The People’s Bank fo China continues to amass huge levels of foreign currency reserves with little attention paid. Those reserves totaled $2.4 trillion as of December 2009, which is larger than the GDP of Italy, the world’s 7th largest economy. China’s reserves are growing at about $400 billion per year, roughly adding Norway’s economy to their reserve surplus every year.
These reserves are generated from structural imbalances in the world economy, with China running huge trade surpluses which are exacerbated by China’s currency peg. To keep the currency within a narrow range, China is forced to buy foreign currency that comes into the country. The Yuan it spends to buy foreign cash is added to the funds sloshing around China’s banking system. In addition, the foreign currency that the Bank of China holds is then reinvested, mostly in low yielding investments like US Treasury Bonds. In fact, China is the largest holder of US Treasuries. The Yuan flowing around the banking system is causing some to wonder about inflation and asset bubbles. Some market participants are taking notice of bank loan growth and Urban real estate markets. Chinese officials have taken steps recently to slow loan growth and to potentially slow inflationary pressures. We’ve seen the market respond with the Hang Seng Index falling over 11% over the last month.
China’s huge arsenal of reserves is increasingly troublesome. William Pesek of Bloomberg has called it a “massive and growing pyramid scheme.” China is essentially trapped in its current arrangement; as it buys more US Treasuries, it becomes harder to sell them without causing huge capital losses.
The challenge for China alone is like trying to park an Airbus A-380 super-jumbo in a Volkswagen. Like all pyramid schemes, there’s no easy end in sight and things could end badly. If the dollar collapses, panicked selling by central banks looking to limit losses would shake global markets more than the U.S. credit crisis has.
Two, reserves are dead money. The wisdom of currency stockpiling came from the chaos of 1997. Speculators sensed authorities in Thailand were sitting on few reserves, and they were right. Their attack on the Thai baht set the stage for an Asian meltdown. Governments spent the 2000s determined not to repeat the mistake.
Three, reserves add to overheating risks. When policy makers buy dollars, they need to sell local currency, increasing its availability and boosting the money supply. Next they sell bonds to mop up excess money in economies. It’s an imprecise science that often leads to accelerating inflation. The strategy works out to be an expensive one.
History has not been kind to economies that have amassed such huge foreign currency reserves. According to Professor Pettis, author of China Financial Markets, there have been two prior periods in which a country has amassed such large foreign reserves; the United States in the 1920s and Japan in the 1980s.
The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP.
The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP.
Both of those periods in time ended very badly. The United States plunged into the Great Depression and Japan has experienced nearly 2 lost decades with virtually non-existent economic growth and asset price declines that have not even come close to retouching the levels of the late 1980s. As the chart below shows, China’s reserves are approaching 4% of World GDP. Will this end as badly as the prior two events? It seems unlikely that China fall victim to the same lost decades that were experienced in the US and Japan. However, this “bubble” in reserves may be an indicator of an economy overheating. We are starting to see the early warning signs in other asset classes in China.