Tuesday, 24 March 2009
China’s Forex Reserve Exposed to Huge Risk by Fed’s Debt Purchase
The US Federal Reserve announced on March 18 it would acquire $300 billion of long-term US national debt in the coming six months and is planning to buy another $850 billion of agency debt. Although preparation for the announcement had been laid for the move, the scheme was still beyond expectations and influenced the market. The return rate on 10-year US bonds dropped by 51 basis points to 2.51%, and the Dow Jones Industrial Average shot up 100 points within several minutes of the announcement. On the other hand, the S&P GSCI rose 6% and crude oil 7% on the same day, showing investors’ concern over future inflation risk.
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China’s Forex Reserve Exposed to Huge Risk by Fed’s Debt Purchase
Zhang Ming, Beijing
24 March 2009
The US Federal Reserve announced on March 18 it would acquire $300 billion of long-term US national debt in the coming six months and is planning to buy another $850 billion of agency debt. Although preparation for the announcement had been laid for the move, the scheme was still beyond expectations and influenced the market. The return rate on 10-year US bonds dropped by 51 basis points to 2.51%, and the Dow Jones Industrial Average shot up 100 points within several minutes of the announcement. On the other hand, the S&P GSCI rose 6% and crude oil 7% on the same day, showing investors’ concern over future inflation risk.
From a short-term perspective, the Fed’s acquisition of long-term US bonds helps to increase effective demand for national debt and offsets possible supply surplus in the national debt market, thereby restraining any significant return rate increase in newly issued bonds and avoiding depreciation of existing national debt. By doing this the Feb aims to comfort US national debt investors, and discourage creditors from selling off, which would cut the government’s most credible financing channel. For investors, the Fed’s purchase of government debt is conducive to maintaining or even increasing the value of US bonds in the short term, which makes them happy. The Fed’s purchase aims to maintain the stability of the US government debt market, cut government financing costs, and help the US economy to get out of trouble as soon as possible.
However, from a mid- and long-term perspective, the purchase may cause serious inflation and USD depreciation. By the end of 2008, China’s foreign exchange reserve totalled $1.95 trillion, over 65% of which is invested in dollar assets. If the USD depreciates steeply, China’s foreign exchange reserve purchasing power will also fall, meaning a huge loss for China’s wealth. China must pay great attention to the risk from the Fed’s purchase, and act quickly to cut the risk exposure of China’s foreign exchange reserve against inflation and USD depreciation.
First, as Premier Wen Jiabao has said, we need the US government to guarantee the market value of its government debt, but Obama’s promise is not trustworthy. International creditors, such as China’s central bank, need a real and believable promise from the US government as a prerequisite of any further purchase. For example, China’s central bank should require the US government to peg the rate of return of newly issued government debt with the US inflation ratio, meaning the US should increase the issuance of TIPS (Treasury Inflation Protected Securities) and replace some existing government debt with TIPS.
Second, we must be aware that the current low bulk commodity and energy prices cannot last for long. During the precious window, the Chinese government should promote Chinese enterprises to buy more energy and bulk commodity spots and futures, and stakes in relevant suppliers. The government can support these purchases by USD loans from policy banks. The China Investment Corporation, China’s sovereign wealth fund, should also conduct positive investment in global resources. China can partly offset the influence of USD depreciation and global inflation by diversifying its foreign exchange reserve. We should not only be satisfied with the returns of short-term US government debt, but look into the future.
(The author is the Deputy Director, Department of Finance of the Institute of World Economic & Politics, Chinese Academy of Science )
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