China’s foreign reserves policy

4 December 2011

An article on The New York Times titled China Signals Reluctance to Rescue E.U. was sent to me recently, and it was a rather interesting but also a quite disturbing read. The key paragraph, to me at least, in the article stated:

The Chinese central bank effectively borrowed the money from the Chinese public to buy the dollars, euros and other currencies that are in both funds. The central bank has forced commercial banks to transfer a fifth of their domestic deposits to it and has used that money to buy $1 billion or more a day of foreign currencies, so as to slow the appreciation of the renminbi against the dollar.

The article goes on to state that the Chinese central bank has also issued bills bearing low interests in reminbi, and pressurized the commercial banks to purchase them. The central bank then purchased foreign currencies with the proceeds, leaving it with a huge amount of domestic liabilities in renminbi, even if it holds a lot of foreign currencies and bonds.

Given some of the Chinese banks are far from healthy, and there are conflicting reports about the actual rates of growth and inflation in China, the situation may be more precarious than it is widely assumed. There are enough problems in Europe and the US, and if China were to implode economically or politically, then the world will be in a much more critical condition. Who knows? The world has been lurching from one crisis to another crisis, and nothing is certain.

Not being particularly proficient in economics (or at all if truth be told), this sounds like a very risky policy. The part that makes sense is that China is attempting to keep its currency cheap so that it can continue to export goods abroad, but it hardly seems a sustainable policy to keep on purchasing more foreign currencies. The other bits do not make much sense. The state, basically, seems to be syphoning off money from the people to the tune of 20% of commercial banks’ domestic deposits plus the low-interest bills, and purchasing foreign currencies that in future will probably be worth less, because renminbi is likely to appreciate against the other currencies over time.

The Chinese central bank is gambling with a huge amount of money. In a strange way, the debtor, in this case the US, seems to be in a more powerful position than the creditor, China. If things were to go really pear-shaped in the US, there may be even more terrible consequences in China than in the US. In such an instance, the Chinese banking sector will probably collapse, because the central bank basically will have gone bankrupt, possessing insufficient assets to cover the renminbi liabilities.

Or perhaps there is a brilliant policy somewhere that is not within my grasp?