Monday, October 29, 2007

China's Growing Reserves....

"China has accumulated huge USD reserves. How might these affect the US in future?" -Arun

China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.

In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.

I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.

The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.

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