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China's Mountain of Foreign Exchange Reserves
Thursday, 11 November 2010 23:26

Over the past decade, China’s foreign exchange reserves have grown by almost US$2 1/2 trillion, while Japan, Russia and Saudi Arabia have only seen their reserves grow by around half a trillion dollars each.  How on earth did China’s reserves get so big?  Does it make sense for China?  Is it a good thing for the rest of the world?


China’s current account balance is the starting point for looking at the growth in China’s foreign exchange reserves. 


Until China’s economic reforms began in 1978, it was an insignificant player in international trade and finance.  But China’s progressive reforms launched it on a path of export-led development.  In the period up to 1996, China usually had small current account surpluses, and sometimes had a current deficit, but the amounts involved were minor.  Then, from 1996 until 2001, China’s current account surplus was fairly steadily in the $20-30 billion range. 


Following that, as China’s export-led development became stronger, thanks in part to membership of the World Trade Organization, its current account surplus accelerated from $17 billion in 2001 to $426 billion in 2008.  The onset of the global financial crisis in 2009 provoked a fall to $297 billion, as exports weakened.  The current account surplus may decline again in 2010.  But as the world economy will likely recover gradually, China’s current account surplus is set to start growing again. 


If China had a freely floating exchange rate, financial markets would respond to such high current account surpluses by appreciating China’s exchange rate.  Herein lies main the reasons for China’s growing foreign exchange reserves.  For various reasons, China did not want its exchange rate to rise.  So in order to control the value of its exchange rate, the Chinese government bought US dollars in exchange for Chinese Renimbi, with the result that its reserves of foreign exchange have grown enormously.  And as it buys US dollars, it increases the local money supply.  This creates inflation pressures, unless it reduces the money supply again by selling domestic bonds (“sterilization”).        


In 1978, China’s foreign exchange reserves were only $2 billion.  They then rose to over $100 billion in 1996, and then over $200 billion in 2001.  They then leaped to over $1 trillion in 2006, then over $1 1/2 trillion in 2007, then over $2 trillion in 2009 and then to almost 2 1/2 trillion today.  (Another factor contributing to the foreign reserve accumulation was the very high inflows of foreign direct investment, especially in the first half of the 2000s decade.)


So how did China’s current account surplus get so big?


As China progressively opened to the rest of the world, it became an increasingly attractive destination for foreign direct investment from other East Asian countries and also some OECD countries.  This was achieved by the Chinese government offering many indirect and direct subsidies to foreign investors, as well as removing restrictions on doing business.  Many of these investment activities involved the assembly of imported components for re-export (“processing trade”), the lower-skilled phase of the production process.  This became a major driver of export-led growth.  Many Chinese companies also progressively learnt how to be effective exporters in areas of their comparative advantage.  In short, this export-led growth resulted in ever-growing trade and current account surpluses.


China’s blocked exchange rate!


In the normal course of events, the Chinese exchange rate would have appreciated.  This would have been very beneficial to China.  The price of imports would have become cheaper for its citizens, thereby increasing their purchasing power and standard of living.  Sure, some exporters would have suffered, but only the least efficient.  And such an exchange rate appreciation would have provided a stimulus to exporters to become more efficient and innovative, and climb the development ladder.  This dynamic effect would have provided a boost to China’s development process.  And exchange rate appreciation would have also stimulated the domestic services industry.


The Chinese government has been extremely cautious about its exchange rate.  Quite justifiably, it is extremely cautious about allowing the exchange rate to float, being freely determined by foreign exchange markets.  There is a great risk of volatility.  However, the Chinese government could always continue with the gradual exchange rate appreciation (as was done between 2005 and 2008), but it could appreciate the exchange rate more strongly.  One problem of this approach is that it becomes predictable, and domestic and international investors can move money into China to make a sure profit.  A third approach would be to make a sudden discrete exchange rate appreciation of say 20 per cent.


Why does the Chinese government block the natural appreciation of the Chinese exchange rate?


There are several reasons why the Chinese government has blocked the appreciation of its exchange rate.  First, as a rapidly ageing society, it is also natural that China be saving for its future by accumulating some foreign reserves (this would however occur naturally under a floating exchange rate).  Second, accumulating some foreign exchange reserves provides insurance against future financial crises and financial volatility.  But China’s foreign reserves vastly exceed any possible needs like these.  The reasons for reserve accumulation must be sought elsewhere. 


Exporters who would suffer from an appreciating exchange rate are lobbying the government – many of these exporters have close like with the Communist Party of China.  The government is frightened that an appreciating exchange rate might cause unemployment, thereby disturbing social stability and threatening the Communist Party.  The government is also concerned that if they revalue the exchange rate, China might fall into a great economic crisis like Japan twenty years ago.  Also, it seems that the more that the US pushes the Chinese government to revalue its exchange rate, the more stubborn the Chinese become!


If Chinese citizens understood the issue, they could lobby the government to revalue the exchange rate in order to improve their purchasing power and standard of living.  Although from 1981 until 2005, the proportion of Chinese living on less than US$1 a day fell from 74 per cent to 8 per cent of the population, the proportion of people living on less than US$2.50 a day only fell from over 99 per cent to 50 per cent of the population.  In short, half of China’s population still lives in great poverty, even if they have escaped the most extreme levels of poverty.  But a nation’s citizens will very rarely manage to organize themselves for such collective action.  And since the China’s media is not free, it will not likely promote its citizens’ interests in this way.


At the same time, it is also true that China’s vast foreign exchange reserves provide the government with immense political power.  The Chinese government has been able to make investments in Africa, Australia and Latin America in order to secure resources.  It has also been able to buy influence and friendship by investing in crisis-struck countries like Greece and Portugal.


But most of these reserves are in reality invested in US government bonds, earning very low rates of interest (although China does not report the currency denomination of its reserves, it is believed to hold about 70-75 per cent in dollar-denominated assets, with euros and yen making up much of the rest).  And although the US government finds itself indebted to China, because of the massive size of this debt, the Chinese government could never quickly sell off these US government bonds, without seeing the value of these investments spiral downwards.  It is Catch 22.


The Chinese government recognizes that there is a great problem with its export-dependent growth and fixed exchange rate.  It knows that it must get itself out of this situation.  It seems to have recognized that the social costs of unbalanced development (big gaps between rich and poor) are greater than the risks of reducing its current account surplus and foreign exchange reserve accumulation.  But it does not want to move quickly and suddenly.  It would prefer to move gradually.


This was evident at the recently concluded fifth plenary session of the Chinese Communist Party where it agreed on the broad outline of the 12th five-year plan.  They key elements are: reducing dependence on investment and exports, which made it vulnerable to global economic recession; increasing domestic demand through consumer subsidies and rising incomes; improving social wellbeing by addressing issues of income inequality and regional development disparities; continue upgrading of the manufacturing sector and accelerate the growth of the service sector, while developing strategic emerging industries;


If this new five-year plan is implemented seriously, we could eventually see reductions in China’s current account surplus and foreign reserve accumulation.  But the slower the Chinese move, the more the problem builds up.



Chinability: Latest news and statistics on China’s economy and business climate


Sky’s the Limit? National and Global Implications of China’s Reserve Accumulation.  Eswar Prasad, Senior Fellow; Isaac Sorkin, Research Assistant. The Brookings Institution



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