How can China use its foreign reserves to help?

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).