China's reserves: Golden dragon or sitting duck

By Edward Krowitz (China Daily)
Updated: 2007-06-07 10:22

The author Edward Krowitz is an economist, retired from the US Foreign Service and a former consultant on macroeconomic reform to the United Nations and the Asian Development Bank

Like good food, good sex or money, can one ever have too much of a good thing?

With their wishy washy "on the one hand but then on the other " attitude, one would normally avoid asking economists - except when discussing the Chinese economy.

Here's what the May 2007 World Bank update has to say about Chinese economic performance: Growth prospects are good; GDP is expected to rise by 10.4 percent this year; the stock market is booming, export growth is surging, the trade surplus is continuing and foreign exchange reserves are soaring. What's not to like in this picture?

With over a trillion dollars sitting in its exchange reserves, earning the going rate of 3 to 4 percent for US treasury bonds, barely maintaining its value in real terms, is China in danger of putting all its eggs in one very fragile basket?

Recent research by Morris Goldstein of the Institute of International Economics demonstrated that despite announced changes in a revised basket of currencies the Chinese currency remains pegged to the US dollar. Why should this be worrisome?

In two words: portfolio diversification. The safety of one's savings, even for a nation, should be the paramount consideration in guiding investment strategy. But with the US current account deficit approaching 7 percent of GDP, the largest ever recorded by any country, questions arise whether this is sustainable.

The flip side of this is foreign purchases of a growing share of US financial assets, now reaching 30 percent of GDP. With any action to correct its imbalances unlikely until after the 2008 US presidential elections, will America's creditors experience a Woody Woodpecker moment?

Related readings:
 Reserve ratios may be further raised this year
 Central bank raises interest rates, reserve requirements
 China to have more Euros in forex reserve
IMF: China forex move no cause for concern

Economist Paul Krugman uses the analogy to Road Runner cartoons to demonstrate a sharp, unexpected turnaround in investor behavior.

In these cartoons, Woody is chased by his nemesis, Wilie E. Coyote, who, during the chase, unknowingly runs off a desert cliff but continues running, this time over thin air. Nothing happens until Wilie looks down, realizes nothing is holding him up, and suddenly plunges to the desert floor below.

Krugman asks if such a scenario is possible with foreign purchases of US assets which sustain a continuation of the US trade deficit.

Could the value of the US currency suddenly plunge after foreigners realize that the increasing share of US securities in foreign hands is unsustainable? They could start to unload their holdings of dollar-denominated assets, precipitously driving down the dollar exchange rate.

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