China's dollar reserves dilemma

China's massive accumulation of dollar reserves, now more than $2 trillion, has been the focus of much attention and speculation abouts its possible impact on the world economy. The expanding trade surplus coupled with the Chinese Central Bank's dollar purchases to keep the renminbi from appreciating have contributed to this accumulation of reserves.



Chastened by the bitter experience of the East Asian currency crisis of late nineties and in the absence of sufficient depth in the dometic capital markets, the Chinese Central Bank has preferred to plough these massive reserves into the safety and liquidity of US Treasuries, despite their relatively meager returns. However, this massive dollar reserves have become a major source of concern for the Chinese, especially in view of the cloud hanging over the fortunes of the US Dollar. To re-phrase the old adage, this massive Chinese loan to finance America's deficits is now more China's problem than America's!

With the renminbi tied to the dollar, China remains stuck with these dollar investments. If they exit now, apart from the problem of finding appropriate alternative investment avenues, they also run the risk of unleashing a downward spiral in these markets thereby bringing the value of their investments crashing down. Repatriation of capital on such large scale would also bring deep instability to the forex markets.

Paul Krugman makes the interesting point that any Chinese recalibration of portfolio from US Treasuries into other currency holdings (say, Euro or Yen) "would, in effect, be engaging in quantitative easing (QE) on behalf of the Fed" and "doing the Europeans and Japanese a lot of harm"! The classic QE would consist of the Fed selling Treasury bills, while buying other assets (mortgage-backed securities; securities backed by credit-card debt; longer-term government debt etc), and expanding its balance sheet enormously in the process. Now instead of the Fed, the Chinese would be indulging in QE by selling US Treasuries. And the flight of such huge quantity of capital over a short time from dollar into another currency would certainly put upward pressure on it.

Paul Krugman argues that China's weak currency, beggar-thy-neighbour policy is "siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere".

Update 1
The Peterson Institute estimates (pdf here) that the renminbi is 40% under-valued against the dollar. Simon Johnson also points to the proposect facing forex speculators - the inevitability of renminbi rising against the dollar, coupled with the low interest rates in US and China's rapid rates of growth, means that capital inflows into China and long positions in renminmbi assets are a one-way bet!

Update 2
Martin Feldstein too argues in favor of CHina letting the renminbi rise in value to redress the global macroeconomic imbalances.