Academic journal article Federal Reserve Bank of St. Louis Review

Chinese Foreign Exchange Reserves, Policy Choices, and the U.S. Economy

Academic journal article Federal Reserve Bank of St. Louis Review

Chinese Foreign Exchange Reserves, Policy Choices, and the U.S. Economy

Article excerpt

China is both a major trading partner of the United States and the largest official holder of U.S. assets in the world. The value of Chinese foreign exchange reserves peaked at just over $4 trillion in June 2014 but has since declined to $3.19 trillion (as of August 2016). This very large decline in foreign exchange reserves is unprecedented, and some analysts have speculated that continued sales of these (mostly U.S.) assets might significantly impact the U.S. and global economies. This article explains the reasons for this large decline in official assets, China's available policy choices, and how these choices could affect the U.S. economy. (JEL E52, E58 F31, F32)

"It [2008] was a time of a financial crisis and a bear market... But
now the root cause is basically China. So, a hard landing [in China] is
practically unavoidable."
--George Soros (1)
"Think Twice Before Declaring War on Chinese Currency."
--Mei Xinyu (2)

1 INTRODUCTION

The U.S. and Chinese economies trade a great deal in goods, services, and assets. China is the source of the largest share of U.S. imports and the destination for the third-largest share of U.S. exports (Figure 1). China has also become increasing important financially. In particular, the Chinese government has the largest foreign exchange reserves in the world, which are assets (usually bonds) held by a central bank or other government agency that are liabilities of some foreign entity. Although the exact composition of the Chinese foreign exchange reserves is confidential, observers estimate that about 67 percent of the value consists of dollar-denominated assets, mostly U.S. Treasury securities, but also many U.S. agency and corporate bonds. The top-left panel of Figure 2 illustrates the estimated currency composition of Chinese reserves (Wildau, 2014). The top-right panel of Figure 2 shows that China holds the largest foreign exchange reserves in the world, by far. Thus, the U.S. and Chinese economies have important trade and financial links.

[FIGURE 1 OMITTED]

The bottom panel of Figure 2 shows, however, the value of Chinese foreign exchange reserves peaked at just over $4 trillion in June 2014 and has since declined to $3.12 trillion (as of October 2016). (3) Although China retains very large foreign exchange reserves--in excess of $3 trillion as of October 2016--this very large and rapid decline in Chinese foreign exchange reserves, most of which are denominated in U.S. dollars (USD), is unprecedented. Indeed, this disturbingly rapid decline in Chinese reserves prompted well-known financier George Soros (2016) to predict a "hard landing" for the Chinese economy. In response to this ominous prediction, an opinion piece in the Chinese authorities' People's Daily warned "Soros's war on the renminbi and the Hong Kong dollar cannot possibly succeed--about this there can be no doubt" (Wildau, 2016b). This war of words between the most famous currency speculator in the world and the Chinese authorities strongly suggests that the rest of this interconnected world should understand the situation and its potential implications. This article explains how this situation came about, China's available policy choices, and how these choices could affect the U.S. economy.

The next section of the article discusses managed exchange rates, the role of financial regulation in the context of the Chinese exchange rate management, and China's accumulation of foreign exchange reserves. Section 3 discusses China's policy options and their potential effects on the U.S. economy. Section 4 concludes.

[FIGURE 2 OMITTED]

2 CHINA'S MANAGED EXCHANGE RATE

2.1 Managed Exchange Rates

Every country with its own currency must choose the extent to which it manages the external value of its currency against other currencies. This strategy is often referred to as an "exchange rate regime." A managed exchange rate regime denotes a promise by a government or monetary authority to maintain the value of its currency by changing policy--mainly monetary policy--and trading foreign exchange reserves. …

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