China: Three Times a Trillionaire!

China recently announced that their FX reserves have gone past the 3 trillion USD barrier in March, and has hit 3.044 trillion USD at the end of the month. The growth from the previous month was about 146 billion USD. Here’s a nice little pie chart to show the distribution of China’s FX reserves:

China's FX Reserves Composition Pie Chart

Do you know how big 3 trillion USD is? According to The Economist, if China wanted to, it could buy approximately 88% of this year’s global supply. Heck, if I had that much money, I would buy myself 6,000,000,000 iPad 2s or 1,875,000 Bugatti Veryrons (Yes, I want more than one)!

The huge jump in reserves was the result of two main reasons.

First on the list is the large inflow of “hot money” – very liquid, short-term investments for the non-nerds – to China. After the Federal Reserve announced that it would do another round of quantitative easing, it was very easy for investors to acquire capital that they could invest elsewhere (i.e., China, Brazil, and other emerging economies).

Second is China’s persistent buying of dollars to keep the yuan’s valuation versus the dollar stable. Remember, the yuan is a dollar-pegged currency, which means they NEED to purchase dollars to keep the yuan’s exchange rate artificially low.

The biggest problem for China in filling up its piggy bank with so many dollars is that it will harder for it to rebalance its economy.

For one, it makes it difficult for the People’s Bank of China (PBOC) to exercise a monetary policy that’s independent from the wants of the government. By undervaluing the yuan in order to keep Chinese exports competitive, the central bank doesn’t completely have free reign to play with interest rates to keep inflation in check.

For example, the PBOC has been forced to resort to hiking the Reserve Requirement Ratio (RRR) for the fourth time this year in an attempt to reel in inflation.

Remember China’s 12th five-year plan which I outlined last Friday? Well, another consequence for the country’s ballooning reserves is that it makes it harder for the Chinese to shift the focus of economic growth away from foreign investments and exports to the private consumers.

Take note that a weak currency means lower purchasing power. This translates to consumers needing more yuans to acquire products from abroad.

And it doesn’t end there, no sir! China also runs the risk of tilting the balance of the global economy. If one day it decides to diversify its reserve holdings away from U.S. Treasury bills, say into euro government bonds, U.S. dollar may lose its international reserve currency status.

I know that Justin Bieber’s voice will most likely develop first before this scenario unfolds. However, let’s not forget that imbalances helped spur the financial crisis and this may just lead us to a new one. Yikes!

Most economic gurus agree that China’s accumulation of reserves imply a hefty cost for its domestic economy and the possibly the global economy as well. As of late, growth in the country seems to be so heavily-dependent on exports especially for generating jobs.

If policymakers don’t do anything about it now, the economy will only grow more dependent on these imbalances that eventually they would become a part of it. So I guess the only question we have to ask now is, how long will Chinese policymakers sit on their hands?

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