Excess liquidity has become a one of the main macro-economic problems facing China today.

There are many ways to measure excess liquidity; a popular method recently makes use of the reserve ratio surplus, itself a measure of reserves exceeding the statutory reserve ratio. According to statistics from the People's Bank of China, in December of 2006, excess reserves stood at 4.78 percent, two percentage points higher than the same time in November. This sudden increase is why, on January 5, the central bank increased the statutory reserve ratio.

In measuring excess liquidity there are other indicators as well, including: the gap between the central bank's policy rate and, according to the Taylor Rule, the prime interest rate; while also considering the gap between the base money supply growth rate and nominal GDP growth.

We can use the difference between broad money supply (M2) growth rates and nominal GDP growth to measure excess liquidity. This indicator reflects to what extent the money supply's growth has exceeded the economy's demand for the currency. Compared with the above-mentioned indicator, this has three benefits: it considers the natural demands that economic growth has of liquidity; it is free from receiving the effect of the currency multiplier (China's currency multiplier for the past several years has been gradually increasing), and finally; the calculation method is simple.

According to this indicator, in considering both our calculations of excess liquidity and the rate inflation since 1991, the following conclusions can be made:

First, the People's Bank of China has implemented counter-cyclical monetary policy during the past 16 years.

In the 1990's, when China's economy was overheating (the inflation rate in 1993 was 15 percent, in 1994, 24 percent), the Central Bank chose measures to tighten the money supply and rapidly decrease the excess liquidity index, pushing it into the negatives between 1994 and 1996. In 1997, after the Asian financial crisis, China's economy felt deflationary pressure, and the central bank implemented loose monetary policy, which caused the liquidity surplus index to stabilize from 1997 to 2003. In 2004, after the domestic economy showed symptoms of overheating, the central bank used tightening measures such as an increase in the reserve ratio and in interest rates to push the liquidity surplus index back into the negatives. Thus, overall, the Central bank has been pursuing an effective counter-cyclical strategy.

Secondly, although attention toward excess liquidity has been high recently, compared with the early 1990's and the period from 1997-2000, excess liquidity is still relatively low.

What should be pointed out is that excess liquidity can accumulate year after year. Even if these two or three years' worth of excess liquidity decreased, the huge amount accumulated during the ten years previous (except for 2004) will still threaten economic stability. Thus, reducing this years excess liquidity standard to zero will not be enough; the annual excess liquidity standard must be decreased to a negative value.

Third, although the liquidity surplus index has decreased for two years, they are still positive.

This shows that in recent years the economy has symptoms of overheating in spite of the central bank's use of tightening measures that have been more forceful than in previous years (including the five increases in the reserve ratio since last April and three increases in the savings rate), though a counter-cyclical policy success has still not materialized. This signifies that the central bank will continue to implement tightening measures.

As everyone knows, with the recent, stable, yuan exchange rate framework, China's liquidity surplus is stemming from an international payments surplus, and especially, the trade surplus. Thus, without a decrease in the trade surplus, there will be no stop to the tigthening measures.

On the basis of our prediction that China will have a trade surplus in 2007, that it will have an international payments surplus, and because of the effect of the forex investment fund company being founded, this year the national forex reserves will still increase-- by approximately ＄200 billion dollars.

It is also possible that this year, the central bank will take a more neutral approach to currency policy.