Thursday, September 21, 2017

China’s Massive Foreign Reserves are a Threat to the US Dollar


China has accumulated a large pile of foreign reserves, the equivalent of $3 trillion. This accumulation, perhaps over $2 trillion of it in dollars, is the consequence of past currency management, the objective having been to enhance the profits of Chinese-based manufacturers exporting to other countries. The early development of the Chinese economy was just an initial phase that encouraged strong flows of inward investment followed by net exports. Furthermore, the Chinese are avid savers, putting aside as much as 40% of their earnings, leading to large and persistent trade surpluses.

On the ground, Chinese economic success has brought substantial improvements to the lives of China’s population. The economy is now being refocused towards services and technology, maturing from its export-led model into a fully-fledged advanced economy with a rising middle class. Furthermore, China has a requirement for enormous quantities of raw materials to satisfy her infrastructure plans, which encompass the whole of Asia.

The need for holding large quantities of dollars, the result of neutralising capital inflows and then suppressing the yuan for export price competitiveness, has now passed. China requires far more modest dollar balances, so she will almost certainly invest them in stockpiles of base metals and the raw materials required for the future. This change in policy is already evidenced by the yuan rising against the dollar by over 7% this year, cheapening commodity imports by this amount compared with dollar prices.

There can therefore be little doubt that China will be a big seller of dollars in future. Her problem is if she is too aggressive in this policy, she will trigger selling by other Asian central banks, and could even risk having her $1.1 trillion holdings of US Treasuries frozen by the US Government. She must tread carefully, unless it suits her to become more aggressive in an escalating financial war. Her policy therefore, is likely to be a seller of dollars into strength rather than weakness. The consequence for the dollar is any price recovery is likely to be capped, and therefore limited in scale and duration.


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