Saturday 7 March 2009

Analysis: How to Allocate China’s Foreign Exchange Reserve

China should gradually reduce its dollar holdings and invest the money in foreign resources, gold, and other currencies.

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Guanyu said...

Analysis: How to Allocate China’s Foreign Exchange Reserve

China should gradually reduce its dollar holdings and invest the money in foreign resources, gold, and other currencies.

Wang Xiaolu, Caijing
6 March 2009

In my opinion, this financial crisis at least taught us some basic economic principles worth keeping in mind. These principles are well grasped even among uneducated people, but our elites, especially we economists, have almost forgotten them.

1. It is not sustainable to spend twice what you earn.

2. Eventually you’ll have to pay what you owe.

From these two principles follow several deductions:

1. Even the best printing machines cannot print wealth, although they may churn out new notes.

2. If someone asks you for a loan and promises he will print money to pay you, hold tight to your wallet.

3. It’s also up to you as a lender to realize that if you hand out too much cash, borrowers will have to default.

4. Moreover, refinancing can drive debts higher. Without a solid base of production, financial innovations can only create numbers, not real wealth.

The U.S. takes advantage of the dollar standard, ignoring credit expansion and massive debt, to enhance domestic consumption levels that have outpaces incomes for years. According to George Soros, the prosperity from the credit bubble lasted for 60 years and has just come to an end.

In 2007, consumption accounted for 86 percent of the U.S. GDP; the ratio of net savings to disposable income was negative 1.7 percent; while the trade deficit equalled 5 percent of GDP. In 2008, the debts owed by the U.S. citizens, governments and non-financial businesses amounted to US$ 33 trillion, 2.3 times the GDP. If you spread that figure out over the entire population, including the young generation, each U.S. citizen bore a debt of US$ 110,000.

Unlike the U.S., the net savings ratio in China is 43 percent. China has a foreign exchange reserve of 2 trillion dollars. This sizable fortune came from the hard work of 1.3 billion Chinese. With this money, we can improve our social welfare and secure our development. But is this foreign exchange reserve secure wealth?

The dollar is the standard international currency, and so all countries exchange their wealth in dollars. But now the U.S. is borrowing dollars to patch the hole in its fiscal deficit. Trillions of dollars have been spent in the last several months for this exact purpose. No one knows how much the U.S. will still need. But the question we should ask is whether we need to continue financing its bailout, or start spending the money where we need it?

We have a very close relationship with the U.S. Having already lent them half of China’s foreign exchange reserves, we gotten into a spot where we have to keep lending to protect our previous investments. But by handing out more dollars, we tie ourselves into a leaking boat, which may waste another 1 trillion, 2 trillion, or more.

A few of our scholars and government officials remain optimistic. The U.S. may have only caught a cough and will recover soon, they reason. By lending now, China can show its support and garner a good reputation – and we may get the money back when we need it. But the truth is that this is an unrealistic dream, and those captured by it need to study better the global trend.

What to do next? It is inevitable that China will lose some money when the dollar devalues in the future. Taking advantage of the good exchange rate now and gradually selling our U.S. treasury bonds is the only rational choice.

But if we do not buy U.S. bonds, where can we allocate our foreign exchange reserves?

There are answers. As China continues its development, we will spend more and more on energy consumption. Faced with the low oil price, we can import oil from abroad and decrease domestic oil production as much as possible. More oil imports will make room for future development.

A lot of overseas natural resource companies are hurting for liquidity, as credit markets have yet to rally back. To invest in mines and oilfields will benefit both those enterprises and China. We have done it already, and we need to do it more.

Some manufacturing enterprises, with good products and technology, are also suffering from the financial crisis, which makes this a good time for Chinese to invest abroad. We should encourage non-government enterprises to freely explore foreign ventures. But caution is also called for. Buying up financial enterprises is not a good choice.

China has 600 tons of gold reserves, less than 10 percent of the reserve in U.S. In the long-run, the dollar may fail but the gold will not. Why not increase our gold reserve? We may also increase other strategic material reserves as well.

Additionally, it is important to diversify our foreign exchange reserves. We need to take good care of our 2 trillion dollars. It is made from sweat and toil of 1.3 billion Chinese.