- Given the Chinese currency uses an artificial peg, these dollar reserves have limited domestic use in any kind of bubble or bank solvency crisis.
- We've talked a little bit in the past about how China is similar to Dubai on a larger scale, where central planning has created excess capacity in real estate and manufacturing, but it's important to remember this activity is often financed by loans from domestic Chinese banks. If there is any kind of meaningful decline in GDP, it could cause a bank solvency problem quickly.
- In any kind of serious domestic contraction for China, these foreign reserves have limited ability to actually alleviate domestic problems or shore up bank balance sheets. These reserves can be used to purchase foreign goods such as commodities or other goods but their domestic use is limited. i.e. The Chinese could sell U.S. assets then buy copper, aircraft, or computers, but that won't help make their domestic banks solvent.
- These kind of bubbles can take a long time to manifest themselves. Jim Chanos and others are calling for the bubble to pop but one can lose a lot of money waiting for it to happen right away. My guess is that this crisis starts due to export retaliation against China by ASEAN, the EU nations and the US all working together to stem Chinese import barriers and a mercantilist trade policy. If a crisis occurs, this is the most likely scenario to set things in motion.
- The Chinese need to gradually float their currency, while the U.S. needs to dramatically cut spending and consumer consumption. U.S. government spending needs to come down by about 25%.
China’s reserves are often thought of as if they were a treasure trove available for spending. They are not. They are simply the asset side of the mismatched balance sheet. If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100. To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes. Reserves are effectively borrowed money.
Can PBoC reserves protect China?
So the PBoC cannot give away the reserves without causing an increase in its net indebtedness. This is why I have often said, to the confusion of some of my readers, that Beijing cannot just recapitalize the banks with reserves. A substantial amount of NPLs will one way or another increase government debt. The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes. Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.
So what are reserves good for? As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China. This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically. It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.
Here is where a great deal of confusion arises. The US crisis of 2007-08 notwithstanding, we seem implicitly to believe that a financial crisis is always caused by an inability to repay foreign debt and investment, in which case having huge amounts of reserves certainly should protect a country from financial crises.
But this is only partly true. Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility). As I pointed out two weeks ago, there are many cases of countries with huge amounts of reserves that nonetheless suffered from all kinds of financial crises. It is just that they never suffered from external debt crises.
Disclosure: Long Chinese Currency