I have heard it said many times that China’s economy is likely to be resilient as it is sitting on huge foreign exchange reserves. The argument goes that should the Chinese banking sector run into trouble, the government will simply bail it out through sales of its trillions of dollars of US treasuries, accumulated over the last couple of decades.
Nothing could be further from the truth.
In order to examine the ability of the government to utilise these foreign exchange reserves, it is worth examining the mechanism though which they were accumulated. It goes something like this:
Chinese exporters sell goods to the rest of the world – particularly to the US. In order to pay for this, the US consumers use dollars, many of them freshly minted by the US central bank.
Chinese exporters now have dollars which they exchange for Renminbi at the commercial banks. The commercial banks then exchange the dollars for freshly printed Renminbi at the Chinese central bank. These dollars are then warehoused at the central bank and not spent. The purpose of the Chinese government in doing this is to keep its currency weak against the dollar.
However, the point of this is that expansion of the domestic Renminbi money supply is dependent upon additional dollar flows. It was this constant increase in new dollars that for many years resulted in the domestic monetary inflation within China.
More recently however, the flow of dollars has not been nearly so strong. When adjusted for overseas debts, the accumulation of new dollars since the financial crisis has been fairly lacklustre. In order to maintain the rate of increase of money in China since the crisis, the government has, therefore, commanded its domestic banks to increase lending through the normal fractional reserve trickery we have seen globally, thus leading to the credit boom we have witnessed in the domestic economy in China.
The point of all this is that any reduction in foreign exchange reserves in China necessarily results in a reversal of the process above – i.e. a reduction in the outstanding number of Renminbi in the system; the dollar reserves are the reserve base of the Chinese central bank and all domestic money is pyramided on this monetary base. Given that the Chinese economy is precariously dependent on overvalued real estate, induced by a credit bubble, this policy option is – therefore – effectively closed for the Chinese government.
Conceivably the Chinese government could diversify out of US treasuries into another currency. There has been some talk of it buying European sovereign debt in order to support the European governments in their increasingly desperate attempts to preserve the Euro in its current format. They can’t – however – afford to lose these reserves on an ill-conceived gamble as this would undermine their own domestic money supply, so Eurocrats hoping for Chinese peripheral debt-purchases may be disappointed; China would need some hefty guarantees.
The most likely course for China remains –therefore- that its domestic bubble will run its course and end like all bubbles: with a crash.