What is the right way to think about China’s foreign reserves?

They are not just a big treasure chest for the absorption of bad debts.   Paul J. Davies writes:

To buy the dollars that China does not want sloshing around the economy, the central bank creates Renminbi. However, in order to avoid a big money-printing exercise it also issues treasury notes into the market to soak up – or sterilise – the local currency created to buy the foreign currency.

The vast majority of the foreign exchange reserve assets at the People’s Bank are matched by Renminbi liabilities in China’s banks and other financial institutions. If it tries to spend dollars without repaying these liabilities it undoes its earlier sterlisation and prints money. If China wants to print money to soak up its bad debts – and take the risks that come with this policy – its foreign reserves are really irrelevant to that decision.

The other problem with “spending” these reserves lies in the misconception that they are an asset of the country – something like its retained profits from its trade with the outside world.

China has run a current account surplus of increasing size since the late 1990s. A good chunk of this is money paid for goods and services sold – but another good chunk is foreign direct investment. This is not money handed over by outsiders never to be seen again. (Okay, so maybe it often seems like it is, but losing to money to fraud and bad investments is not the point here…)

The point is that the stock of net foreign direct investment represents a liability of the country to outsiders – it is plant, equipment, streams of future profits and so on that are owned by foreigners not by Chinese.

This is interesting too:

Betweeen 2008 and 2012, the total accumulated by China, India, Korea, Taiwan, Hong Kong, Singapore, Indonesia, Malaysia, Thailand and The Philippines almost exactly matches the growth in the US federal Reserve’s balance sheet due to quantitative easing. As he says, the correlation appears very high.

What this suggests – and what is backed up by data from Hong Kong banks in particular – is that along with FDI, China has recently drawn in a lot of cheap credit from overseas. This also amounts to an external liability against the forex assets.

Here is more.


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