Who wants to be a trillionaire?

The Economist Oct 26th, 2006 | HONG KONG | from the print edition  

BY THE end of October, China's foreign-exchange reserves are likely to top $1 trillion, twice their level two years ago and more than one-fifth of global reserves. This handsome sum would be enough to buy all the gold sitting in central banks' vaults (indeed, twice over) or almost all of London's residential property.

China's massive hoard is the result of its large current-account surplus, significant inward foreign direct investment, and big inflows of speculative capital over the past couple of years. In theory, flows of foreign money into China should push up the yuan, but China has resisted this, forcing the central bank to buy up the surplus foreign currency. The growth in reserves has slowed in recent months, but it is still averaging a hefty $16 billion a month.  

China's official reserves already far exceed what is required to ensure financial stability. As a rule of thumb, a country needs enough foreign exchange to cover three months' imports or to settle its short-term foreign debt. China's reserves are equivalent to 15 months of imports and are six times bigger than its short-term debt. The explosion in reserves is also a headache for the central bank. It creates excess liquidity, which risks fuelling higher inflation, asset-price bubbles and imprudent bank lending.

There are two simple ways to stop reserves rising. China could set free its exchange rate or it could relax restrictions on capital outflows and allow private citizens to hold foreign assets. Significant moves of either kind seem unlikely in the near future. So long as China runs a large external surplus (the natural result of its high saving rate) and refuses to set its currency free, its stash of foreign currency will probably continue to mount.

How that money is invested has big implications for the world economy, not just for China. Brad Setser, head of global research at Roubini Global Economics, estimates that about 70% of it is invested in dollars, mainly Treasury securities. This has propped up the dollar and reduced American bond yields—by up to 1.5 percentage points according to some estimates. A big shift out of dollars could therefore push up bond yields and hence mortgage rates, damaging America's already crumbling housing market.  

China's central bank is thought to be switching from Treasury bonds to American mortgage backed securities and corporate bonds in an attempt to earn higher yields. Chinese officials have also discussed in private the need to diversify reserves out of dollars in order to reduce exposure to a big drop in the greenback. The bank may be putting a bigger slice of any increase in reserves into euros and emerging Asian currencies, but so far there is little sign of a shift out of its existing stock of dollars. One problem is that China's investments are so big that they move markets. Shifting money into euros would push down the dollar. China would then not only suffer a capital loss on its remaining dollar reserves, but it could also be forced to buy yet more reserves to hold its currency down against a weaker dollar

Fear of a capital loss, and dissatisfaction with unrewarding yields, have triggered a flurry of ideas on how to put the money to better use. One popular idea is to use some of China's reserves to buy oil and other commodities. The snag is that stockpiling oil would push up prices, yet absorb only a tiny proportion of the sums at China's disposal. Buying the equivalent of sixmonths' oil consumption, as has been suggested, would take only 8% of total reserves at current prices, but the extra oil bought would amount to three times the growth in global oil demand this year. Buying gold would have similar results: if China invested just 5% of its reserves in gold, it could buy the world's entire annual mine production.

Another proposal is to spend more money on infrastructure investment, which would yield a much higher return than American bonds. However, since China's investment already accounts for 40% of GDP, it is not clear that China needs more. Writing off banks' non-performing loans might seem more sensible. In 2004 and 2005 the People's Bank of China did indeed shift $60 billion to state banks. The remaining stock of bad loans is now around $250 billion, according to UBS.  

By buying American bonds, China is subsidising rich American consumers while China's health care, education and social safety net are starved of funds. So why not use reserves to relieve rural poverty, improve health care, or inject money into the under-funded pension system?  

Unfortunately, all of these proposals to spend money at home misunderstand the nature of foreign reserves. The problem is that conversion of the foreign currency into yuan would put upward pressure on the yuan and so force the central bank to buy yet more foreign currency to hold it down. Reserves would return to their original level.  

The only real solution to the poor return on China's reserves is to stop accumulating them. That requires policy reforms to reduce China's massive saving, which drives its current-account surplus, and a more flexible exchange-rate system. But before that happens, China's reserves could well hit $2 trillion.

1) Based on the article facts, why was China's massive hoarding of foreign exchange reserves the result of its large current-account surplus, significant inward foreign direct investment, and big inflows of speculative capital? Explain and motivate your answer.