China’s foreign exchange (‘forex’) reserves and its holdings of U.S. government debt are two of the most frequently misunderstood issues in relations between the two countries. Recent events have underscored this problem. On September 18^th, a car carrying Gary Locke, the U.S. Ambassador to China, was surrounded and partially attacked in a sideshow to an outbreak of Beijing anti-Japanese protests over the Senkaku/ Diaoyu islands. The attackers allegedly shouted anti-American slogans, including the cry “Pay us back our money” – a reference to Chinese investments in U.S. government debt. Then, a poll by the Pew Institute again demonstrated worried opinions in the U.S. about China’s large holdings of U.S. debt. The poll showed that 78% of the general public surveyed thought that Chinese holdings of U.S. debt are a “very serious problem”.

With the U.S. election season in full swing, we can expect the candidates and their parties to spout some fairly unrealistic things, but the misunderstanding around the forex issue is by no means recent, and by no means limited to the eastern side of the Pacific Ocean. In fact, there has been much confusion about this issue for years. It has elicited passionate commentary and even threats have been issued.

There is an old banking saying which goes something like: “If you owe your bank a thousand pounds, you are at their mercy. If you owe a million pounds, then the position is reversed.” This epigram highlights the problems of being a large lender, and yet it still fails to fully capture the forex reserve issue.  China is not a commercial bank; it did not decide to “lend” its foreign exchange reserves to the U.S. per se. Rather, China’s accumulation of reserves is a by-product of the government’s exchange rate policy. It used to buy large quantities of U.S. dollar assets because it had to maintain reserves of the currency to which the renminbi was pegged (although Beijing has allowed the renminbi to fluctuate around a basket of currencies since 2005). Furthermore, it is impossible for a country to run a trade surplus without being a net exporter of capital.

As a simple explanation, the People’s Bank of China (PBOC) maintains a weakened renminbi by agreeing to purchase nearly all U.S. dollars accumulated by Chinese exporters and corporations. These earned dollars are only partly profit, since the incoming ‘top-line’ dollar revenues must be used to pay company costs as well.  The PBOC must buy these dollars by selling renminbi – which is effectively borrowed. Selling such large amounts of renminbi is inflationary, so the PBOC must further ‘sterilize’ the resulting liquidity by issuing debt or raising the ‘required reserve ratio’ of capital that must be set aside by Chinese banks.   The result is that the PBOC owes renminbi (which it since sold at an unnaturally low dollar price), and owns dollars (bought at an unnaturally high price). 

That the U.S. became the destination for many of the PBOC’s resulting dollars is not surprising. Importing large net amounts of capital means that an economy must run a large trade deficit, and also must have developed, deep, and well managed financial markets.  The U.S. fits this description and makes an attractive destination for China to park its trade surplus. Maintaining China’s surplus has thus meant that the PBOC has accumulated an ever larger pool of forex reserves. Even Zhou Xiaochuan, the PBOC’s governor has called them “excessive”.

China could legally sell off its holdings of United States government debt at any time – the protestors surrounding Mr. Locke’s car were clearly confused on this point. The U.S. is not disallowing such action. Realistically though, it is almost impossible for China to do so.  Despite much talk about diversifying reserves, China really is in a “dollar trap”.

China could pull funds out of United States government debt, but other than bringing them back to China (which would be highly inflationary and devastating to China’s export sector), all other options fail to provide much benefit to China. Moreover, they would do very little damage to the United States, and perhaps actually help it reduce its trade deficit – which is not necessarily in China’s interests. If China were to buy eurozone debt, for example, it would force down eurozone debt yields, but that would cause existing investors to search for higher yields elsewhere. Meanwhile, U.S. government debt yields would have climbed as China withdrew, so as Chinese money moved to Europe, funds currently in Europe would eventually flow to the United States. Alternatively, the eurozone may accept the extra capital from China without an offsetting outflow, in which case some of the U.S. trade deficit would shift to the eurozone. Buying U.S. corporate debt would have a similar net effect, with various holders switching assets until someone ends up back at U.S. government securities. 

For China, of course, switching to the eurozone or to corporate debt would mean an increase in risk. Equally, purchasing foreign corporations or assets outright raises objections, sometimes dubiously, about sovereignty, national security and reciprocity. Investments in resources (such as in Australia) are proving risky, since high resource prices seem to be driven greatly by China itself, and will fall as China’s economy slows – a very volatile strategy.

For now, China’s dollar trap remains a reality. While foreign exchange reserves can protect China from a currency crisis (the PBOC can sell them to support the renminbi) or an external debt crisis, they really are not much use for a domestic financial crisis or as a weapon against the U.S. (as long as people in the U.S. understand that these threats are empty, that is.) The reserves are not wealth, since the PBOC had to borrow in order to purchase its dollars. In fact, as its US dollar assets have devalued relative to its liabilities in renminbi, in this area, the PBOC is sitting on a massive unrealized loss.