Either the Chinese do not understand banking and investing or the line being fed the Western press about the struggle over the Bank of China's reserves is a cover story of some sort.

Given the fact set, Dean Baker's reaction 'Is China's Central Bank Run By Morons?" is not unreasonable. I have a different theory, which we'll get to in due course.

The plot overview:

The Bank of China buys lots of dollar investments to keep the yuan from rising. However, as we all know, the yuan has been permitted to appreciate somewhat. Note that this means the value of those holdings in local terms has fallen.

However, the central bank has still had to keep buying dollars to keep the yuan from rising rapidly. It is running out of capacity and has to go to the Finance Ministry for a handout.

This is the bizarre bit. The Finance Ministry is mad that the central bank lost money on its dollar investments and wants no more yuan appreciation. This of course commits it to even greater dollar purchases, which guarantees that its eventually currency losses will be all the greater.

Key bits of the New York Times article:

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China?s exports gain an edge over the goods of other countries.

The two bureaucracies have been ferocious rivals. Accepting an injection of capital from the finance ministry could reduce the independence of the central bank, said Eswar S. Prasad, the International Monetary Fund?s former division chief for China.

?Central banks hate doing that because it puts them more under the thumb of the finance ministry,? he said.

Mr. Prasad said that during his trips to Beijing on behalf of the I.M.F., he had repeatedly cautioned China over the enormous scale of its holdings of American bonds, emphasizing that it left China vulnerable to losses from either a strengthening of the yuan or from a rise in American interest rates. When interest rates rise, the prices of bonds fall....

The finance ministry, however, has pushed for investments in overseas stocks. Last year, it wrested control of the $200 billion China Investment Corporation, which had been bankrolled by the central bank. That corporation?s most publicized move, a $3 billion investment in the Blackstone Group in May of last year, has lost more than 43 percent of its value....

But even in a country that strongly discourages criticism of its economic policies, hints of dissatisfaction are appearing over China?s foreign investments.

For instance, a Chinese blogger complained last month, ?It is as if China has made a gift to the United States Navy of 200 brand new aircraft carriers.?...

China finds itself hemmed in. If it were to curtail its purchases of dollar-denominated securities drastically, the dollar would likely fall and American interest rates could soar. China spent more than one-eighth of its entire economic output last year on foreign bonds, and then picked up the pace during the first half of this year....

Victor Shih, a specialist in Chinese central banking at Northwestern University, said that when he visited the People?s Bank of China for a series of meetings this summer, he was surprised by how many officials resented the institution?s losses.

He said the officials blamed the United States and believed the controversial assertions set forth in the book ?Currency War,? a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

?A lot of policy makers in China, at least midlevel policy makers, believe this,? Mr. Shih said.

If US officials privately assured the Chinese government that Fannie and Freddie debt were government guaranteed, as reader Scott's well-placed sources say, there is a germ of truth in the Chinese view.

Still, this is breathtaking reading. How could the Chinese have thought they could maintain a currency peg forever? At some point, the scale of the purchases becomes so large that they are unsustainable, the pegged currency rises and the country takes huge losses on its FX reserves. However, all of its local currency denominated assets are worth more in global terms. If this is a net plus, wealth-wise, why is there a problem? The computation of gains and losses is far from complete.

Equally worrying, neither of the two parties at odds is considering the only way out of this box: encouraging growth of China's domestic economy so it is less export focuses and therefore less in need of managing its currency. Admittedly, this would be a long-term program, while the question of the central bank's capital base is immediate, but it appears that no one is looking at the real problem, which is an economy overly dependent on a big customer.

Baker was more withering than usual:

It is almost inconceivable that anyone who followed economic data did not realize that the dollar would decline from the level it has reached in 2001 and 2002. The United States had a large and growing trade deficit...

It was understandable that China's central bank might buy up dollars in a conscious effort to keep the dollar high and thereby sustain its export market to the United States. This would mean that China was effectively paying people in the United States to buy its exports. This would be a reasonable growth strategy if China for some reason lacked the capability to generate this demand internally....

However, it would be bizarre if China's central bank bought up dollar denominated assets in the last 7-8 years thinking that they were making a good investment.....Apart from buying bonds from Zimbabwe, it's hard to imagine how they could have made a worse investment.

If the people who run China's central bank are really this ignorant, that should have been the headline of the article, which should have been on the front page.

Given the ferocity of bureaucratic battles and the anger in the public at large, the Times may have the story 100% right. But there is one way this might be a brilliant bit of gamesmanship.

Recall that China is suffering from a bad bout of inflation. That inflation is exacerbated by hot money inflows which have reached mind-boggling levels this year. The money is coming in in anticipation of a currency revaluation, and by pushing inflation higher, increases the odds of a revaluation.

Remember the ploy used by Henry Kissinger in his negotiations with the North Vietnamese? He presented Nixon as crazy, not the paranoiac that he was, but violent, impulsive, prone to extreme reactions if provoked. The notion that Nixon was an utter nut who would do something unthinkable (presumably the unspoken threat was dropping a nuclear bomb) was believed to have served Kissinger well.

Something like that may be at work here. Perhaps a genuine internal power struggle is being played up and positioned to persuade the hot money speculators that the finance ministry may soon have the upper hand, and the finance ministry is crazy enough and determined enough to keep the yuan weak, no matter how dangerous that might be in the long term. That would hopefully convince the hot-money players that their fast-profit revaluation hopes were misguided, and they'd shift their mony back overseas, providing some relief to inflationary pressures.

But it is just as plausible that the Finance Ministry is willing to cut off China's nose to spite the central bank's face.