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China has pegged the exchange rate of
their currency in dollars to a below-market level. In order to enforce this
price control, the central bank must be willing to purchase any amount of
dollars offered at the official rate. After a number of years, they have, as
reported by the China Daily, accumulated over $1 trillion of so-called
"reserves".
The willingness of the central
bank of China to accumulate large amounts of dollar reserves and
"invest" them in US government debt has been a major reason that US inflation has been low relative to the amount of money creation. The inflation has been
exported to China.
As economists Nouriel
Roubini and Brad Setser have written, there are not enough domestic
savings in China to fund their purchases in dollars. The Bank of China is
monetizing the difference, driving a credit boom in China (see Setser's paper on bad debt in the
Chinese banking system).
The exchange rate control makes
their exports cheaper to Americans than they otherwise would be, and their
imports more expensive. While Chinese importers may show an accounting profit
in terms of their local currency, their government accumulates large amounts
of dollar-denominated claims, which realistically can not be converted into
dollars worth anywhere near their current purchasing power. The central bank
will ultimately take a large loss on its currency position, which will be
born by the people of China either in terms of inflation, higher costs for
exports, or taxation.
These assets could in theory be
used to intervene in the foreign exchange market, should their currency
become overvalued and they wished to maintain the over-valuation. But
realistically, they have far more reserves than they could ever use for this
purpose. The linked China Daily article discusses a shift in thinking that is
ocurring within the central bank as to what to do with these reserves:
"How to manage such a huge reserve is a big
challenge," said Yi Xianrong, a research fellow at the Institute of Finance Research under the Chinese Academy of Social Science. "The crux of
the problem is that you have to keep the value stable or increasing," Yi
said.
The ballooning foreign
reserves, many economist say, is a major reason behind the loose money
supply. This is because the central bank has to issue additional money to mop
up the excess US dollars in the market, resulting in excessive liquidity in
the banking system.
And the fluctuating
foreign exchange rate also poses a huge risk, economists say.
In a bid to minimize
such risks, the central bank should diversify its existing US
dollar-dominated foreign reserves structure, and increase its holdings of
euros or other major international currencies, said Li Yongsen, a finance
professor at Renmin University of China.
The central bank, he
said, could also buy more state bonds issued by other major economies and
decrease holdings of US Treasury bills.
"It's better to
spread the risks, and not put all your eggs in one basket," Li said. The
professor also suggested that the country might consider using the huge
foreign reserves to purchase some strategic resource reserves such as oil.
To the extent that China uses their dollars to purchase real things, rather
than hold US debt, the US$ inflation originating from the Fed would no longer
be shunted into the Chinese economy.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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