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China and Foreign Exchange

October 30, 2006

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.

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