The State Administration of Foreign Exchange (SAFE) said yesterday it had found irregularities commmitted by some banks in their designated forex settlement operations during an inspection that started last year.

Such irregularities were largely prompted by expectations that the local currency, the renminbi, would appreciate, disturb the financial order and distort the view of the nation's international balance of payment situation, SAFE said.

The administration also identified other "abnormalities" that led to additional capital inflows, especially those that came in under the cover of personal transfers but were used in direct, portfolio and real estate investments.

"Given the expectations for the renminbi's appreciation, people tend to, through various ways, sell their forex assets and hold more renminbi assets," said Wang Yuanhong, a senior analyst with the State Information Centre.

Many Chinese enterprises have not only stopped trying to keep their forex earnings overseas, as they did before, but have been moving existing forex assets back home for renminbi assets, he said.

Market speculation for a yuan revaluation is believed to have contributed to a rare decline in forex bank savings and rapid increases in forex loans last year, as individuals and businesses opted to hold more renminbi assets and forex liabilities.

"Currently, the State Administration of Foreign Exchange is closely monitoring those developments, and will be quick to draft regulations so as to improve administration of foreign exchange and prevent our foreign exchange market from being disturbed by unidentified overseas capital,'' a SAFE spokesperson said.

The administration required 10,300 bank branches to conduct internal audits into the designated forex settlement business, and inspected 1,165 of them.

Under China's current forex management regime, businesses and residents are required to sell most of their forex earnings to authorized banks and can purchase dollars from them only under permissible conditions. The renminbi is convertible under the current account, but only partly convertible under the capital account.

The banks settle their forex positions in the interbank market, where the central bank, in recent months, has been purchasing huge amounts of US dollars to enforce the floating range of the renminbi's exchange rate.

A large discrepancy last year between China's trade surplus and the settlement surplus at the level of banks had raised worries about unregulated inflows of "hot money" resulting from market speculation about a stronger yuan.

China's trade surplus fell by an annualized 66.5 per cent in the first half of 2003 while the forex surplus at banks rose by 14.6 per cent.

A discrepancy of that kind is normal for statistical reasons, the authorities have said, but the magnitude of that gap is believed by analysts to be a major reason that prompted the SAFE inspection launched in September.

The results show that some banks had converted domestic forex loans in unpermitted categories into the local currency, and some banks had granted forex-collateralized renminbi loans to domestic enterprises, which is not allowed.

The administration pledged that severe penalties would be placed on the banks that failed to perform their duties and broke regulations ensuring the normal flow of capital.

Among the "abnormalities" spotted, the administration mentioned cases of arbitrage in pursuit of the higher interest rates on renminbi deposits, where some manufacturing and investment businesses converted dollars in the name of registered capital or advances but put the local currency into property or portfolio investments or bank deposits instead.

Inspectors also found both current and capital account inflows disguised as personal transfers.

"Since (the start of) 2003, domestic personal foreign exchange earnings and bank settlement have been growing fairly fast,'' the spokesperson said. Some of the increases actually came from overseas institutions and companies, and, after being converted into renminbi, are transferred to commercial and manufacturing businesses, securities firms and real estate companies for respective operations.

"For those abnormal phenomena, some banks have not paid sufficient attention, and some even did not carry out their verification obligations," the spokesperson said.

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