The one trillion dollar mark is a perfect hook. Richard McGregor's excellent story in today's FT is the first of no doubt many stories on China’s phenomenal stockpile of reserves.
McGregor highlights my argument that the composition of China’s reserves is a second order issue, at least from China’s point of view. Shifting reserves from dollars to euros won’t prevent China’s central bank (the PBoC) from taking losses if the RMB appreciates against both the euro and the dollar. And, as my regular readers know, the RMB sure looks undervalued against the euro. The size of China’s capital losses will be primarily a function of the size of China’s reserves – not the composition of China’s reserves.
But that is not the reason to read McGregor. I don’t have any influence over Chinese policy. But a lot of the other folks that McGregor quotes do. He provides a great window into the internal Chinese debate, and that is really the only debate that matters.
What struck me?
The PBoC’s worries that it will be blamed for taking big losses on its foreign exchange portfolio, even though those losses were basically “baked in” -- to use Dr. Swagel's phrase -- at the moment China bought its current holdings of dollar bonds at an inflated price.
The PBoC’s concerns are understandable. The last Chinese reserve manager who took large losses (by betting on the euro a bit too quickly) took those losses hard. And the Bank of Korea has come under pressure for the capital losses (more here) it has taken as the won has risen against the dollar.
At the same time, so long as the state council instructs the PBoC to resist pressure for the RMB to appreciate against the dollar, losses are unavoidable.
China Foreign Exchange’s Mr Zhong is right:
“We cannot blame the US Treasury [for future losses]” he says. “No one forced us to buy dollars.”
I think McGregor’s reporting on China’s internal debate– which really is worth reading closely -- raises two important issues.
First, China’s large financial stake in the US economy could be a source of future tension, not a source of shared gains that lubricates the overall US-Chinese relationship.
The argument that China’s huge holdings of US debt (which now dwarf US FDI in China) give it a stake in America’s success is a bit off. It is true, but it misses a key point. The interests of a creditor are not always the same as the interest of a debtor. China (at least its central bank) would rather see the US take policy actions that minimize the scale of China’s capital losses by minimizing the needed adjustment in the RMB/ dollar. The US, on the other hand, has traditionally taken the view that the dollar is our currency but your problem --- it has never promised to direct its policy to maintaining the dollar’s external value. And it certainly has never promised China that if China keeps financing the US, the US will look after China’s financial interests.
That could be a point of future tension, particularly if the PBoC starts taking capital losses and feeling the heat.
Second, I think DeLong may be underestimating the costs of China’s current policy. He argues that China is basically taking a one-off 3% of GDP capital loss (on its 10% of GDP annual reserve accumulation) in exchange for a permanent increase its exports and its income. I would argue that sustaining China’s current level of exports requires ongoing financial flows from China to the US. If Chinese reserve growth slows and China stops financing the US, the US wouldn’t be able to afford its current imports from China. Consequently, China has to take an annual capital loss to sustain its current (inflated) level of exports.
China doesn’t just have a $1 trillion in reserves. It has put itself on a course that requires adding at least another $1 trillion to its reserves over the next four years. I actually suspect the pace of Chinese reserve accumulation might pick up to around $300b a year, which would imply Chinese reserve would hit $2 trillion in 2009.
Basically, I suspect that China will need to keep financing the US (on subsidized terms that imply losses for the PBoC) even after the pace of Chinese export growth slows – just to sustain its already high level of exports.
That raises another point where I think I differ from DeLong. DeLong argues that China’s policy of using the balance sheet of its central bank to subsidize its exports has generated a permanent increase in China’s income. I would argue that it more likely has pulled China’s future export growth (and investment growth) forward – very, very rapid export growth now will likely be offset by far slower export growth in the future. And very, very rapid investment growth now likely will be offset by far slower investment growth in the future. That means a higher level of income now, but not necessarily a higher level of income in 10 or 20 years.
Given the size of the PBoC’s balance sheet -- $1 trillion is a bit under 40% of China’s GDP – and the impact China has had on the world economy, these questions obviously matter, for both China and the world.