A post on my personal blog, Saturday Morning Musings - fall of the US dollar, pointed to the growing mismatch between the pattern of currencies traded and the evolving structures of the world economy. There I said in part
All I am saying is that I feel that, in the longer term, traded currencies are likely to better reflect real patterns of economic activity. In the past, the reserve currencies (gold, sterling, the US dollar) facilitated global transactions by providing a measurable store of value in circumstances where other currencies were either not traded or were of uncertain value. The position today is different. Who can really say that the US dollar is a secure currency?
The types of changes that I am talking about will take time. However, that time may be less than we all expect.
This led a colleague (Denis Wright, an historian) to ask if I could write a simple non-technical explanation of the significance of China's foreign exchange reserves. It's actually quite an important topic, so here goes.
In the comments that follow, there are just two economic identities that you need to bear in mind.
The first is that if one country has a surplus on its balance of payments, another country or countries must be running an equivalent deficit or deficits. The reason for this is that one country's exports are other countries' imports. Globally, imports and exports must balance. If one country is selling more than it is buying, it acquires foreign exchange reserves. However, since imports and exports must balance in total, that means that other countries are buying more than they are selling. They must be running deficits that exactly match others' surpluses.
The second is that if you are going to buy more than you sell, then you have to fund the gap through borrowings or capital flows of some type. Otherwise, you can't buy.
Growth in China's foreign reserves
Initially China's foreign exchange reserves were relatively small, then they started to accelerate. The following gives an indication of scale:
|Year||Reserves $US billion|
The increase has obviously been quite dramatic, an increase of over $US 3 trillion in 20 years. To put this in perspective, Australia's total GDP is something over $US1,200 billion!
Why did China's foreign reserves increase?
There is a lot of argument on this one, but I think that we can simplify.
On the Chinese side:
- The country had a high domestic savings rate meaning that local cash was available for investment.
- The country had a large industrious underemployed workforce, meaning that low cost labour was available for new activities.
- The Chinese currency, the yuan or renminbi, was largely non-traded. The Government was able to keep the value of the currency low, facilitating export growth.
It takes two to tango. Elsewhere:
- Reducing trade barriers facilitated China's export growth.
- Savings rates in many developed countries dropped. With rising asset prices, consumers felt able to increase consumption by more than income, thus providing a growing base for Chinese exports. This was aided by tax cuts, placing more income in individual hands.
Increasing Chinese reserves necessarily flowed back into into developed countries. In a very real way, the Chinese themselves were funding their own exports.
China's reserve conundrum
The accumulation of large quantities of investable funds by a country is not unique. The British Empire, the economic superpower of the nineteenth century, accumulated such investment wealth that it took the rise of the US, a great depression and two world wars to wipe it out. However, China is in a different position.
One difference lies in the then power of the City of London. This marshaled surplus funds and channeled them round the world from mining companies to railroad investments, from the Russian Empire to Argentina. China has no domestic equivalent.
A second and critical difference is simply time. China's accumulation has happened very quickly. China has looked for ways of redeploying reserves via things such as a $US 300 billion sovereign wealth fund and direct overseas investment, but all these take time to build up. In the meantime, China has to put its money in deposits or some form of financial investment. Here it faces a problem
To illustrate this, have a look at the attached graph. This was included in my original posts and comes from one of my favourite bloggers, Stubborn Mule.
The graph simply shows the most important currencies in the world in trading terms. The Chinese authorities simply cannot invest their reserves willy nilly, but have to put them where they can be realised as required. This means they have very few short term choices.
To illustrate their problem further, consider the Australian dollar, the world's fifth largest traded currency.
According to newspaper reports (I don't have the links), China has decide to place 1.6% of its foreign reserves in Ozzie dollars or Ozzie dollar denominated securities. That sounds a tiny proportion, but it actually amounts to over $US51 billion. That's quite a large amount relative to the size of the Australian economy. You see their problem?
The immediate practical effect is that China is locked into holding US and especially US Treasury securities, something like $US2,000 billion. This makes what happens in the US kind of important to China in financial terms.
The longer term
In both the short and longer term, economic changes in China and its trading partners will affect the equation. I will discuss these in another post. For the moment, I just want to focus on what might happen to the Chinese reserves on the assumption that they continue to be significant. This links to the point that I made in my original post, about likely changes so that traded currencies better reflects the pattern of trade.
Here I want to point to just three things:
- As China globalises, its capacity to invest effectively in other countries will increase , thus shifting Chinese assets from financial to real investments.
- As more trade and investment is written in Chinese currency, the Chinese will be able to invest more in assets denominated in their own currency.
- The number of significant traded currencies will rise, making it easier for China to invest in a bundle of currencies, not just the US dollar.
If I'm right, these changes will have quite profound influences on the distribution of economic power and activity.