Monday 16 February 2009

Tapping China’s huge reserves carries risks

Beijing has to consider inflation and exchange rate stability

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Tapping China’s huge reserves carries risks

Beijing has to consider inflation and exchange rate stability

By Ching Cheong
13 February 2009

Chinese Premier Wen Jiabao has pledged that China would do whatever was necessary to maintain its economic growth at 8 per cent this year, including possibly tapping its vast foreign exchange reserves.

Beijing had been reluctant to dip into its foreign reserves, for good reasons, until now. Mr. Wen’s remarks therefore highlighted the gravity of the impact the financial meltdown is having on China.

The 8 per cent growth target is regarded as the minimum needed to create enough jobs and prevent social unrest in China.

A slump in fourth-quarter growth to 6.8 per cent saw annual growth for last year slow to 9 per cent, the first single-digit expansion in six years.

The bad news came last week that at least 20 million migrant workers had returned jobless to the countryside. The number excludes the six million to seven million who enter the rural labour market every year.

The new jobless figure means that total unemployment this year could reach 153 million, or 16.6 per cent of the total labour force of 922.9 million, according to the Institute of Macroeconomics, a think-tank related to the State Planning and Development Commission.

Clearly, the massive 4 trillion yuan (S$885 billion) stimulus package announced last November would not be sufficient to bolster the economy.

Such a dire situation requires China’s leaders to take drastic measures.

Thanks to the country’s huge reserves, Mr. Wen was able to caution against panic and instil the recent World Economic Forum meeting in Davos, Switzerland, with a strong sense of confidence.

China’s foreign reserves totalled US$1.95 trillion (S$2.95 trillion) at the end of last year. If other foreign assets held by the central bank, the commercial banks and the China Investment Corporation (CIC) are included, total foreign reserves stood at US$2.1 trillion - the largest in the world, double the size of Japan’s and four times that of Russia’s.

‘This could be the largest single store of liquid wealth available on earth,’ said Mr. Martin Walker, senior director of the Global Business Policy Council, a private think-tank founded by the A. T. Kearney business consultancy.

According to a study by the US Council on Foreign Relations, 72 per cent of China’s reserves are held in US dollar-denominated assets, making China the US’ single largest creditor.

It estimated that in the last four quarters when the US financial meltdown was taking a heavy toll, China had lent roughly US$40 billion a month to the United States and contributed a lot to easing the latter’s credit crunch.

Mr. Brad Setser, the study’s author, remarked: ‘Never before has a relatively poor country lent out so much money to a relatively rich country. And never before has the US relied on a single country’s government for so much financing.’

He estimated that as of end-last year the Chinese portfolio included roughly US$900 billion in treasury bonds, US$600 billion in agency bonds (Fannie Mae, Freddie Mac and Ginnie Mae), US$150 billion in corporate bonds, US$40 billion in US equities and another US$40 billion in short-term deposits.

According to Mr. Sester, such a portfolio would ‘imply large losses at China’s central bank’.

The study lent support to critics of the current Chinese government who questioned the rationale for holding an overwhelming proportion of the country’s reserves in US dollar assets.

When China’s foreign reserves first passed the US$1 trillion mark in 2005, there were already strong calls for harnessing the reserves.

However, there are risks in doing so.

Foremost is the spectre of inflation. Until now, the impact of the huge reserves on domestic money supply was somewhat neutralised by retaining them as foreign currency assets.

If the funds were to be ploughed back into the domestic economy, money supply would increase and prices would be likely to rise.

Then there is the problem of maintaining exchange rate stability. Unloading sizeable foreign reserves could lead to a corresponding rise in the yuan exchange rate, which could put many of the export manufacturers at risk, since many operate on razor-thin profit margins.

After seeing how the 1997 Asian financial crisis devastated sovereign authorities, China naturally would like to preserve a strong reserves position to hedge against speculative strikes. Unleashing the reserves might weaken its defence against such attacks.

Furthermore, there is the problem of servicing China’s huge external debt. According to Mr. Walker’s estimates, Chinese corporations have to roll over some US$2.4 trillion of external debt this year.

As a result of the global credit crunch, it would be tough for these corporations to find bankers willing to help, especially when capital flow to emerging markets is drying up.

Indeed, the Institute of International Finance had just released a report during the Davos meeting showing that such flow is expected to drop to a low of US$160 billion, down from its peak of US$840 billion in 2007.

Clearly, China has to brace itself for some rough times ahead.

These risks explain why Beijing has been unwilling to tap these reserves - until now.

But deteriorating conditions and circumstances both at home and abroad have left China’s leaders with no other choice.