In an excellent article on the ADBI blog, Willem Thorbecke argues that it is time for China to stop buying US Treasuries and start investing in its people.

But China's overseas investments now go well beyond US Treasuries and provide China's communist party government with "external strength" which is helpful at a time of internal weakness.

Thorbecke's article makes a very strong case for China's adoption of a more flexible exchange rate.  China's current policy of manipulating the exchange rate by buying foreign exchange reserves complicates macroeconomic management, has led to inflation, and distorts investment.  An appreciation of the exchange rate would have a contractionary effect on the economy.  But this could be offset by spending on education, health care and affordable housing, which would improve the wellbeing of China's citizens and strengthen the foundations for continued economic development.

This is a very sound argument on economic grounds.  But China's current policy of accumulating and investing foreign exchange reserves may provide many other benefits to the Chinese government.

It is clear that since China is "America's banker", the US must take a relatively accomodating approach to China in its international relations (as will Europe now that it is begging China to contribute financially to solving the euro crisis).  And now Chinese overseas investments are spreading beyond US Treasuries to financial and real estate assets in Europe, Japan and Australia, as well as mining and agricultural projects in Australia, Africa and Latin America (in recent times, Australia has received more Chinese foreign direct investment than any other country).  Recipient countries of these investments enjoy great benefits and thus become stakeholders in the stability of China's political regime.  This friendship is particularly welcome when the US/China relationship passes through occasional testy moments.  These investments can also provide great benefits to China as it secures future supplies of energy, minerals and agricultural products.

All of these investments can also enable China to appear and be "externally strong" in the eyes of Chinese citizens who are fed a discourse of nationalism.  This is very useful for political stability at the moment when China is "internally weak" as reflected in social unrest, arrests of political dissidents, concerns about corruption, and unease about the implications of the upcoming change in Chinese political leadership.

In short, while it may be in the best interests of the Chinese economy and citizens to stop buying US Treasuries and start investing in its people, it may well also be in the best interests of the Chinese Communist Party and its survival to continue with its policy of accumulating foreign exchange reserves and investing them overseas.  And needless to say that China's endemic corruption also means that many of these overseas investments serve to fill the pockets of Communist Party officials.

Chinese politics have now become a very major constraint on the country's reform.

Reference:

Thorbecke, Willem.  Time for the PRC to stop buying US Treasuries and start investing in its people.  Asia Pathways: a blog of the Asian Development Bank Institute.

http://www.asiapathways-adbi.org/2012/01/time-for-the-prc-to-stop-buying-us-treasuries-and-start-investing-in-its-people-2/