China and their foreign reserves

 

This article appeared on the iBankcoin site over the weekend. As it is a topic that I have previously discussed, it seemed an easy re-entry into the blogosphere. It was written by;

Heather Johnson is a freelance finance and economics writer, as well as a regular contributor for CurrencyTrading.net, a site for currency trading and forex trading information. Heather welcomes comments and freelancing job inquiries at her email address heatherjohnson2323@gmail.com

The vast majority of all significant worldwide oil and coal purchases are conducted with the US Dollar as the currency of choice. Whether it’s Canada purchasing oil from Peru or Israel buying coal from Australia, these transactions almost always take place using Dollars. This virtual monopoly has helped keep the Dollar strong over the years, but this safety net could soon vanish.

This is simply incorrect. The currency that any commodity is priced in has no bearing upon the strength or weakness of that currency. The influence on the currencies strength or weakness is simply in what currency does the selling currency [country] hold their RESERVES.

If Saudi Arabia sells $100 million of oil to the US, and the US pays in $100M US$ there are two possible outcomes;

#1…Saudi Arabia holds the US $100M as US$ in a bank account, or as say US Treasury paper. In this scenario, the US$ is in equilibrium, or with a downward pressure exerted on US Interest rates if Treasury paper is purchased. This downward rate *may* deter further purchases of US Paper.

#2…Saudi Arabia sells their US $100M and purchases EU 100M [or value at exchange rate] thus the selling pressure on the US$ surpresses the US$ exchange rate, and elevates the EU, relative to each other.

China’s current per-capita energy consumption is roughly 7 percent of that of the United States, but this number is rising dramatically and will continue to do so for the foreseeable future. And though it may take China a long time to catch up to the US in its per capita energy gluttony, don’t forget that there are a lot more people living in China than there are in the States. As their energy needs have increased, the Chinese have recently become leading players in the global energy markets. If trends continue, everyone could soon be paying for their oil in Yuan rather than in Dollars, an unprecedented development that will wreak havoc on the forex markets.

I agree that China’s energy consumption is growing, and there is an abundance of data to support the assertion.

It is also possible, that the Yuan, at some point might take the Reserve Currency status from the US$.

However, as previously shown, the currency that your commodity is “priced” in, is irrelevant. What is relevant is, in which currency those reserves are held.

China’s forex reserves are undoubtedly its most important and influential asset in its economic relationship with the US. Until recently, the Yuan was pegged to the Dollar and, as often happens, a significant discrepancy began to develop between the value that the market would assign to the Yuan if it were allowed to float and the fixed value of the currency. As China’s economy took off, it began amassing forex reserves by removing foreign currency from circulation. This was done in order to suppress the value of the Yuan and maintain the peg to the Dollar. China accumulated immense forex reserves, which are currently estimated to be in the trillions of dollars.

This entire paragraph is confused.

China ran a trade surplus with the US. That is China exported more product in monetary terms than it imported from the US. The Chinese government then *printed* Yuan, and purchased from the manufacturers the US$ they had accumulated via payment.

These purchased US$ were then sterilized, to maintain an exchange rate that the Chinese government were seeking, by purchasing US Treasury paper.

There are some obvious outcomes;

Chinese printing of additional Yuan would be highly inflationary, if they do not sterilize via purchase of a foreign currency, in this case US$

By artificially keeping exchange rates lower, they increase the competitiveness of Chinese exports to the US and other exporting locations.

By letting the Yuan rise, by a non-sterilization policy, the cost of Chinese exports will rise, thus making them less competitive, and reducing net exports. As China’s economy currently is highly export dependant, this would slow growth and pressure unemployment in China, which is a threat to political stability.

China’s internal consumption is in the region of 42%. This is very low. When you examine their per capita wealth at $5,300, it is very low, thus exporting is incredibly important part of their GDP at;

agriculture: 11%
industry: 49.5%
services: 39.5%
note: industry includes construction (2007 est.)

Here’s where things start to get scary. The majority of China’s reserves are in the form of US Treasury securities, meaning that their forex reserves are primarily secured by assets that are denominated in Dollars. While this policy has annually helped bail the US government out of its expanding budget deficits, it has set up a situation that could be lethal for the Dollar. If China decides to diversify its investments by switching just a portion of its vast reserves from US assets to other foreign holdings, it could potentially send the Dollar into a sharp downward spiral, suddenly rewriting the rules for all forex markets.

China’s foreign reserves are held predominantly within Treasury paper. Thus selling of their reserves would *decrease* the price of the Treasury paper, while increasing the yield. An increased[ing] yield, makes Treasury paper more appealing to investors, thus potentially increasing the demand for US$

The problem area is not in the selling of current assets held, but rather in a continued trade imbalance, with no sterilization to maintain a relative value, with reserves to be held in either the Yuan, or another currency, say for argument the EU. We then have the situation where, the US runs a trade deficit, the US$ is sold on the FOREX markets, and EU are purchased.

Here, we have then a downward pressure on the US$ and the loss of the artificial suppression of US interest rates. It is estimated that the purchase of Treasury paper has suppressed rates up to 100 basis points. Now the increased yield may provide a base for the US$. This would be dependant upon yields available from other AAA rated government paper. Further, it may stimulate further the Yen carry trade, there are a myriad possible outcomes.

Problems will quickly arise, however, if China were to abruptly revalue the Yuan by the 30% that many American experts are demanding. Not only would this have an immediate and drastic affect on all forex markets, but the repercussions in this arena would be extraordinary and long-lasting. Prices on nearly every product produced in China would skyrocket overnight and American purchasing power would plummet. This could quickly push the US economy deep into recession and deal a final deathblow to the Dollar.

US purchasing power relative to the Yuan would be reduced.

As to pushing the US into recession [more quickly] I disagree. How many purchases from China are essential purchases?

If we consider the essentials; Food, Shelter, Energy, Clothing, only clothing can be potentially a source of inflation to the US consumer from China.

 Can clothing be substituted?

Most likely the answer is yes. Even assuming for a moment that the answer is no, what % does clothing represent in the US consumers annual budget of outgoings?

The remainder falls under discretionary spending. Discretionary spending by definition means that should the purchases be reduced, eliminated, or deferred, that life can continue.

Finally, how likely is the hypothetical scenario likely to take place? China as stated is highly export dependant…how probable is it that they would want to reduce their exports to the US, their largest single market?

By definition, for an economy to show growth, another economy has to finance that growth by stagnation and or running deficits. This is exactly what has happened. China has grown at such a pace that directly correlates to the deficits run by the mature economies and predominantly by the massive US deficits incurred