The worlds second largest economy has changed out of all recognition in the 35 years since it adopted paramount leader Deng Xiaopings open door economic reforms and embarked on the long road towards western-style capitalism. Evolving into the worlds largest export economy, it has reaped incalculable economic and social benefits. However, the contradictions inherent in mixing free-wheeling capitalism with a tightly controlled authoritarian state are throwing up some roadblocks. The tendency to suck in vast amounts of foreign currency is one of the most pressing, with too much capital chasing too few real opportunities, and the potential for bubbles in areas such as real estate. The other main impact, the opposite side of the same coin, is the massive build up of the countrys foreign exchange reserves. Chinas reserves have grown from about $165 billion in 2000 to $3.44 trillion in the first quarter of this year. Strong reserves are not inherently bad. They act as a cushion to absorb currency fluctuations and capital outflows, and give confidence to foreign investors. However, there can be too much of a good thing. Qinwei Wang, China economist at Capital Economics, says that while China started out trying to shield itself from the capital outflows and currency crises that marked the 1997 Asian financial crisis, todays record reserves are a symptom of an unbalanced economy. The problem is central bank intervention to hold down the value of renminbi (RMB) through purchasing of foreign currency and assets mostly USD and US treasuries in order to maintain a trade surplus, explains Wang, a former economist at the Peoples Bank of China. When appreciation pressures on RMB eased in late 2011 and through most of last year, we saw the reserves stabilize as capital inflows slowed and exporters held on to their dollars. But now expectations of RMB appreciation are back, the reserves are rising again. The upward trend of RMB encourages short-term and speculative capital inflows as opposed to the long-term investments China desires on expectation of profiting from yuan appreciation, Wang explains. This in turn puts RMB under more pressure, forcing the central bank to buy dollars to prevent RMB from strengthening too much. Official figures show that capital is indeed pouring in. Credit growth rose 58% to RMB 6.2 trillion ($1 trillion) in the first quarter compared with the same period last year. There are various benchmarks to calculate the optimum reserves an economy should hold. Traditional calculations used by the IMF say there should be sufficient currency to cover three months of imports or 100% of external debt. The latest guidance from the IMF uses a weighted benchmark that combines short-term debt, other portfolio liabilities, plus an element of M2, and exports. By any of these, China would have been guilty of mismanagement had it not built up its reserves from the mid-1980s onwards in line with growth in imports of materials, goods and energy, and external liabilities. It did not always succeed and reserves went down as well as up in the 1980s and early 1990s. As recently as 2002, reserves were smaller than the optimum. However, from then onwards reserves have grown exponentially and are now more than double their optimum size, according to the Brussels Institute of Contemporary China Studies. Wang argues that the solution always comes down to the currency. A flexible RMB will appreciate making everything China more expensive thereby reducing the trade surplus, which will rein in the countrys foreign exchange reserves. A strong, flexible RMB will ultimately produce a more balanced economy as China moves away from exports-led development in favour of developing its domestic market, he says. In fact, China has been allowing RMB to appreciate. Since July 2005 when the central bank removed the dollar peg allowing RMB to move against USD within a fixed band, RMB has appreciated by more than 25% from 8.28 to the dollar to 6.17. Given the risks of exchange rate volatility to Chinas economy, its policy of trying to maintain a stable exchange rate while managing the orderly appreciation of its currency is entirely legitimate, says Patrik Säfvenblad, investment partner at Harmonic Capital. It is moving in the right direction but its not going to let itself be bullied into switching to a fully floating exchange rate before it is ready.