Fool's gold

China''s huge forex reserves reflect the high price of the exchange rate regime.

For a developing country to have over half a trillion dollars in forex reserves could very well be seen as too much of a good thing. A developing country, by definition, needs as much capital as it can lay its hands on. That is especially the case with China, with huge wealth disparities to address, both within cities themselves, and between cities and the countryside.

China has freakishly large $514 billion, second only to Japan on $840 billion but a far higher percentage of GDP, since Japan's economy is almost five times as large.

Yet instead of pouring these billions into critically-needed schools, hospitals, roads, bridges irrigation projects and even social welfare schemes, the mainland government has poured the funds into low-yielding US government bonds - bonds denominated in a currency that has weakened to record lows against almost all the major currencies in the past months.

That is a very high opportunity cost, most experts agree.

Theoretically, China could use the money to invest in the Western regions, says Chi Lo, an independent economist in Hong Kong.

"But there are two problems with this seemingly simple scenario. On the one hand, converting the forex into Rmb would increase the money supply and fuel inflation. The other is that using administrative measures to ensure the (newly-released forex) funds do not flow into existing bubbles such as real estate, steel and other construction materials goes against the government's efforts to be more market-oriented and steer clear of heavy handed methods of controlling the economy," he points out.

It is easy to underestimate the seriousness of the central government in its efforts to encourage market forces.

The planned listings of two of its four great banks is predicated on granting them increased autonomy in their lending decisions, for decades a prime weapon in the government's dominance of the economy.

So reversing this trend could create a substantial loss of reform momentum in the economy, something the government would be loath to do.

As regards the first point concerning inflation, it is due to the US dollar peg that the Chinese central bank, the People's Bank of China, is forced to constantly intervene in the forex market to control the money supply.

That is because the more money that comes in China, the higher the level of the Rmb should be.

But because the government does not want to break the peg to the US dollar, it has to 'sterilize' the strengthening effect on the dollar by selling the Rmb into the financial system. Selling Yuan counteracts the upward pressure on the exchange rate caused by the buying of the Yuan by the US Dollar sellers.

Thus, instead of the US dollar inflows causing a shortage of Yuan, and driving the price of the Yuan up, the government ensures supply is plentiful by selling the Yuan onto the market.

However, this means huge inflationary pressure in China, since the banks will naturally lend out as much of the new funds as possible.

To counteract this, the government 'borrows' money from the banks by issuing bonds to them. Unfortunately, it has to pay interest on the bonds, although this is a handy bonus for the banks.

So far, the cost of this sterilization is low, because interest rates are low. The question is: How long the government can keep low interest rates in view of demand-led inflation caused by robust domestic demand on the back of an undervalued Yuan that boosts exports, and cost-led inflation in the form of higher oil and other commodity prices.

"When an economy is growing at 9% per year demand for funds is strong. But if the money is being mopped up to protect the exchange rate, in addition to these inflationary factors, then sooner or later competition for capital means interest rates will go up," explains Chi Lo.

A sustained rise in rates could be tricky.

"It could be crushing for the economy if a rise in interest rates came at a time when growth is slipping, or when bubbles in the real estate market and steel sector are popping," says Lo.

Japan showed the dangers of ill-judged rate hikes, when the finance ministry tried to correct the bubble economy with rate hikes in 1990 which sent the economy plunging into a ten-year recession.

Higher interest rates could also cause chaos by accelerating the closure of borderline SOEs unable to pay their more expensive debt, contributing to social unrest.

Yet it is perhaps a sign that the government has recognized that higher capital costs are inevitable that deposit and lending rates were raised by 27 basis points on October28.

The rise in interest rates is clearly the wrong policy if you want to weaken pressure on your currency. But China has boxed herself into a corner on account of the contradictions in the currency regime.

Obeying market principles, large capital inflows into a country with a floating exchange rate and an open capital account would sooner or later cause that country's currency to appreciate and its interest rate go down, thereby making the target currency less attractive and slowing inflows.

Yet the exact opposite is happening in China. As the government sterilizes inflows, capitals becomes short, and interest rates go up, thereby attracting even more capital inflows and constantly increasing the scale of sterilization, and hence its cost.

Indeed the rise foreign exchange reserves is increasingly the result of hot money sneaking in through the current account, around $59 billion of the $111 billion in inflows between January and September according to central bank figures, rather than the result of a trade surplus, less than $4 billion from January to September, or even robust FDI, expected to top out at $53 billion for the whole of this year.

Many local media blame Chinese enterprises for sneaking large sums of money in through the current account, as well as foreign speculators.

It is obvious that given the increasing cost of sterilization on the back of increasing inflows, as reflected in the recent rise in rates, that China's currency regime must change. But with an open capital account (which reflects short-term foreign capital flows, for example to a country's bond and equity markets) out of the question, and command economy mechanisms difficult to implement while China's banks are heading for listing, China does not have many attractive options.

In theory, China could either have a fixed exchange rate, an open capital account and flexible interest rates, as Hong Kong has, or it could have fixed interest rates and a flexible exchange rate policy alongside an open capital account. Either interest rates or exchange rates must be flexible in order to reflect changes caused by an open capital account.

However, China does not want an open capital account until its financial system is fixed. With a tiny bond market, a highly inefficient stock market and bankrupt banks, the last thing China can afford is outflows of capital. It is the population's one trillion dollars plus in savings which is keeping the mess solvent.

In addition, it is only when the capital account is closed, that a government can determine the levels of both interest rates and the exchange rate, as China does.

That provided the government with powerful levers to control the economy.

Closing the capital account also ensures the government's sterilization efforts are not overwhelmed by large international capital inflows.

Finally, the open capital account and fixed peg structure were shown to be potentially dangerous during the Asian Financial Crisis. Central banks simply do not have the resources to defeat huge movements of international capital attacking a currency peg, regardless of whether the attacks are unfair and speculative.

China's closed capital account and control of both interest rates and the exchange rate is orthodox, despite the costs listed above, and not likely to lead to a financial crisis - after all, the Yuan is perceived as being undervalued, rather than over-valued. It was the perceived over-valuation of several Southeast Asian currencies which triggered the blood letting almost 10 years ago.

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