The Impact of China's Growing FX Reserve
With its labour force now numbering around 792 million people, (out of a recently estimated population in excess of one-and-a-quarter billion) China occupies the position in this century, exactly as Japan did in the back end of the last, as the world’s fastest growing large economy to emerge as a global economic force in its own right. As Ted Fishman, the author of a recent bestseller, China Inc, points out: “One of the things that most people find especially incredible is there are 85 million private businesses in China. That’s an astonishing number when you consider that just 10 or 12 years ago there were none at all, and more than three times that of the United States, which has been playing the free enterprise game for 350 years!”
China has witnessed an economic evolution throughout the last 25 years from that of a centrally planned system, largely closed to international trade, to one significantly more market-oriented with a rapidly growing private sector that now sees the country dramatically recast in the role of a major economic player on the global stage. Initial reforms began in the late 1970s with the phasing out of collectivised agriculture, followed closely by fiscal decentralisation, increased autonomy for state enterprises, the foundation of a diversified banking system, the development of stock markets and opening to foreign trade and investment. A fascinating visual indicator on the ground of all this activity, and certainly unthinkable a mere few years ago. Beijing’s streets now buzz with city-suited types, eager to conspicuously consume a large slice of US lifestyle, hurrying from Starbucks to McDonalds; no wonder Harley Davidson – that quintessential icon of the American dream – has just opened up its first Chinese showroom.
And so it is that the process continues apace, including key moves implemented in 2005 with the sale of equity in China’s largest state banks to foreign investors and refinements in foreign exchange and bond markets. Foreign investment likewise remains a strong element in China’s remarkable expansion in world trade and has been an important factor in the growth of urban jobs.
These innovations in economic restructuring and resultant efficiency gains have contributed to a more than tenfold increase in GDP over the passage of the past quarter of a century. The construction boom alone has given rise to a massive increase in China’s demand for commodities eaten up by the county’s rapid urbanisation and infrastructure development. With domestic resources unable to keep abreast, China has turned to global suppliers, with startling effect. One example alone, according to Macquarie Research, suggests that between 1994 and 2003, China was responsible for 54% of growth in the world’s entire copper consumption.
Putting aside the issues surrounding the possibility articulated by some observers that the Chinese economy may be at risk of overheating, China’s transformation has not come about without an increasing degree of disquiet, specially in the United States – to whom China sold some US$160bn more in goods than it bought – and where on Capitol Hill there can be heard murmurings of a possible Sino-US trade war brewing up in the not too distant future. In the land of the free-market, the American goal has been viewed not so much in terms of a final resolution of trade disputes, rather a means of managing them in a responsible way. The US, for instance, filed a World Trade Organisation case in April this year over China’s barriers to imported car parts and said that, as a mature trading power, China should expect to be the target of more complaints. As a senior US official commented recently: “There is a deep-seated concern about whether China is playing by the rules agreed to when we allowed them into the WTO. What we’ve been stressing to the Chinese is it really will be in everybody’s interests if they take these problems seriously.”
Forming a key element of China’s current ‘roll’, we can specifically look to a major contributing factor of recently released data on China’s 10.2% growth in GDP for the first quarter of 2006 as compared to the same period last year, namely its 80% share of the wider Asian foreign exchange reserve boom. This, crucially, hinges on accelerating exports and resurgent Chinese bank lending based on above-target rises in money supply that, in fact, saw new loans of Rmb1,100bn in the first quarter alone, (US$137bn) nearly half the whole year target.
China, of course, sent something of a shockwave across the Pacific last July when revaluing its currency, (the first time it had done so in 11 plus years) de-pegging it from the US dollar in favour of an exchange rate system referencing a basket of currencies comprising the yen, euro, Hong Kong dollar and South Korean won, thereby signalling China’s desire to diversify its foreign holdings. This led some commentators to conclude that the move was merely an initial step, with Beijing likely to allow the currency a gradual, further strengthening.
“We expect the renminbi to be tightly managed over the coming months, leading to an impression in the foreign exchange market that very little has changed in regard to China’s foreign exchange regime,” concluded Derek Halpenny, senior currency economist at Bank of Tokyo-Mitsubishi.
Hans Redeker, head of currency strategy at BNP Paribas, said: “Beijing was wise to prevent immediate further strengthening,” further arguing that “…this would merely have encouraged speculative flows.” But he foresaw 7.9 by the year end, and a second revaluation to 7.5 next year.
The potential double-whammy to all this good fortune is China’s growing trade surplus and unwanted growth in the money supply. The surplus dollars flowing into China are purchased by the government, thus fuelling inflation and, currently, also pushing along the property sector. To gain control of all this influx of foreign money, the Chinese central bank has kept interest rates low – artificially so, at least to many peoples’ thinking – while the US has raised theirs, thereby making itself less attractive to foreign investors. A meeting of China’s cabinet in mid-April this year reported how the main problems for the economy were “too rapid growth of investment and credit, a relatively high money supply and a structural contradiction of foreign trade.”
The renewed weakness in the US dollar allied to the continuing bearish stance of US dollar against Asian currencies per se, may result in more forex accumulation by Asian central banks in general, similar in fact to 2004, where China, specifically, looks certain to remain dominant. Both China and Japan could be described as being somewhat in a Catch-22 situation. After investing so much of their reserves in the US, any sudden decision to move out, or to diversify, will see the US dollar fall sharply, thereby leveraging a downward impact on asset prices.
Amply demonstrating China’s seemingly inexorable economic rise, its currency revaluation – a smallish increase on the face of it – nonetheless is seen by many as heralding more substantial rises over the coming years. China now accounts for the world’s second-largest cache of foreign exchange (standing at US$819.90bn at the end of 2005), second only to Japan. And as Chinese industry floods the world with cheaper alternatives of electrical goods, cars, clothing et al, the dollars continue to amass at roughly US$15bn per month.
Recent, anonymous whispers have been coming out of influential Chinese government offices suggesting the need to “explore a more efficient use of foreign exchange reserves”, or a move into such currencies as the euro and yen, for example, as well as purchases of commodities, especially oil. While some consider these comments as a way of testing the waters, one just has to look at the current levels of the euro and yen to ponder if you were a central bank looking to diversify your foreign currency reserves, would this be a good time to start accumulating?
Over 80% of the growth of Asia’s foreign exchange reserve in 2005 was accounted for by China, whose economy overall grew 9.9% during the same period. China, therefore, clearly plays a significant role among Asian central banks’ demand for US dollar assets. And while China’s FX reserves continue to expand apace, (achieving more than a fourfold rise between 2001 and 2005 from US$169bn to US$819bn) many industry observers around the world are predicting that, if current trends prevail, China could soon outpace Japan. Indeed, measured on a purchasing power priority, (PPP) basis, China last year established its status as the second-largest economy in the world after the US.
One point that bearish US politicians are in danger of overlooking is what impact the revaluation will have on their own budget deficit, and their appetite for debt. If China were to continue to revalue its currency, as expected, this will reduce its need to accumulate foreign reserves, which until now have been largely used to buy US government debt. If the Chinese don’t buy the bonds, then the US budget deficit will need to be financed by the private sector. An over-supply of bonds will require higher interest rates, to attract investors, but will also dampen demand, and thereby hurt economic activity. The crucial questions, therefore, in relation to revaluation are: when will China next revalue; how much will they revalue; and when will they say that enough is enough?
Whatever the answer, there’s no doubting China’s enjoyment of its new-found status as a global superpower. And as far as its economy is concerned – as much else beside – China certainly will not be told what to do or how to do it. In his visit to Washington recently, Chinese President Hu Jinato offered the calming statement that his country was “…ready to work with the US in the spirit of seeking mutual benefit and win-win outcomes to properly address each other’s concerns and facilitate the sound and steady growth of economic co-operation and trade.”
You can’t ignore the hype over China’s economic rise. It tends to be as big as Shanghai’s skyscrapers, of which there have been more built in the last 10 years than currently exist in New York. But is the country’s long march from Mao to membership of the top economic superpower club likely to run smoothly? According to economic scientist, Dr Steve Tsang, the situation of China – the very scale of its spectacular growth and the stark contrast between metropolitan glitz and rural poverty – makes the whole situation actually very brittle. “On the one hand it’s very strong,” he says, adding “but if it gets into serious problems, the situation could disintegrate very quickly.”
This warning may seem surprising amid so much talking up of success, but recent events such as Google’s agreement with the Chinese authorities to block access to certain websites serve as a timely reminder that China remains a very different cup of tea to western culture. China may be changing, but change will happen in a very particular Chinese way. Certainly the sheer scale of the developments there means that whatever happens, it will affect us all.