China's Dilemma

In my previous post, I elaborated on the one of the point of debate that Dr. D. Subbarao (Governor, RBI ) discussed in his speech at RBI-BIS. In this post I am going to elaborate on his second point of debate. He believed most of the Asian countries especially China have held huge amount of foreign reserves as measure of self-insurance.Asian Economic Crisis in 1997 saw IMF impose strict conditions on bailout recipients.Most of these emerging countries felt that they hadn’t been treated fairly and thus to avoid themselves getting into such trouble they have maintained huge reserves. But is this self insurance viable policy? Is it serving the purpose?

India’s foreign reserve was more to do with capital inflows and with the crisis that turned negative and now we have deficit. China’s foreign reserve was from trade surplus and seems to be real. This would suggest that China should not face any problems at surface but that’s not the case. Problems are twofold. To earn this huge reserves China has made herself dependent on exports. Now this has become liability because the growth of your nation is now dependent on foreign economy for which you have no control. Current crisis exhibits the same problem.Next problem is are thess reserves for real?

There is a set of people who do not believe on Dr. D. Subbarao’s logic of self insurance. They believe China deliberately bought US dollars to manage the value of the yuan which provided the Chinese manufacturer cost leadership in market and thereby gain competitive advantage. In doing so China's foreign exchange reserves have increased from $216 billion in 2001 to $1.52 trillion in 2007, then $1.95 trillion in 2008, according to a Congressional Research Service (CRS) report published in March. Economists estimate that about 70% of those reserves are held in dollar-backed assets. These numbers on the face indicates the power China has over US by helping them finance their huge debt of $11 trillion. But then why does China not exhibit the same? Because the fact is that she cant without damaging herself. Lets look at Chinese investment portfolio. As risk averse nation it initially used to invest on US Treasury bonds which were considered risk free. Later on it diversified to riskier assets like investment in PE firm Blackstone and Morgan Stanley. They had bought $3 billion share worth $31 each of Blackstone whose value fall to $8 in October 2008. Similarly they had exposure to asset backed securities thus they lost of foreign reserves in such investments. Paul Krugman writes humorously in one of this article that they supplied us with poisonous toys and we gave them false assets so its like what you give you get. China subsequently purchased $44.5 billion and $65.9 billion of U.S. Treasury securities in September and October of 2008.Now China’s huge reserves are in form of US dollars and US bonds. If they starts to sell their dollar reserve then there is none presently in world to buy them thus it would bring value of dollar down. This implies value of China’s foreign reserve would also decrease by similar amount.To invest in its own country also she would have to sell dollar and buy RMB which would appreciate its currency and depreciate dollar.This would again affect its exports which have already dipped. If it does nothing then worry is that the value of the US bonds would decrease significantly due to rising inflation.

Thus China is in huge dilemma with what can be done with its huge foreign reserves. Neither can it invest nor sell. It would be great if some of the valuation guru’s of the world try to find the true value their foreign reserves. Further to add to her woes there is no other currency on which China can rely upon. So recently China has voiced the need for new global currency and its concerns about any action taken by US government which affects value of US dollar.So I still ponder is China really rich? Was her export oriented policy not correct? Is success story of China just limited to its even more reliance on US? In this struggle to be global powerhouse who has edge over other US or China? Co-opetition at its best.