China is the largest reserve holder among developing countries, having amassed over US$ 600 billion of reserves by end 2004. Given the potential liquidity overhang concerns in China due to the rapid reserve buildup, the People’s Bank of China (PBOC) has actively attempted to sterilize these inflows using a combination of market-based and administrative measures to mop up the excess liquidity. This paper focuses on the magnitude and sources of reserve buildup in China as well as their monetary consequences since the 1990s. It undertakes an econometric investigation to assess the de facto extent of monetary sterilization by estimating a set of simultaneous equations explicitly derived from an optimizing framework to examine the relationship between net domestic assets and net foreign assets.
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