China's foreign exchange regulator said yesterday it found widespread irregularities in forex settlement operations by local banks in its inspections this year.

The State Administration of Foreign Exchange (SAFE) said such illegal behavior resulted in unwanted hefty increases in China's forex reserves and complicated the State's macro-management efforts. SAFE pledged to crack down on speculative capital inflows.

The administration inspected 35 banks and their branches on their purchases of forex from individuals and businesses from January to September, and probed 41 businesses about their forex sales to banks. A total of US$120 million of illegal transactions were spotted, it said.

Under China's tight forex management regime, local companies are required to sell most of their legitimate forex earnings to designated banks, most of which are subsequently sold to the central bank and become part of the nation's forex reserves. China's forex reserves jumped by 27 per cent from the end of last year to US$514.5 billion at the end of September.

"The illegal foreign exchange settlements between banks, businesses and individuals have affected the international balance of payment, resulted in abnormal growth of foreign exchange reserves and disrupted macro-management," SAFE said in a statement.

Illegal forex sales - by both businesses and individuals - to banks were found not only under the current account, which mostly covers foreign trade, but also in the capital account, under which the local currency, or renminbi, is only partly convertible, the administration said.

Forex inflows into China have been growing rapidly in the past couple of years, as businesses and individuals, as well as currency speculators, tried to accumulate renminbi-denominated assets in expectation of an appreciation of the renminbi exchange rate and in pursuit of higher interest rates in the local market.

Signs of currency speculation became more evident this year, with capital inflow growing fast even in months when the nation's trade surplus, a typical driver of forex surpluses, narrowed significantly even when trade deficits were recorded.

China's new external borrowings, excluding trade credits, surged by 97.8 per cent on a year-on-year basis to US$83.4 billion during the first six months of the year, SAFE said earlier. And the net inflow of foreign liabilities - new borrowings minus repayments and interest - registered US$22.7 billion for the period, six times what was recorded a year earlier.

"The situation of excessive foreign exchange supply in the domestic market became more serious, which has undermined the effect of macro-management," SAFE said.

The rapid forex increases have resulted in greater money supply in the local banking system, as the Chinese central bank - the People's Bank of China - has to purchase excess dollars to enforce a narrow range for the renminbi's exchange rate.

But that's not what monetary policymakers want to see currently. Rapid monetary growth since last year has already been identified as a major driver for frenzied fixed investment that has prompted worries that the Chinese economy is overheating.

The State has initiated a round of macro-management measures, including credit curbs, land controls and higher reserve requirements for banks, to appropriately slow down investment and economic growth.

In a related development, SAFE reported major progress in its efforts to eliminate all types of illegal forex transactions yesterday, saying it had smashed 86 underground forex dens so far this year and confiscated 50 million yuan (US$6 million) in cash.