Economics play a huge role in the foreign exchange market. I enjoy looking at economic trends and trying to see how it affect currencies and life in general. I will post my thoughts and observations here. I'm throwing macroeconomics, forex trading, pop culture, and everyday life into a pot and hopefully the final product are lessons that are easy for you to consume.
The King and Queen of Foreign Reserves
How did China and Japan amass such huge foreign reserves?
I’ve received a bunch of emails asking how China and Japan have such large foreign reserves. The simplest answer is due to international trade. Trading with the United States to be more specific. Let me give you an example:
Let’s say China manufactures shoes. The United States with all their shoe-loving consumers wants to buy $1 trillion worth of shoes from China.
The United States manufactures nice airplanes. China’s airline industry is rapidly expanding so its airline companies buy $500 million worth airplanes from the U.S.
So here's what happens...
The United States receives their shoes. This is the easy part of the trade.
Now China receives their airplanes. But because it’s not an even trade, the United States also provides a suitcase containing $500 million US dollars.
If you’re weak in math, this makes the trade equal:
$1 trillion dollars worth of shoes = $500 million worth of planes + $500 million cash
So what does China do with this $500 million bucks?
They can do three things:
- Convert US dollars to Yuan, their domestic currency
- Buy US-denominated stuff like US stocks, US bonds, US real estate, US businesses, LeBron James sneakers, Jay-Z albums, etc.
- Stash it as foreign reserves
China’s answer is usually the second and third choice. Unless there’s a blue moon out or hell freezes over, they try to avoid the first choice.
Why? They want their exportable goods to remain "competitive" aka be cheap as possible for buyers like the US.
If they converted their US dollars back to Yuan, they would have to sell the US dollars and buy Yuan. Doing this would cause the Yuan to appreciate in value. This would make everything made in China more expensive.
So for example, those $1 trillion worth of shoes bought would now cost $1.2 trillion to buy. The US dollar’s purchasing power in China has decreased.
Now here’s the kicker. One hop and skip away Is Japan. They can sell the United States the same shoes as China but it’d only cost $1.1 trillion. Guess who just lost a customer?
You can feel free to substitute Japan with another country but the point is this:
If your domestic currency appreciates, your exports become more expensive, and you risk your trading partners leaving and buying from someone cheaper.
For export-dependent countries such as China, Japan, and other Asian countries, they will make every effort to keep theirs goods "competitive".
This is why their stashes are so big. One can only buy so much US-denominated assets. You have to store the rest underneath your central banks' mattress.
