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How can China use its foreign reserves to help?

David Dollar's picture

A reader of the blog sent me the following interesting comment and question:

You wrote in your blog entry ("China’s growth surprises on the downside"): 'Because China saved during the boom times -- through a fiscal surplus and through reserve accumulation -- it has considerable scope to stimulate its economy if the global slowdown threatens a hard landing in China.’ I'm always intrigued by these references to China's reserves. As I follow the financial press and websites like yours, I never see any explanation of how China would use its forex reserves to help itself (or the help the world recover from the economic crisis). I have seen, however, that China has already invested the bulk of those reserves in U.S. government bonds, leaving it with little scope for any other kinds of action involving these sums. [Recently], news reported that China has surpassed Japan as the largest holder of such bonds. Can you comment?

China’s saving through a fiscal surplus puts it in a good position to directly stimulate its economy through public spending. It has low debt and could stimulate the economy a lot without raising fears of indebtedness and inflation. As implied by your comment, foreign reserves are trickier to use. China cannot spend these directly on its domestic economy without first converting them to Yuan, which would have the kind of large effect on the exchange rate that the country wants to avoid.

There are indirect ways that the reserves can be used, however. As you say, currently the bulk of reserves are in U.S. government bonds. Any large-scale move out of those bonds would be destabilizing. But China is set to continue to accumulate $400 billion-or-so per year in new foreign exchange reserves. China can use some of this flow to help the liquidity needs of other developing countries that need to borrow foreign exchange; it could do this directly or indirectly by augmenting the lending capacity of the IMF or World Bank. It also recently used some of the reserves to recapitalize the Agriculture Development Bank. This capital injection increases that bank’s ability to finance agriculture and rural development in China. The reserves can strengthen the capital base of that or other banks without being converted into Yuan.

Editor's note: Ask questions about China's economy to David Dollar and World Bank senior economist Louis Kuijs in a live online chat on Monday, Dec. 1 at 8 a.m. EST (13:00 GMT/UTC and 9pm in Beijing).


Submitted by AJS on
Do you have any response to the NYT article "China Losing Taste for Debt from US"?(Bradsher). China's exports are slowing, FDI has fallen, and there is significant outflow of money to Hong Kong. Is it possible that the amount of China's investment into US debt will actually fall, just as the US embarks on huge stimulus plan and associated deficit expansion? What sort of implications could this have? An increase in interest rates? "Fitch Ratings, the credit rating agency, forecasts that China’s foreign reserves will increase by $177 billion this year — a large number, but down sharply from an estimated $415 billion last year." AJS

I found the title and content of the NYT article quite surprising for two reasons. First, the US is going to increase its fiscal deficit to provide stimulus to its economy. The US does not need foreigners to finance this, just the opposite. To the extent that foreigners finance it, the package provides stimulus to their economies, not to the US. So, from the point of view of stimulus, the US administration should prefer that foreigners lose their appetite for US assets. In that case the US dollar would devalue sharply, imports would drop, and US demand would be met by US producers and workers. Admittedly, if the adjustment were too sudden that would be disruptive, but the notion that the US needs foreigners to finance its stimulus package seems odd to me. Second, I do not see much diminished appetite for US assets on the part of Chinese firms and the Chinese government. We are projecting an even larger trade surplus for China in 2009 than in 2008. True, China’s exports have declined sharply in the past few months; but imports fell even more, partly because the price of the big import item – petroleum – has dropped so much. So, recent monthly trade surpluses have hit new records. The trade surplus is the main source of China’s overall balance of payments surplus; capital flows are small in comparison because of pretty effective capital controls. The authorities say that they do not want sharp appreciation of the yuan; given the ever-larger trade surplus, that means they have to buy large quantities of US treasury bonds. My own view is that China’s large trade surplus is not in the country’s interest, just as such a large US trade deficit is not in that country’s interest. So, the best hope is that we will see gradual resolution of these imbalances.

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