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FOREIGN EXCHANGE MANAGEMENT ASSIGNMENT

Comparison of Chinese currency with US currency

In 1994, China had less than $25 billion of foreign currency reserves.Since
then, China’s enormous trade surplus and the inflow of foreign investment
have helped boost its foreign exchange reserves to U.S. $1.76 trillion by the
end of April 2008 with reserves said to be growing by U.S. $100 million per
hour. Whereas many economists tend to think that a country’s foreign
reserves should be sufficient to pay for 3-6 months of imports, China’s
reserves can pay for a year and half of imports – leading many to conclude
that China’s foreign reserves are unnecessarily large. Critics point to these
astounding figures as a further example of how out of balance China’s trade
with the rest of the world is.

How China’s Foreign Exchange Reserves Got So Large

Increased Exports: The reserves started growing when China pegged its
currency (the renminbi or yuan) to the U.S. dollar in 1994, with the intention
of keeping the yuan’s value low and steady, thereby allowing Chinese
products to remain low cost and affordable to overseas buyers. This in turn
boosted exports, which allowed the Chinese economy to grow at the torrid
rate of around 9%-10% it has in the last decade or so (with some exceptions
during a regional-wide Asian Financial Crisis in the late 1990s). As China’s
economy surged ahead in the last 5-10 years, but the exchange rate remained
pegged to the dollar, dollars have stacked up in the Chinese banking system
as the government has withdrawn the foreign currency from circulation.
“Sterilization”: When foreigners buy products made in China, they pay in
foreign currency – usually the U.S. dollar – which Chinese manufacturers
take to the bank to exchange for RMB to pay their workers and other costs.
Whereas banks in many countries can decide what to do with the dollars to
achieve the highest return, Chinese banks cannot and must send the dollars
to the People’s Bank of China (PBoC - China’s version of the Federal
Reserve) to be “sterilized” for yuan. The PBoC in turn reverts the dollars to
the State Administration for Foreign Exchange (SAFE), which decides what
to do with the huge, ever expanding foreign exchange reserves.
Overexpansion: China’s inflexible and undervalued currency regime has
locked the country into a situation whereby the large trade surpluses and
capital inflows have led and continue to lead to domestic monetary
expansion as the excess capital is reinvested in industrial production; this
creates over-expansion and over-investment. Since production outpaces
consumption, the trade surplus naturally increases, which feeds monetary
expansion, starting the cycle all over again.
Greater Productivity: Besides the growth in exports, China has also seen a
burst of manufacturing productivity (from the restructuring and privatization
of a number of China’s inefficient state enterprises), investment and credit,
which have all contributed to the excess liquidity in the economy.

Impact of large foreign exchange reserves on China

Inflation: In China, all the dollars from exports that need to be converted to
RMB is causing inflation: as demand for the yuan increases, rather than let
the value of the yuan rise too quickly, Beijing is printing up new money
instead. Even with bonds, China’s monetary system cannot absorb all the
extra cash, so prices have risen as a result and the stock and real estate
markets have become inflated. China has tried to slow its accumulation of
reserves by cutting export subsidies so as to decrease its trade surplus, by
letting the yuan appreciate against the U.S. dollar (by 20%), and by
encouraging domestic firms to invest abroad, but all to no avail so far as the
reserves keep increasing.

What does China do with all of its foreign exchange reserves?

For many years, SAFE has parked about 70% of its reserves in government-
backed securities – primarily U.S. Treasury bills – with the rest in Euros and
Japanese Yen. In the last several years, though, as the dollar has declined in
value relative to the yuan, the Chinese government has indicated a desire to
diversify its investments in order to get a better return. In recent years,
however, with a host of other domestic problems besetting the country, the
Chinese people are starting to question why their government is financing
another country’s spending spree instead of using some of the large reserves
to address the country’s domestic needs.

Impact of China’s foreign exchange reserves on America

The United States has welcomed China’s investment of its excess foreign
reserves in U.S. Treasury bills, which has effectively helped to finance the
U.S. current account deficit – the result of a low savings rate and
government spending that far exceeds its income. This massive “loan” from
China has effectively helped the U.S. government to do everything from
waging wars in Iraq and Afghanistan, to paying Congressional salaries
(including those of politicians criticizing China), to rebuilding roads in New
Orleans, and writing Social Security and Medicare checks. In turn, China
has had a safe place to park its excess dollars.
Is this a tenable situation for America?

Although both the United States and China have benefited from this
arrangement, many experts and observers believe this is not a tenable
situation in the long run. According to economists at the Petersen Institute of
International Economics, in early 2008, the U.S. government was running a
global current account deficit of almost $800 billion, the largest it has ever
been. In order to finance this deficit and its own foreign investments, the
U.S. must import about $1 trillion of foreign capital every year or more than
$4 billion every working day, which is simply unsustainable in the long
run. After all, at some point, foreign appetite for dollar assets will wane.
As average Americans become more aware of the reality that they are
relying on money controlled by a foreign government and that never in
America’s history has she been so deeply in debt to another country (as of
early 2008, foreigners now control over 40% of the U.S. national debt),
especially one with whom America shares an ambivalent relationship, and
who America has at times blamed for taking away job, fear is setting in
about how long this imbalance will continue and about what might happen
should China decide to pull its massive reserves out of the U.S. economy.
Moreover, long-term U.S. interest rates are driven by the buying and selling
of bonds, making these interest rates effectively at the control of foreign
central banks, especially those of China and Japan. In short, China’s
excessive foreign exchange reserves are causing some Americans to fear that
control of their economy is increasingly at the mercy of China.

What would happen if China switched from dollar assets to other assets?

Moving from dollar assets to other assets will cause the dollar to depreciate,
as the dollar will be worth less. At the same time, the bulk sale of U.S.
treasury bills (short term bonds) could cause U.S. bond prices to drop and
therefore yields to increase. Since government bond yields determine
mortgage rates, this will result in higher long-term interest rates, which
could make borrowing for a home more difficult, which would in turn
further decrease already-dampened demand for housing and cause even
more of a decline in the value of American real estate.

How likely is China to exercise this economic “nuclear option” of


withdrawing its reserves?
While China has in fact been looking to diversify its forex reserves
byinvesting abroad, it will likely do so very gradually and in relatively small
amounts, for otherwise they would stand to lose a lot with a bulk sale of U.S.
treasuries as the value of the government bonds they don’t sell would
decline. Hence, any moves toward diversification should have minimal
impact on the value of the dollar. And although the value of the dollar is
weak, there is no more stable alternative right now for China’s vast sums.
Most economists agree that barring any unforeseen or major incident
between the two countries, China will not exercise this economic “nuclear
option” as China already has its own set of domestic problems to contend
with at home as a result of its enormous forex reserves.

Conclusion
China: The yuan’s slow appreciation does not seem to have had much of an
impact in reducing China’s reserves, hence some economists believe China
will have to allow for an even faster appreciation, though that may hurt
exporters. China will also likely face higher inflation, which the government
may try to offset by using some of the reserves to give subsidies to the poor,
though it has to be careful not to exacerbate inflation in the process. Some
experts think China’s foreign exchange reserves will not continue to grow
“exponentially” as some have feared because there is pressure to use some
of it on China’s infrastructure needs and on education and health for the
poor.
United States: Many economists, such as those at the Petersen Institute of
International Economics, think that correcting the U.S.’ global current
account deficit is the highest priority for U.S. foreign economic policy.
Proposals for the useful short-term remedy include sizably reducing the U.S.
budget deficit; generating greater domestic savings than greater output, thus
expanding U.S. net exports; expanding domestic demand in other major
economies such as China, Japan, and Europe to absorb U.S. exports; and the
continuing gradual realignment of exchange rates.While the U.S. can
continue to pressure foreign economies to shoulder more responsibility for
global consumption (China has a savings rate of about 50%), these
autonomous sovereign nations in the end will act in their own self-interest.
The only part that the U.S. has any real control over is in regards to its own
spending habits. Unfortunately, the likelihood of the U.S. reducing its
budget deficit in lean times and during an election year is not very high.
Expect American politicians unwilling to get their own house in order
(undoubtedly at some cost to the American public) to continue to put the
blame and responsibility on foreign countries and to threaten protectionist
responses.

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