Question

Who wants to be a trillionaire?

The Economist Oct 26th, 2006 | HONG KONG | from the print edition

BY THE end of October, China's foreign-exchange reserves are likely to top $1 trillion, twice their level two years ago and more than one-fifth of global reserves. This handsome sum would be enough to buy all the gold sitting in central banks' vaults (indeed, twice over) or almost all of London's residential property.

China's massive hoard is the result of its large current-account surplus, significant inward foreign direct investment, and big inflows of speculative capital over the past couple of years. In theory, flows of foreign money into China should push up the yuan, but China has resisted this, forcing the central bank to buy up the surplus foreign currency. The growth in reserves has slowed in recent months, but it is still averaging a hefty $16 billion a month.

China's official reserves already far exceed what is required to ensure financial stability. As a rule of thumb, a country needs enough foreign exchange to cover three months' imports or to settle its short-term foreign debt. China's reserves are equivalent to 15 months of imports and are six times bigger than its short-term debt. The explosion in reserves is also a headache for the central bank. It creates excess liquidity, which risks fuelling higher inflation, asset-price bubbles and imprudent bank lending.

There are two simple ways to stop reserves rising. China could set free its exchange rate or it could relax restrictions on capital outflows and allow private citizens to hold foreign assets. Significant moves of either kind seem unlikely in the near future. So long as China runs a large external surplus (the natural result of its high saving rate) and refuses to set its currency free, its stash of foreign currency will probably continue to mount.

How that money is invested has big implications for the world economy, not just for China. Brad Setser, head of global research at Roubini Global Economics, estimates that about 70% of it is invested in dollars, mainly Treasury securities. This has propped up the dollar and reduced American bond yields—by up to 1.5 percentage points according to some estimates. A big shift out of dollars could therefore push up bond yields and hence mortgage rates, damaging America's already crumbling housing market.

China's central bank is thought to be switching from Treasury bonds to American mortgage backed securities and corporate bonds in an attempt to earn higher yields. Chinese officials have also discussed in private the need to diversify reserves out of dollars in order to reduce exposure to a big drop in the greenback. The bank may be putting a bigger slice of any increase in reserves into euros and emerging Asian currencies, but so far there is little sign of a shift out of its existing stock of dollars. One problem is that China's investments are so big that they move markets. Shifting money into euros would push down the dollar. China would then not only suffer a capital loss on its remaining dollar reserves, but it could also be forced to buy yet more reserves to hold its currency down against a weaker dollar

Fear of a capital loss, and dissatisfaction with unrewarding yields, have triggered a flurry of ideas on how to put the money to better use. One popular idea is to use some of China's reserves to buy oil and other commodities. The snag is that stockpiling oil would push up prices, yet absorb only a tiny proportion of the sums at China's disposal. Buying the equivalent of sixmonths' oil consumption, as has been suggested, would take only 8% of total reserves at current prices, but the extra oil bought would amount to three times the growth in global oil demand this year. Buying gold would have similar results: if China invested just 5% of its reserves in gold, it could buy the world's entire annual mine production.

Another proposal is to spend more money on infrastructure investment, which would yield a much higher return than American bonds. However, since China's investment already accounts for 40% of GDP, it is not clear that China needs more. Writing off banks' non-performing loans might seem more sensible. In 2004 and 2005 the People's Bank of China did indeed shift $60 billion to state banks. The remaining stock of bad loans is now around $250 billion, according to UBS.

By buying American bonds, China is subsidising rich American consumers while China's health care, education and social safety net are starved of funds. So why not use reserves to relieve rural poverty, improve health care, or inject money into the under-funded pension system?

Unfortunately, all of these proposals to spend money at home misunderstand the nature of foreign reserves. The problem is that conversion of the foreign currency into yuan would put upward pressure on the yuan and so force the central bank to buy yet more foreign currency to hold it down. Reserves would return to their original level.

The only real solution to the poor return on China's reserves is to stop accumulating them. That requires policy reforms to reduce China's massive saving, which drives its current-account surplus, and a more flexible exchange-rate system. But before that happens, China's reserves could well hit $2 trillion.

QUESTIONS:

1) Based on the article facts, why was China's massive hoarding of foreign exchange reserves the result of its large current-account surplus, significant inward foreign direct investment, and big inflows of speculative capital? Explain and motivate your answer

2) Based on the facts in the article, would you say that China is following a new-mercantilist policy? Explain and motivate your answer (Maximum length one page).

3) Based on the facts in the article, would you say that China is a currency manipulator? Make use of a demand and supply diagram to explain your answer

4) Note: this is a research-based question and all sources used should be properly referenced. What happened to China’s foreign exchange reserves since 2006? Is China still hoarding massive foreign exchange reserves? What are the implications of this in terms of new-mercantilist policy and currency manipulation?

Answer 1

1. as stated in the article china's massive hoarding of foreign exchange is because of the following reasons:

• current account suplus- current account means the relationship between the net imports/outflow of currency and net exports/inflow of currency of other countries. in case of current account surplus exports are more than imports which means less amount of yuan is spent and more amount of foreign currency is entering into china. this is resulting in massive amount of hoarding of foreign currency.
• significant inward foreign direct investment- with increse in foreign direct investment meant that a foreign entity is investing in local economy that is in this case china. so with increase FDI more foreign currency is entering into the Chinese market hence leading to hoarding of foreign currency.
• inflow of inward speculative capital- speculation capital refers those investment which are earmarked for speculation. for example if technology sector outperform other sectors then invstors would move their investment to technology sector resulting increase in the stock prices of the speculative technology. similarly with inflow of inward speculative capital from other countries is likely to increase foreign exchange leading to its hoarding.

2. mercantilism is a national economic policy designed to maximize the trade of a nation to maximize its monetary reserves. mercantilism includes a national economic policy aimed at accumulating monetary reserves through a positive balance of trade. since china has current account surplus and to keep its products cheap in the international market the government does not allow the value of yuan to rise up against US dollars, it can be said that china is following a new mercantilism policy.

current account surplus leads to increase in foreign exchange reserve which is a aim of mercantilism policy i.e. to hold monetary reserves. similarly to maintain its price of goods cheap in the international market the central bank of china maintains a fixed exchange rate and does not allow value of yuan to rise against US dollars. to maintain low value of yuan china has to maintain large amount of US dollar foreign exchange again leading to its excess foreign reserve. thus china is following new mercantilistic policy through current account surplus and maintainung the value of yuan.

3. in a broader sense every country with a functioning central bank is a currency manipulator because all central bank maintains its currency's value by expanding and contracting its money supply. but hte term currency manipulator is used for china because it deliberately tries to keep yuan cheap in terms of dollar, china's currency policy consistenly undervalues yuan to keep its goods cheap in relation to hte goods of other countries, especially those of the US, its number one overseas market. currency manipulation claims are also based on the fact that in free markets the value of currencies ought to reach an equilibrium that balances trade. since chian persistently maintains a current account surplus its currency though rising in value must not have been rising fast enough.

in the figure below shows an increase in demand for yuan. the demand for yuan has increased from D to D1, which was caused by an incresed demand for chionese product as it is cheap therfore other countries citizens would want more yuan, thus incresing the emand for yuan on the foreign exchange market.

4. china's foreign exchange reserve continues to remain high even though it has decrease since 2014 and it has been lowest in 2017 since 2011. foreign exchange reserve of china was continually rising in the past but after 2006 its rate of increase has gone down. though china maintains current account surplus it has allowed its value of yuan to rise in terms of dollars. it has changed from fixed exchange rate to flexible exchange rate. like every country china remains a currency manipulator but is no longer deliberately triying to maintain yuan low compared to US dollars even though it is still quite cheap.