China has now accumulated more than $1 trillion in foreign exchange reserves. Crossing this symbolic threshold has led many to underscore the destabilization potential of the situation.
First, how did this come about? Chinas trade has expanded enormously. Imports have risen from $160 billion in 1999 to about $800 billion in 2006, exports from $200 billion to $950 billion. Chinas current account surplus rose dramatically during 2005, as the government deliberately tried to slow domestic investment spending. Chinas surplus for 2006 is estimated at over $200 billion a big number, but far lower than the corresponding deficit in the U.S., at $857 billion.
A country with a current account surplus is usually faced with excess demand for its currency by foreigners, and its value may see upward pressure. In theory, when this happens, the surplus countrys exports begin to slow, and its imports pick up, thereby narrowing the surplus.
Chinas authorities, however, peg the value of their currency, although in the past 18 months they have allowed a modest 6-7% appreciation. To limit the currencys rise, they issue as much new yuan as foreigners need to conduct their business in China, and accumulate the corresponding foreign currency in the central bank now over $1 trillion. By accumulating these reserves, the Chinese authorities have flooded their economy with the equivalent amount of new yuan.
The new yuan must go somewhere, whether into stocks, bonds, banks, real estate, mattresses or consumer spending. By choosing to control the exchange rate, the authorities give up the ability to control the domestic economy, particularly the inflation rate. It is very possible that, at some point, the newly-created domestic currency will prove to be too much for the economy to handle.
So far, inflation is not much of a problem in China, although the rate has been drifting up and real estate and stocks have been running hot. With inflation running between 2-3%, Chinas exchange rate peg cannot yet be declared unsustainable, but pressures may be building.
Two key release valves are reducing those pressures. First, it is estimated that 50-60% of Chinas exports come not from Chinese companies but from foreign companies operating in China. For these companies, exporting from China is an internal transaction, so the associated foreign exchange pressures are less than they would be were most exporters Chinese. Second, China is experiencing a veritable productivity boom as workers shift from the low-productivity agricultural or state-owned business sectors into new manufacturing activities, new economic value is created as if out of thin air. This new activity needs to be supported by a steady stream of new local currency in short, the money supply growth fills a growing demand, and is not inflationary.
The bottom line? China is in an asset accumulation phase of its development. If the Chinese authorities did not accumulate foreign assets, Chinas private sector would do so instead. Should inflation rise decisively, the yuan will be permitted to appreciate more rapidly, and reserve accumulation will ease or reverse. But the situation is less dangerous than commonly perceived.
Stephen Poloz is Senior Vice-President, Corporate Affairs and Chief Economist, Export Development Canada. His column on trade-related issues appears weekly on www.ctl.ca. Poloz will be speaking at the upcoming SCL annual conference.