This Time is Different

What would China do with its massive and growing $4 trillion in currency reserves? According to Louis-Vincent Gave of Gavekal Dragonomics, there is a more attractive proposition than keeping foreign reserves in low-yielding U.S. or eurozone bonds, which is to finance “foreign infrastructure projects, even at relatively low returns.” Presumably this is where the Asian Infrastructure Investment Bank (AIIB) and the $40 billion Silk Road infrastructure fund come in to play an important role, i.e., which is for yuan to be more widely used around the world starting first in Asia.


Wider holding of yuan in the investment portfolio would also be desirable for China. However, even though foreign investors can already buy up to $1 billion worth of Chinese securities, there isn’t much for them to buy, which hampers the yuan’s internationalization. The conventional wisdom is that for foreigners to become big holders of yuan, China has to run a trade deficit. It was suggested that China could instead simply give yuan to other countries to invest in (presumably Chinese-made) equipment and know-how, as the United States’ Marshall Plan gave Europe dollars with which to rebuild. That would certainly be a more practicable approach. The AIIB and the Silk Road infrastructure fund seem to be a step in that direction.

However, there are other interesting dynamics at play on the domestic front. Under the old export-led model, currency-weakening interventions by a country’s central bank effectively transfers wealth from consumers to exporters, since they drive up the cost of imported household goods but make exports cheap overseas. Similarly, interest rate caps on deposits also penalize household savings but makes business loans cheap. Such economic distortions misdirect growth into a trap of investment for investment’s sake, the so-called “treadmill to hell” that leads to whole swaths of vacant apartment buildings – or even entire ghost cities, as is the case in China’s economy today. Reversing the household-to-business subsidy would be a first step to get off that treadmill, cool the speculative property bubble, and make China’s economy less vulnerable to flagging demand in the U.S. and Europe.

If People’s Bank of China (PBOC) subscribes to this view, then there is a very good chance that its currency would soon reverse course and go from being undervalued in the past, to requiring state support to prop up its value going forward. At the moment, people and businesses want dollars to invest overseas; the market has traded at the lower end of the PBOC’s trading band as a net $25.3 billion in foreign exchange was sold in March. What’s more, it appears that the giant inflows of “hot money” that had accumulated in recent years, attracted by earlier one-way speculative bet on the Chinese yuan, are also itching to leave. If capital flight takes hold amidst slowing growth and the yuan plunges, there will be an exodus of funds going overseas. So it looks like PBOC’s massive $4 trillion in currency reserves might come in handy on such a rainy day after all. Unless, of course, there are good incentives for foreigners to be carrying out infrastructure projects denominated in yuan or holding yuan-denominated securities before that happens.


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