security could subsequently be threatened by large withdrawals of hot money from the market. The Asian financial crisis in 1997 was mainly caused by huge short-term inflows and outflows of hot money.

Chinese financial authorities are paying close attention to the problem and a discussion on hot money supervision was held on April 19. The People's Bank of China has been closely monitoring inflows of international funds, said Zhou Xiaochuan, governor of the bank. The State Administration of Foreign Exchange has been focusing on management of foreign exchange settlements and payments as well as supervising flows of cross-border capital. The financial authority will also crack down on illegal foreign exchange and other criminal activities, and strengthen monitoring of the flow of funds.

The increase in foreign exchange reserves cannot be attributed solely to hot money. Also contributing are individual and business exchange settlements, and profit increases from foreign exchanges. Statistics provided by the Central Bank show that foreign currency deposits dropped by US$ 5.5 billion in the first quarter of 2008, a US$ 8.9 billion year-on-year decrease. This is a natural consequence of the volatility of the international financial climate and the appreciation of the RMB. However, restrictions on foreign exchange investment channels will exert an influence in the long run.

Sun Yudong, a Professor of the Public Finance Institute of the Renmin University of China, said that the auditing procedure for overseas investment is inefficient and accessible investment channels are limited, resulting in restrictions in amounts invested. Foreign currency held by individuals can only be invested in B shares, QDII schemes (Qualified Domestic Institutional Investors) and foreign currency financing products. But QDII currently lacks appeal. According to fund newspapers of the fourth quarter, four QDII funds such as China-Global Fund are showing negative growth, and three of them have fallen 10 percent. With security in mind, individuals are choosing to deposit their money in the bank, and the appreciation of the RMB is another incentive to hold currency.