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There are two kinds of foreign reserves, one proactively created to defend the local currency against excessive devaluatoin, another passively created to keep the local currency low. They are opposite of each other in almost all aspects. Yet it's a sad statement about the market and society that so many people, including both those in U.S. and those in China of course, confuse the two. Joe Schmoe and Joe Li aside, are the politicians on both sides of the pond really that stupid, or are they deliberately trying to muddy the waters in order to sell something they wanted to sell? Perhaps more worrisomely, are the academics in both countries really that stupid, or is it they just don't have the guts to out the truth against popular sentiments? (My answer to both is "the latter" but that's beside the point.)

Back to China. I hope it goes without saying that China's foreign reserve is the latter type. What this means is that PBoC has little control over either the amount or the composition of its foreign reserve as long as it's tasked to maintain the trading bands in Yuan exchange rates. If and when the market wants to buy the Yuan and pushes it up against the upper bound, PBoC starts to sell the Yuan and buy whatever currencies the demands come in from. This is how PBoC ends up with a huge pile of foreign money, mostly USD, over the years.

To call for China to "invest the reserve money," "divest from the dollar," or "rein in its growth," or to worry about China doing any of these, shows gross misunderstanding of the subject matter. The P&L of the reserve is of no meaning outside the monetary policy context - PBoC is a central bank, not a for-profit entity. There's no reason to mess with the reserve composition except when anticipating future direction of intervention needs, which is highly uncertain and hardly worth the trouble and risk. The reserve is not money the government can freely tap into, as many in both countries mistake. I know this is hard to believe for many but the Chinese government does have a somewhat checked budget that is at least no worse than the Pentagon, FEMA, New York, or Greece-- how can anybody possibly do worse?

The notion of PBoC having to "sterilize" its dollar holding by buying U.S. treasuries is misinformed at best. They could just as easily sit on the cash dollar; again the interest income on the treasuries has no meaning to PBoC. But it's advantageous to them to recycle the cash into treasuries, effectively helping the Fed to sterilize the extra dollars in the global system, suppressing inflation pressure in the U.S., and financing Uncle Sam's spending habits. This doesn't change a bit even if the treasuries yield exactly 0 or even negative. It's a beautiful, mutually beneficial arrangement, criticism against consumerism or mercantilism notwithstanding. (PBoC does have to sterilize part of the Yuan sold but that's beside the point.)

But our politicians in their infinite shrewdness find it convenient to make China the scapegoat for their failure and corruption. And many a Joe Schmoe has been brainwashed into joining the circus of calling on China to revalue the Yuan. And Fed Chairman Bernanke has joined the fray recently as he threw away the technocrat labcoat and put on the politician tie. Bernanke's latest move has proven deadly effective, much more so than all the political noise. Yes! We will finally get the Yuan revaluation we've all been trying so hard to get for so long, any day now.

But what will we get, exactly?

The above analysis of PBoC's foreign reserve should make this question easy to answer. But a recent development adds to the clarity. China's purchases of U.S. treasuries were very high in Sept and Oct, then came to a screeching halt in November, right after the QE2 announcement. This is very easy to explain in light of the above analysis: The dollar was tanking pre-QE2 and flowing into China, forcing PBoC to buy up, which subsequently got recycled into treasuries; after QE2, dollar and yield both went up, hot money left China and headed for the US, PBoC didn't need to buy and recycle dollars anymore -- on the contrary, they might have had the unusual experience of defending the lower bound.

From this we can see what would happen if China revalues the Yuan, which I think is an increasing possibility as the domestic calculation for Beijing shifts due to rapidly rising inflation. Warning: those of you calling for Yuan revaluation may not like it.

1. Surging treasury yields and, along with them, Libor, corporate/muni bond yields, loan rates, mortgage rates. No conspiracy needed here; China doesn't have to sell any treasuries, just stop buying - it wouldn't make any sense for them to continue buying treasuries if they don't have to buy dollars, although they may sell if PBoC ends up defending the lower bound repeatedly. When a buyer of such magnitude and persistence goes missing, it's a huge shock to the market. This has already been demonstrated by the post-QE2 action but, relax, it's only a teaser. Mr. Bernanke, get your uber-bazooka ready to buy everything.

2. Extra inflation pressure from a sudden surge in global dollar supply. China has been a huge and very reliable buyer of dollars in the global system, which I think is a primary factor behind the mysteriously missing inflation in the U.S. since the '90s and especially throughout QE1. Now Uncle Ben has killed his staunchest ally. So Mr. Bernanke, get your 100% sure, instant inflation fighting bazooka ready, at the same time as you're busy with your uber-bazooka buying everything.

3. Extra inflation pressure from rising Chinese import price. Funny how Amazon commenters, when describing some faulty merchandise, never forget to casually mention "made in China" but nobody seems to mind flashing their iPhones and iPads (hint: yup, made in China duuude). I think the import price, of which China is the biggest component, is probably as important to inflation as commodities price, if not more. As the Yuan rises, with Chinese manufacturers already being squeezed to 2-3% profit margin, the import price will inevitably rise. And if you're thinking of finding an alternative manufacturing base to China, wake me up in five years. There's just no alternative base capable of offering the same breadth and capacity as China, and it'll take years to build one, if ever.

Few on both sides of the pond can look past the supposed ideological issues and see to the truth, or if they do, care to admit it. And the truth has been laid bare for all to see: Our collective hips are tied together as we have grown to be co-dependent partners over the past 30 years, and we both are intrusive, fascist (as in "state capitalism") governments.

Source: Dissecting the Chinese Foreign Reserve - Be Careful What You Wish For