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Monday, November 13, 2006

China finance: Reserves—US$1 trillion and beyond


China's foreign exchange reserves, which have been growing by around US$20bn a month, now exceed US$1trn. The announcement is likely to lead to a further round of China-bashing in the US, and more pressure on China to allow a more meaningful appreciation of its currency, the renminbi. It has also drawn attention to China's increasingly important role in the world financial system, and there is increasing unease that the growing stock of reserves, while helping to cushion China from economic shocks at home, increase the risk of triggering them abroad.

Two main imperatives have been driving China's rapid accumulation of foreign reserves over the past two years, during which time its stock of reserves has more than doubled. The first is the precautionary principle, whereby China has been buying reserves to protect it from a financial crisis. China's stock of foreign reserves is large, especially when measured against the size of its imports or the level of short-term debt. However, when one considers the precarious nature of the country's financial sector (the official total stock of non-performing loans was an estimated US$164bn at end-2005), as well as the risk of capital flight as China experiments with further liberalisation of its capital account, China's rapid accumulation of reserves looks more reasonable.

The second reason China has been accumulating foreign exchange reserves at such a rapid rate is to keep the exchange rate stable. A combination of significant inward foreign direct investment, big inflows of speculative cash betting on a major currency revaluation, and the country's large current account surplus has put major upward pressure on the currency. The government is concerned that a much stronger renminbi could undermine the competitiveness of the country's exports. To prevent this from happening, the central bank has been forced to buy up surplus foreign currency.

Accumulating problems

The huge increase in China's foreign reserves has created problems for the operation of monetary policy. China's purchases of foreign reserves have contributed to a rapid expansion of the money supply, and subsequently bank lending, which is one of the main factors behind the current investment binge. To prevent reserves from rising further, and so help in efforts to control over-investment, the government could allow the renminbi to appreciate, or to relax restrictions on the capital account. However, China would be loath to allow any large appreciation of the renminbi, amid fears over the impact this would have on low-margin export industries and hard-pressed farmers; the latter could be undercut by cheap agricultural imports. Meanwhile, although progress is being made on freeing up the capital account, such as the lifting of some restrictions on Chinese companies and individuals investing abroad, both President Hu Jintao and Prime Minister Wen Jiabao have shown themselves to be cautious reformers. They are unlikely to allow the sort of risks associated with a sudden liberalisation of the capital account.

As the size of China's foreign reserves continues to grow, the central bank is under pressure to increase the returns on its holdings of foreign currency. It is currently estimated that 45-70% of China's foreign exchange reserves are invested in US dollars, mostly in low-yielding Treasuries. This has helped keep long-term US interest rates low—anything from 0.5 to 1.5 percentage points lower, according to some estimates. In doing so, however, it has also reduced the returns that its own stocks of reserves have been earning. There is fear in Washington that China could dump its holdings of US-denominated assets in a search for higher returns elsewhere. This would cause the US dollar to crash, sending up long-term interest rates, and in the process almost certainly pushing the US economy into recession. However, a recession in China’s largest export market is scarcely in the country’s interest. And since such a large proportion of China's own reserves are in US dollars, such a policy would mean China suffering a major capital loss on its remaining US dollar reserves. China would also be forced to purchase more reserves to prevent the renminbi from rising against the dollar.

How to spend it

With reserves now past the US1trn mark and almost certain to continuing increasing, and the central bank under pressure to earn a higher return on its investments, there is growing debate inside China over how the reserves could be put to better use. One proposal that has received a lot of attention is to use the reserves to buy oil and other commodities, which China's booming economy is becoming increasingly dependent on. The problem is that because China is now such an important player on the world oil markets, such a policy would help push up oil prices, causing a dampening effect on growth.

Another proposal is for China to use its reserves to help alleviate rural poverty at home by spending its reserves on improving the provision of rural healthcare and education, which has been largely neglected during the economic boom of the last 25 years. However, the nature of China's exchange-rate regime makes it impossible to use its foreign exchange reserves for local-currency spending. Converting foreign currency into renminbi would put upward pressure on the domestic currency, forcing the central bank to purchase more foreign reserves, thus leaving reserves at their original level.

The only real solution to stop reserves increasing even further is therefore to allow a much larger appreciation of its currency. This, however, is unlikely to happen any time soon. So expect China's stock of foreign reserves to continue their rapid growth.

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