China's Foreign Exchange Reserves Conundrum

The Chinese regime is facing a huge challenge with respect to its large foreign exchange reserves.

Authorities don't want to increase the foreign reserves; their aim is to keep the economic growth going, a Chinese economist says. Economic growth means more jobs and helps the regime maintain its hold on power. That’s also why they keep the yuan undervalued. But now inflation is becoming a threat that could undermine this plan.

China’s exchange reserves have risen beyond a reasonable level, and the rapid increase in reserves may have led to excessive liquidity and created “significant monetary sterilization pressure,” Central Bank governor Zhou Xiaochuan said on April 18 after a speech at Tsinghua University in Beijing.

Monetary sterilization refers to actions in which a central bank or federal reserve attempts to insulate itself from the foreign exchange market to counteract the effects of a changing monetary base. The sterilization process is used to manipulate the value of one domestic currency relative to another, and is initiated in the forex market, according to investopedia.com.
A staff member counts money at a branch of Industrial and Commercial Bank of China Limited (ICBC) on April 18 in Huaibei, Anhui Province of China. The People's Bank of China (PBOC), the central bank, raised the required reserve ratio of the country's lenders by 50 basis points from April 21 for the fourth time this year to curb stubbornly high inflation. (ChinaFotoPress/Getty Images)

China’s foreign exchange reserves have increased by US $197 billion to US $3 trillion during this year’s first quarter, becoming the largest foreign currency reserve in the world.

Meanwhile, inflation in the country has been worsening. China’s consumer price index in March has increased by 5.4 percent over the same period last year.

Economist Dr Jian, who once worked at China’s Central Bank, talked with The Epoch Times about the causes and consequences of China’s ever-increasing foreign reserves. He said the ballooning exchange reserves and inflation are related, and this has been caused by Chinese authorities’ wrong economic policy.

The main purpose for accumulating foreign exchange reserves is to minimize the impact imbalanced international payments from world trade and the financial crisis could have on domestic currency. “Having some reserves is necessary for any country, but US $3 trillion is too much,” Dr Jian said.

A large amount of the foreign exchange reserves were used to purchase overseas bonds, especially U.S. Treasury bonds. China holds at least US $2 trillion in U.S. treasury bonds, Fed chief Ben Bernanke said in February.

But since last year, many countries have relaxed their monetary policy to stimulate the economy, and major currencies around the world have depreciated at a faster rate, with 11 percent for the yen and 6 percent for the pound.

This resulted in China's foreign reserves to become depreciated.

“A 5 percent depreciation, for example, would devalue China's reserves by US $500 billion. The real numbers should be even higher than this,” Dr Jian said. “Other countries actually benefited from this,” he added.

Dr. Jian said the huge amount of foreign reserves hasn't brought any benefits to the Chinese people, only inflation.

The increasing proportion of reserves to GDP has resulted in a continued growth of money supply. “The growth of inflation in recent months is related to the increasing reserves. There are other factors, but of little impact,” Dr Jian said.

Dr Jian said there are a number of ways to reduce the trade surplus. You can appreciate the yuan, or you can increase the price of export goods by either raising worker’s wages or through inflation.

Another way to solve the problem of excessive reserves is to substantially increase imports. But the fundamental solution is to improve the exchange rate, according to Dr Jian.

“The authorities use domestic inflation to reduce the reserves. They try to solve the problem at the expense of the majority of Chinese people,” Dr Jian said.

Preventing Unemployment and Uprising

Dr Jian said he believes the Chinese authorities didn't want to increase the reserves. Their aim is to keep the economic growth going. Economic growth means more jobs and helps the communist regime to maintain its power, he said.

China's economic growth during the past 20 to 30 years can be mainly attributed to the undervalued yuan and the growth of fixed asset investments. The undervalued yuan has led to the annual export growth of 30 percent.

“If the unemployment rate gets too high, it will cause social unrest, and the communist regime won't be able to maintain the stability of its control. This is why the authorities didn't take action to reduce the excessive reserves,” Dr Jian said.

The authorities are still reluctant to improve the exchange rate even though inflation has been rising every month. They are afraid of the implications of slowing economic growth. They try to tighten the monetary policy to suppress inflation by increasing the interest rate and reserve ratio for banks, Dr Jian said.

Will Hutton, an author and governor at the London School of Economics, says China is a "tinderbox" and “revolt in China is only a matter of time,” The Sydney Morning Herald said in an article on April 19.

The article quotes Mr Hutton saying while it was not clear when China could be hit by a people's revolt, it already had a fragile financial system that could lead to further social unrest.

“There's an iron rule in economics—you know, what's unsustainable can't be sustained,” Mr Hutton said about China's increase of its foreign exchange reserves to $US3 trillion.

“The Chinese cannot carry on acquiring foreign exchange reserves like this. It's a massive distortion. This is all about to blow,” he said.

The Chinese financial system is many times more fragile than the American and British and Western banking system was in the run-up to the financial crash in 2008. I mean, it lent many times more than GDP now. On many of these loans, there's no interest paid or principal ever repaid. I mean, this is an accident waiting to happen,” the Sydney Morning Herald article quoted Mr Hutton telling Australia’s ABC.


Read the original Chinese article.