Source: www.asiaecon.org |

China and Its Changing Dollar Policy

Chinese Premier Wen Jiabao announced on January 20th that China plans to make greater use of its nearly $1.07 trillion foreign currency reserves.  The plan calls for the diversification of foreign exchange reserves away from dollar-denominated assets, and the announcement has fueled speculation about the value of the dollar.  China…

Chinese Premier Wen Jiabao announced on January 20th that China plans to make greater use of its nearly $1.07 trillion foreign currency reserves.  The plan calls for the diversification of foreign exchange reserves away from dollar-denominated assets, and the announcement has fueled speculation about the value of the dollar.  China has become one of the largest holders of US dollars and Treasury bills, and an abrupt policy change could have significant consequences for the U.S. economy.  On the other hand, spending the foreign exchange surplus could address the imbalances in the Chinese economy and better position the country for future growth.

An Issue of Imbalance
The Chinese government has become increasingly concerned over imbalances in international trade and in the domestic economy.  The Chinese trade surplus now totals over $14 billion and foreign currency reserves have grown by about $20 billion a month.1  Most of these currency reserves come from trade surplus and foreign direct investment.  Analysts say China should not acquire foreign currency reserves more quickly than can be used for productive modernization.  The large surplus of foreign currency has allowed extensive lending and large investments in construction and the residential sector.  The central government now wants to slow the rapid, unsustainable pace of growth and hopes to cut back bank lending and scale down investment in saturated sectors. 

Using Reserves
There are several suggestions for how China can use its foreign currency reserves.  Yu Yongding of the People’s Bank of China has encouraged government officials to expand China’s energy holdings.2  He and others think China should buy oil stocks to help with the country’s energy needs and to hedge against a sharp decline in the dollar. But China could go other directions.  The $1.07 trillion surplus could enable China to become the preeminent global military power.  The Chinese government seems most concerned with strategic priorities.  Financial goals do not factor as much in monetary policy.

Addressing Imbalance
The most prudent use of the foreign reserves surplus would entail addressing the central bank’s bad-debt problem.  The People’s Bank of China has made several poor loans.  These bad-debts can jeopardize the bank’s long-term liquidity, and the problem presents a serious obstacle to future growth.  Another, equally prudent measure would address the divergence between urban and rural areas.  The spread of economic growth has been very uneven, and the Chinese interior has lagged far behind the coast. The Chinese government could use the $1.07 trillion surplus to restructure the financial system and to extend infrastructure, education, and healthcare to these less developed regions.  Doing so would help address the growing rural resentment toward the government and thereby remove a major threat to political stability.

Acting in Context
However, there will be challenges to any change in the Chinese dollar policy.  The United States does not want a dollar sell-off and so will likely protest any attempt to diversify China’s foreign exchange reserves.  China must therefore be careful how it approaches its currency problem.  Relations with western countries are already strained due to yuan appreciation disputes.  China does not want to further jeopardize these relationships.  Thus, the most tenable solution is to focus on domestic development while addressing internal imbalances. 

Source: www.asiaecon.org |