Chinese money creation: why the Chinese central bank’s reserve position is no defence.

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.



  • Ray Daniels says:

    I’m completely ignorant on the subject of China, so if anyone could help me little on a couple of points it would be appreciated.

    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…

    The implication being that the trouble the Chinese banking sector would run into would be Dollar denominated. Otherwise how would the sale of T-Bills help?

    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…

    I can see that buying Dollars from the central bank with Renminbi would reduce the number of Renminbi in the system, but otherwise I don’t see the mechanism. If the Chinese government wanted to cash in some T-Bills to buy GM, for example, how would that reduce the number of Renminbi?

    Thanks for any enlightenment.

    • Dan Mosley says:

      Ray, taking your points in reverse order: As I understand it, if the Chinese government wanted to cash in t bills to buy GM then this would have no effect on the number of Renminbi. All that is happening in this case is that China is swapping one US asset (t bill) for another (GM stock). 

      And on your first point, as far as I know the Chinese banking sector does not have much dollar denominated debt due to strict capital controls – see my post below for my criticism of the article. 

  • I fail to see why money creation by the Chinese central bank is dependent on its dollar holdings. E.g. Tim Lucas says “dollar reserves are the reserve base of the Chinese central bank and all domestic money is pyramided on this monetary base.”

    Any central bank in the World can print money at will. (Whether they SHOULD is another matter) Alistair Darling created £60bn at the click of a computer mouse for the benefit of RBS and HBOS at the height of credit crunch. As far as I now he didn’t worry about the dollar holdings of the Bank of England when doing so.

  • Dan Mosley says:

    There are a number of things wrong with this article. Firstly, the expansion of the Chinese money supply is not at all dependent on additional dollar flows. If China wanted to expand its money supply without purchasing dollars, all it would have to do would be to lower reserve requirements at its commercial banks or buy domestic assets. As Ralph points out, China’s central bank can create as much money as it wants. 

    So when it is said that “expansion of the domestic Renminbi money supply is dependent upon additional dollar flows” this is simply not the case – yes, if the central bank sells a US bond for yuan then this will decrease the money supply, but those yuan can then be used to purchase a domestic asset, which nullifies the effect on the money supply. 

    In addition, it is said that “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”. Again, not the case – PBOC have been raising reserve ratios at commercial banks to contain inflationary pressures throughout the crisis. 

    • Tim Lucas says:

      Dan – you are right in saying that the Chinese central bank can simply lower reserve requirements or buy domestic assets in order to expand its money supply. It is not in dispute that there are various ways of expanding the money supply. The purpose of the article was to demonstrate that deposit of dollars into the commercial banking sector is one mechanism through which growth in money supply occurs. Indeed it was the principal one prior to 2008.

      There is currently a great deal of concern that the Chinese banks have over-extended and I have heard many times that the “strength of the Chinese fiscal position” wrt to its overseas FX reserves ought to insulate it since these reserves can be used to plug any gap. I would contend however, that this is incorrect as the expansionary effect of more renminbi has already been felt as a result of the creation of dollar deposits within the Chinese banking system. This has resulted in an expansionary effect through the fractional reserve system such that the outstanding private dollar debts held against long-term illiquid assets of dubious quality far outweigh the size of the reserves held at the central bank.

      Your other point Dan – that the Chinese government has been raising reserve ratios of late – I would make two comments here:

      Firstly, it is entirely accurate that when dollar flows reduced in 2008 the rate of Renminbi money supply growth and in response to this the Chinese government ordered its banks to lend. As a result, bank loan books grew at some 30% that year against a backdrop very poor investment opportunities.

      You are right now in saying that the Chinese have been increasing reserve ratios. However, the Chinese government itself has redefined loan growth to include various other routes of creating credit, through letters of credit, private trust funds for example. When these are included in the mix, loan growth in China has slowed down not one bit, with total social financing growing at greater than 30% both last year, the year before, and this year has likely been running at similar rates until very recently.

      As a result of this phenomenal credit growth (note that 30% credit growth is managing to create only 8% growth in GDP…how long can this go on before the debts become unmanageable), the country has seen a domestic boom – sky high house prices with large increase in the supply of new housing. The growth in money supply took place firstly through the mechanism I outlined and then through straight bank credit creation.

      Should the flow of new dollars decline, then this is one mechanism though which the growth in Renminbi in the system would slow (yes, there are others). Any slowing of growth in the supply of Renminbi is likely to result in an asset crash.

      In support of this argument, look over the past few weeks – the trade-weighted dollar has rallied. Coincidentally, Chinese housing companies are finally going bust, and prices of housing is down some 20% across various different regions in China.

      • Dan Mosley says:


        I would argue that the creation of renminbi from dollar accumulation has not been a significant problem for China thus far. The People’s Bank of China (PBOC) is an inflation targeting central bank, and as such it will create sufficient money base to maintain its inflation target. Until 2003, the expanding money base from dollar purchases was not a problem, as China’s economy was growing quickly and the expanding money base was accommodating that growth, keeping a lid on inflation.

        However, after 2003 China’s dollar accumulation started to accelerate which threatened to cause inflation to heat up. The way the PBOC got around this was to issue sterilization bonds – basically mopping up the excess renminbi created through dollar purchases by issuing renminbi bonds. In this way the PBOC can maintain control of the money supply even though it keeps adding to its dollar reserves. So I think that China’s hand is not really being forced by accumulation of dollars; it still has mechanisms to control inflation and prevent money supply growth if that is what it desires. For example, if the flow of new dollars declined, the PBOC could buy back some of those sterilisation bonds to ensure that the money supply was not effected.

        I guess my point is that I don’t see the relevance of a lower flow of new dollars to a slowing in the growth of renminbi and consequent asset crash (although you may well be right that credit growth is causing an asset bubble).

  • Rob Thorpe says:

    I agree with Dan’s criticism of Tim, and I agree with Tim refinement of his position.

    In central bank systems that target interest rates people tend to think of interest rates as the variable controlled by the central bank. Bear with me this is relevant :). Ralph used to tell us that if the profitability of creation of money by commercial banks increases while the interest rate stays the same then the money supply will increase. That is true, “Horizontalists” have used this fact to argue that the central bank doesn’t control the money supply. That’s true, but only in the very short run, the central bank controls the amount of outstanding reserves and the reserve ratio. Through these tools it has a great deal of effect on the money supply over a slightly period of time, that’s what the horizontalists forget. (Just like in the very short run I control the amount of internet bandwidth I use, but over the period of a month my ISP controls it by charging me a huge fee if I exceed my cap. Central banks also don’t control interest rates in the very long run, but that’s another story)

    The same sort of thing is true of foreign exchange rates. It’s wrong to think that when a central bank controls the exchange rate that it’s controlling that variable directly. Central banks never do that, whether they target NGDP, money supply, interest rates or forex rates they do so indirectly by controlling reserves and reserve ratios.

    It appears that “expansion of the domestic Renminbi money supply is dependent upon additional dollar flows” because the Chinese central bank is targeting exchange rates. But, in the long run the relationship won’t hold, the central bank will expand and contract when they like as other central banks to, they have enough Chinese assets to do that.

    I think that Chinese property could well be in for a crash too. This could happen no matter what happens to the commercial banks. Property prices can go down even if all the commercial banks are saved at little cost to the taxpayer. I’m a bit of an Austrian traditionalist here. The problem is account falsification and money illusion. The central bank have created lots more money than is demanded, as a result there is high price inflation in output and assets. Once expectations of the real interest rate settle down there will be a crash. That is, once investors realise that high nominal returns will probably be washed out by future price inflation asset prices will fall. It’s mostly a domestic issue not an international one, though it may have international repercussions.

    • Dan Mosley says:


      You say that the Chinese central bank is targeting exchange rates. But the Chinese central bank actually targets inflation like most other central banks.

      The usual method for targeting exchange rates is for the central bank to buy and sell its own currency on the market until the desired exchange rate is reached. In this case, the central bank can be said to be targeting an exchange rate. But I don’t think that this is what the PBOC does. It simply makes it illegal to trade dollars for renminbi at any other rate than the one it sets. This is only possible because of the strict capital controls in place in China.
      So when a Chinese exporter earns dollars from selling to the US, as Tim points out the only thing the exporter can do with those dollars is trade them for renminbi at the official rate, which is the rate determined by PBOC. It is not set by the market as such.

      What this means is that the PBOC can pursue an independent monetary policy which is not tied to achieving an exchange rate – i.e. it can target inflation just like most other central banks. But it can only do this through the imposition of capital controls. If those exporters were free to sell their dollars for renminbi on the market, the renminbi would appreciate (if the money supply were not increased).

      • Rob Thorpe says:

        You’re right. China can target the exchange rate using capital controls alone and use monetary policy for other purposes, such as targeting the price level. They don’t seem to be doing a very good job of targeting the price level though.

        I’m a bit sceptical about whether this capital controls business really works, but that’s a subject for another day.

  • John Dreiling says:

    All of your comments have been valid and informative. I haven’t followed the Chinese business situation for several months and all of these thoughtful comments did a great job of bringing me up to date.
    China’s problem will always be the Communist Party’s stranglehold. Personally I have a great faith in central banking’s and central government planning’s ability to destroy whatever prosperity a somewhat free market may bring. China has only been doing well in comparison to its communist past. It really dosen’t have that much of a free market. The CCP lunges forth with huge macro-projects whose true value has not been set by valid free market pricing sensibility. These big projects will likely end up a burden along with the government corruption and their mercantilistic/Keynesian economics. I wish the Chinese people well, but I fear their time is running out. Perhaps there is hope though. After all, it was Chinese students who laughed at Geithner’s promise of fiscal responsibility.
    After complimenting your comments on their usefulness, I find that I am rambling out my opinion about things you undoubtedly know. I mainly wanted to say hi from Colorado and wish you in the U.K. good luck.
    Websites such as this one (and Mises.Org) are presenting thoroughly rational economic sensibility that will appeal to any of the world’s people who wish to survive and prosper economically.

Comments are closed.