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China's trillion dollar surplus

Analysis

By Steve Schifferes

BBC News economics reporter

China's currency is undervalued, say many of its trading partners

In November China will achieve a new milestone in its economic development when its total foreign exchange reserves reach $1 trillion.

As of 1 October, China's central bank announced that its reserves were $987bn - and they are growing by $18bn each month.

See how foreign currency reserves have grown

That sum is the largest holding of foreign exchange reserves in the world - and more than the annual value of economic activity in all but a handful of the world's big economies.

The huge surplus is a product of China's success as an exporter to the world.

China sells the world more than $100bn yearly in goods than it buys, with the imbalance especially marked with the US.

As a result, China receives more and more foreign currency each year, which it puts in its reserves.

But China's currency reserves are now so large that some economists fear they will unbalance the entire global economy.

Grip on US

Foreign currency reserves are generally seen as a good thing - it is the lack of reserves that means that countries might suffer runs on their currency, as Britain did in the 1970s.

But China's surplus is much more than China needs to cover its exports, or pay for its own investments abroad.

And China has mainly invested its foreign currency reserves in long-term US Treasury bonds and other government securities.

Brad Setser, a former US Treasury official, estimates that China now holds $700bn in US long-term bonds, enough to lower US long-term interest rates by 1.5% - which helped stimulate the recent housing boom.

But those holdings are a double-edged sword.

If China attempted to diversify its holdings, it could cause a collapse in the value of the dollar and higher inflation in the US.

That would also lower the value of China's own reserve assets - so China is only slowly moving out of dollars and into other currencies such as the euro.

However, it also ties the fate of the US economy to China.

Worries for China

In economic theory, China's currency should rise in value since it has such a big trade surplus and currency reserves.

The world wants China's cheap goods - and is paying in dollars

That would make its goods more expensive and cut the trade surplus.

But China's economic growth is highly dependent on exports and investment, with relatively little coming from domestic consumption.

So the Chinese government wants to keep the value of its currency, the yuan, fixed at a rate tied to the US dollar (with a 3% variation allowed).

This helps boost foreign investment but makes it more difficult to control inflation.

In the long term, China wants to switch the emphasis in its economy to domestic demand.

But that will take time - and in the meanwhile the currency reserves could double to reach $2 trillion in a few more years.

Foreign investment

Some economists argue that the pattern actually benefits both the US and China.

The US gets a cheap and stable source of funding for its trade deficit, allowing the economy to continue to grow as consumers purchase cheap foreign goods - whose low prices keep inflation in check.

And China is able to maintain its export-led economic growth, generating jobs for its growing urban population, while continuing to attract foreign investment.

But others argue that it may not be sustainable - and the attempt to unwind these huge imbalances could destabilise the world economy.

Brad Setser believes that unless China rapidly revalues its currency, it will face increased pressures on its domestic economy - with over-investment (now approaching 50% of GDP) eventually collapsing, putting pressure on the banking system.

Fred Bergsten of the Institute of International Economics argue that the problems of adjustment - and the huge trade imbalance - will generate growing protectionist pressures in the US and Europe, undermining support for free trade.

The IMF and the OECD also see this adjustment as the central problem of the world economy.

And unless it is tackled, the prospects for future world economic growth might well be derailed.

[Harry Sacks]

I think the world chooses to forget that China is is governed by an autocratic regime which acts like a pimp to the labour market and, incidentally, executes more of its own people than any other country. America is the punter, the relationship is mutually beneficial but won't last forever.

[Harry Sacks]

How the dollar got so big is no mystery. Once freed from the discipline of backing dollars with gold in 1971, the money supply increased thirteen-fold – an event forewarned by economists. One reason why this inflation doesn't show up in the Federal Reserve's numbers is that the U.S. exports much of its inflation. (China holds probably $600 billion in dollar reserves.) Without the rest of the world's absorption of dollars, which recirculate via cheap goods and low interest rates, the U.S. would have seen runaway inflation. Also the Federal Reserve – the supposed inflation watchdog – ignores a host of data signaling price appreciation. Spending more for food and energy? Too volatile to consider. Did your real estate tax just double? Doesn't count. Your new car more expensive than the last one? It's really cheaper due to the extra pleasure it affords. In other words, the Fed disregards about 40 percent of what the normal person spends money on.

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