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Figures don’t lie, baby! Just as a cream-filled cupcake soon manifests itself in the waist line, China’s currency interventions are taking its toll on the country’s foreign exchange reserves. Data released by its central bank yesterday revealed that China’s foreign-exchange reserves swelled to a new high of 2.65 trillion USD in the third quarter of 2010, which is the fastest quarterly gain on record.

Meanwhile, other developing nations are concerned that the recent drop in the dollar is causing a rapid rise in their respective currencies. With China’s currency reserves jumping by record levels, it has certainly raised some eyebrows amongst those who believe that China is keeping the yuan from appreciating.

Many forex junkies say that China’s 194-billion-USD jump in foreign currency reserves last quarter wasn’t only caused by its large trade surplus, but its efforts to control the yuan’s value as well. In order to keep the yuan’s value from rising, China’s officials have to purchase large amounts of foreign currencies by selling the yuan, thereby causing the local currency to lose value.

Now, we ain’t saying that that China is a currency manipulator, but the fact is, this news comes at a very sensitive time, as the yuan has had a spotlight on it this past year.

The issue was brought up this past weekend during the IMF meeting, as the U.S. once again brought up the topic of currency manipulation. The U.S. officials walked on a very thin line when they said that countries who artificially weaken their currencies pose a threat to economic recovery.

Meanwhile, Chinese officials said that a more relaxed monetary policy (a.k.a. more quantitative easing) was causing massive flows of capital inflow in developing countries, which could destabilize their economies. Clearly, they were talking about the U.S. and the prospect that the Federal Reserve will be injecting another round of economic steroids into the economy.

Now why do I get the feeling that we’re right smack in the middle of a currency war? While the Chinese have been called out as currency manipulators, chances are, they are simply going to do it their way and not give in.

And why would China give in? If China chooses to “unpeg” its currency and let it appreciate, it could lead to a huge inflow of capital as speculators bet on the yuan to appreciate. In fact, it is estimated that most of the 40 billion USD capital inflow that China experienced during the third quarter was due to speculation that the yuan would appreciate. This is a bad thing, as it could create large asset bubbles. Hah, you probably know how dangerous asset bubbles can be by now!

*cough* dotcom bubble burst *cough* 2007 financial crisis *cough*

To counter this, China will probably continue (and even be more aggressive as the dollar continues to weaken) its accumulation of dollar-denominated assets. It’s going to be an uphill battle for China, so we’ll have to wait and see how things play out. Hopefully, only feelings will get hurt in the end and not the global economy.