Among the items that G20 leaders will likely discuss at their big meetings this year — in Toronto in June and Seoul in November — is what to do about the massive foreign currency reserves that many economies are accumulating. A number of critics say their currency caches are far higher than needed to protect against liquidity crises, such as what Asia experienced in the late 1990s. One of the critics’ chief concerns is whether the stockpiles of reserves — largely in U.S. dollars — are being used as a carrot-and-stick policy with the Obama administration.
Underlying such discussions is a focus on China. Its reserves, which have increased steeply since 2000, reached US$2.5 trillion in March and now account for nearly one-third of the world total. With around 70% of the US$2.5 trillion said to be in U.S. dollars, China is now in a sticky situation.
The Chinese government is keeping a close eye on the U.S.’s burgeoning budget deficit and the Obama administration’s loose fiscal and monetary policy — both of which could weaken the dollar and devalue China’s reserves. That’s why the country has been diversifying its reserves by gradually increasing its holdings of commodities, such as oil. However, a number of experts point out that the steps that China can take are limited.
Lending a Hand
Even critics, however, concede that China’s hefty pile of foreign reserves has played an important role in helping to calm the global financial crisis by allowing China to provide liquidity to countries. Argentina, Indonesia and South Korea were among the countries that were facing short-term liquidity problems in 2008 which turned to China for assistance. Since November 2008, the People’s Bank of China (PBOC), the central bank, signed currency swap arrangements totaling US$95 billion with those countries.
But it’s not just the total amount of China’s reserves that’s raising eyebrows. According to Gene Ma, managing director of the China research team at International Strategy & Investment (ISI), an investment advisory company, the biggest problem for China now is that the government holds a disproportionally high level of the country’s foreign assets. “As far as China’s total amount of foreign assets is concerned, around 75% is held by the central bank, in the form of foreign reserves, while Chinese companies and individuals hold the rest. To ensure the safety and mobility of its foreign reserves, the government invests the foreign reserves mainly in U.S. Treasury bonds. However, the annual return of those bonds is only around 2% or 3%,” notes Ma. “In contrast, in Japan, only around one third of its total foreign reserves are in the government’s hands. Japanese companies and individuals hold the rest and these investors use the foreign assets to invest in countries like China by purchasing equities or investing in long-term corporate assets, which can generate a much higher annual yield of 12% to 13%.”
Aware of the problem, the Chinese government is gradually transferring some of its reserves to companies and individuals. Since 2000, it has been encouraging domestic companies to invest overseas by allowing them to exchange renminbi for the U.S. dollars it has been holding. Thanks in some part to this measure, China’s outward foreign direct investment more than tripled, from US$90 billion to US$230 billion, between 2006 and 2009.
Another problem with the country holding large amounts of foreign reserves is that fluctuations in the value of dollar — as well as the other two foreign reserve currencies, the euro and yen — affect the value of China’s reserves. Moreover, according to Zheng Hui, a finance professor at Shanghai Fudan University, because most of China’s reserves are in dollars, potential inflation in the U.S. is a big concern. “If the inflation rate is higher than the interest rate of Treasury bonds, the real return of the majority of China’s foreign reserves would actually be negative,” notes Zheng. To avoid fallout from rising inflation and a weakened dollar currently, the government recently sold some short-term U.S. Treasury notes and parked them in long-term Treasury bonds.
During a forum of the U.S.-China Strategic and Economic Dialogue last year, Chinese officials requested that the U.S. Treasury Department issue more so-called Treasury Inflation-Protected Securities (TIPS), despite the fact that the low risk of these bonds, bills and notes also means low returns. According to an article published in January this year by The Wall Street Journal, experts say the U.S. Treasury has obliged and is likely to sell around US$80 billion of TIPS in 2010, about 40% more than 2009’s US$58 billion.
Zheng adds that China’s foreign reserves are helping to drive up its own inflation rate. Inflation rose to a 19-month high in May to 3.1%, which is a nudge above the government’s 2010 target of 3%. “The high-powered money on the central bank’s balance sheet [is] resulting in a surge in the money supply in China,” he says. “To temporarily relieve inflationary pressures and soak up some excess liquidity, the PBOC in recent years has been issuing central bank bills — a government-backed investment instrument for Chinese individuals.” However, Zheng points out that to make the bills attractive to investors, the central bank has to arbitrarily set the annual yield higher than the interest rate. “As this distortion continues, the Beijing authorities’ goal to introduce more market-determined interest rates can hardly be realized.”
Marshall Meyer, a Wharton management professor, comments that China’s foreign reserves are potentially a source of inflation. “By absorbing all the dollars and issuing equivalent renminbi, albeit in the form of long-term bonds, rather than selling the dollars, the growth of China’s money supply will eventually accelerate,” he says.
Meanwhile, China has been aggressively diversifying its reserves with commodities. For example, the State Reserve Bureau (SRB) bought 290,000 tons of aluminum in December 2008, then another 300,000 tons two months later. Around the same time, China signed agreements with Russia and Brazil to lend its dollar reserves to them in exchange for strategic commodities. One of the deals involved a US$25 billion loan from China Development Bank to oil firms Rosneft and Transneft in return for guaranteed oil deliveries for the next 20 years. Moreover, in April 2009, China reportedly increased its gold reserves to 1,054 metric tons from 454 metric tons in 2003, making it the world’s fifth-largest holder of gold.
However, according to Charles Freeman of the Center for Strategic and International Studies (CSIS), a Washington, D.C.-based public policy research institute, diversifying only has a marginal impact on the composition of China’s foreign reserves. “When China shifts the assets into commodities, such as oil or gold, it drives up the demand of those commodities, which pushes up their international prices,” says Freeman, who also has been an assistant U.S. trade representative for China. “When the prices of those commodities increase, China is reducing the value of its reserve assets, which would not be sustainable if the Chinese authorities were to purchase too much of those assets.”
Fudan’s Zheng also points to the political risk of signing deals with those resource-rich countries. “Lending China’s dollar reserves to other countries in return for a continued supply of strategic assets such as oil requires China to maintain a good political relationship with those countries,” notes Zheng. “The political regimes of those resource-rich developing countries are usually not stable, which prevents China from using the deals to alter the composition of its foreign reserves substantially.”
Freeman says that in the short run, the most effective way for China to safeguard the value of its reserves is to preserve a good political relationship with the U.S. “There is not a whole lot China can do. Diversifying from the dollar to the euro and yen are certainly options, but both those currencies are not stable,” he notes. “With the spread of the European debt crisis [this year], it is said that the euro’s status as one of the reserve currencies might be challenged. Meanwhile, the Japanese economy has been relatively flat for nearly 20 years.”
Meyer of Wharton reckons that China is facing a tricky dilemma. “It’s difficult to spend trillions of dollars. Most governments are not successful in investing overseas. What China could do now is simply to hold U.S. Treasury bills (T-bills) as they don’t have much choice.”
Freeman also points out that under the fixed exchange rate regime, as long as the U.S. remains China’s major trading partner and transactions are still denominated in dollars, China will continue to build dollar reserves as its trade surplus grows. So in the long run, the most important thing for China is to balance its current account, reduce its trade surplus with the U.S. and increase domestic consumption. One way to do the latter is address wage levels. “Wages in China have been depressed too much. However, the average rate has been increasing recently, offering a hope that it could lead to higher domestic consumption,” he says.
Because China has been using its huge dollar reserves to purchase T-bills for the past few years, it is now the second-largest holder of Treasury securities — which includes bills as well as bonds and notes of varying maturities. At the end of 2009, China held US$755 billion of Treasuries, while Japan had US$769 billion.
There is concern that China could dump the dollar and cripple the U.S. economy. Between November 2009 and February 2010, the PBOC decreased its holdings of Treasury bonds by as much as US$61 billion, which raised concerns about how the global market would react if it continued selling more.
Yet according to Ma of ISI, although the central bank has been buying fewer U.S. Treasuries lately, there was a surge in the Treasury notes purchased on the offshore market in London, and the capital to purchase them might be “Beijing” money. So China’s T-bill holdings might have actually increased rather than decreased during that period.
Meanwhile, in a recent testimony before Congress about U.S. debt with China, Simon Johnson, a professor of entrepreneurship at MIT’s Sloan School of Management, and former chief economist of the International Monetary Fund, pointed out that the amount of U.S. debt that the United Kingdom holds rose in 2009, from US$131 billion to more than US$300 billion, despite the fact that the U.K. ran a substantial current account deficit. “A great deal of this increase may be due to China placing offshore dollars in London-based banks, which then buy U.S. securities,” notes Johnson, “China may also purchase U.S. securities through other routes.”
Fudan’s Zheng notes that the PBOC needs to allow the subsidiaries of Chinese companies to register in overseas locations, such as the British Virgin Island, so they can purchase some of its Treasury securities through London’s offshore market. “Technically, with such a huge amount of dollar reserves, if the PBOC continues purchasing T-bills through official channels, the price would be pushed up,” notes Zheng. “Purchasing T-bills through different channels is a way for China to keep the price of T-bills stable. The view of China using its Treasury securities as a political weapon with the U.S. is groundless.”
Freeman of CSIS also notes that it is unlikely that China will threaten the U.S. by selling its dollar reserves. If it did, the value of its dollar reserves would drop to zero and its export sector would be destroyed since the U.S. is one of the country’s biggest trading partners. “The two countries are locked in a desperate but also quite balanced relationship,” states Freeman. “The only country that [has ever] punished the U.S. by selling its dollar reserves was Russia, whose government was unhappy about the U.S.’s stance on the Russia-Georgia crisis in 2008 and [wanted to] emphasize the strengthening of its political power and disregard economic factors. However, Chinese leaders are always most concerned about their country’s economic stability. Therefore, it is highly unlikely that China’s huge amount of Treasuries would pose a threat to U.S. national security.”
Attached at the Wallet: The Delicate Financial Relationship between the U.S. and China