Saturday, August 1, 2009

How China Accumulate So Much Of Foreign Reserves?

Before 1980s, the Chinese economy was rather insignificant due to the establishment of herself as a ‘self-centered’ economy. In other word being a centrally planned economy where there was very little trading that took place, very few private enterprise and much of the economic activities were in the hand of the government. China conducted minimal trade with outside world by exporting just enough raw materials and simple manufactured goods to cover payments for the import of strategic minerals and other necessities not available back home

How it accumulate so much of foreign reserves then?

(1) Massive trade. The Chinese economy took a turn when Deng Xiaoping, the leader of the Communist Party of China became a reformer who transformed China towards market economics. It took place somewhere in late 1970s. This means unleashing the economy from the central grip by allowing private firms to grow, promoting international trade and encouraging the flow of foreign capital.

As at 1978, its foreign reserves stood at $1.6 billion. However by 1984 the figure whooped up to $17.4 billion. What an amount during that time and considering the accumulation within just 6 years. However by 1985 and 1986 the foreign reserves shrank to around $12 billion. Nevertheless it was a healthy indicator as China was importing capital goods like machineries to finance and expand its production capacity (outward shifting PPF) to meet the growing demand from outside. China’s major export destinations are like US, Hong Kong, Japan, South Korea and Germany. Since then, China’s accumulation of foreign reserves continues to mountain ‘abnormally’ especially with her accession into WTO (World Trade Organisation) in 2001. Countries like US being the world’s largest consumer, continues to buy from China due to factors like low production cost, improving quality and innovation but mainly due to the undervalued yuan. Amazingly China is set to topple Germany as the world’s largest exporter this year due to tumbling European economy.

(2) Inflow of foreign capital. The liberalisation of Chinese economy is one but out of many other reasons as to how it becomes the centre of attention. Large number, cheap and yet educated workforce is often cited as the top reason why increasing number of transnational firms are relocating or even outsourcing part of their production process in China. Of course there are other reasons too, such as tax-friendly policy, ease of obtaining certain natural resources and modern infrastructure. When foreign firms set up subsidiaries, factories or outlets in China the process is called inward investment. They will more often than not, raise capital from home country and bring it into China, especially new firms

In the recent, its foreign reserves had surpassed $2.13 trillion for the first time. However, it is not due to excess of exports over imports. This is as a result of foreign investors perceiving China as the world’s ‘safest’ haven in uncertainties like now. Its economy is estimated to grow by around 8% in the second quarter, indicating that the stimulus package seems to be working well unlike in other major economies. As foreign investors continue to pour money into Chinese stock market as well as property market. The Shanghai Composite Index surged has jumped over 74% alone in this year. There is also a fear that this will create a bubble in an already heating commercial property market. Much of these however are hot money. It refers to money controlled by investors who actively seek short term but high-yielding investment opportunities

As such it can flow out of the country anytime too. Therefore it could be highly unlikely for China to sustain its position of foreign reserves at such high level for long term


hishamh said...

Some further nuances to your explanation:

1. Even given the excess of exports over imports as well as positive net capital inflows, official foreign reserves would not be rising unless the central bank is partially or fully sterilising foreign exchange inflows.

2. Reserve accumulation can also be taken as proof that the Yuan/Renminbi is undervalued, and that the PBOC is targeting a particular level or rate of change of the exchange rate. In a free float regime, exchange intervention is not required, and no change in reserves should be seen.

Lawrence Low said...

Hi, thanks for sharing