As China's foreign currency reserve hits one trillion-dollar mark, suddenly many scary stories appear on major media about how China may use this vast mostly dollar-denominated foreign currency reserve to harm US interests. Though many of those stories are attributed to supposedly knowledgeable economists and financial market observers, most of them are based on misunderstandings of the purpose of China's rapidly increasing foreign currency reserve. On the other hand those stories overlook the real threat of China's foreign currency reserve posed on US economy. The purpose of this comment is to clarify those points.
Many countries around the world are accumulating outsize foreign currency reserves, thanks to the run away US trade deficits. When US runs trade deficits, US dollars are handed over to foreigners. Many foreign governments buy up those US dollars from private parties, which want to sell those trade-deficit-dollars for their own currencies, in order to prevent the upward revaluation of their currencies versus US Dollar; they fear that an expensive currency will hurt their exports. Especially notable in this kind of currency market manipulations are the countries of Asian Pacific Rim, like China, Japan (with a reserve of about $880 billion dollars), Taiwan (about $260 billion dollars), and South Korea (about $230 billion dollars). Among those four countries, only China, an authoritative communist regime, is not a firm US ally so that many worries have been aired from the fear that China may use this vast foreign currency reserve against US in case of a US-China discord. Those people fear that if China shifts its foreign currency reserve en mass to other currencies like Euro, Yen or gold bullions, US Dollar will collapse and US will plunge into a depression. Those people are forgetting that China is accumulating those dollars in order to suppress the value of Yuan so that it can continue to hold its wage level low and to attract foreign manufacturing capitals to make goods to be exported to US. If US Dollar collapses by China's rash movement of shifting its foreign currency reserve away from dollar-denomination, its Yuan will rise sharply against Dollar, its exports to US suddenly drop, its own export industry collapses and the regime itself will be in grave danger. If US Dollar should collapse in some future time, most likely it will not come from China's action but from some other factors. It should be noted that to induce a depression both in USA and China, the collapse of US Dollar is not necessary; the sudden disruption of US-China trade will be enough. A sudden disruption of US-China trade can occur due to outside factors, like a US-China military confrontation, a worldwide pandemic, or a unilateral action on the US side to impose a heavy import tax on Chinese made goods.
Some economists within China suggest that China can use its vast foreign currency reserve to fund domestic projects like social welfare. However, those people are ignoring the reality that US Dollar is not a legal tender within China. In order to use dollars in the reserve to fund China's domestic projects, Chinese government must sell dollars for Yuan, thus completely destroying the purpose of dollar buying from the very beginning. How about to allow other Chinese parties to hold those dollars instead of the central government itself? If Chinese government still holds the decision making power of dictating how those diversified dollars will be used, it is no different from the current situation that Chinese government holds those dollars. If those Chinese parties can decide how to use those dollars as they see fit, they will behave just like other private parties outside China by selling those dollars for Euro, Yen, gold bullions or even Yuan itself, causing the collapse of Dollar that will drag down the economies of both US and China; at the end Chinese government will be forced to buy back those dollars.
China is already buying all it can from US, ranging from agriculture products to civilian aircrafts, but is not be able to close the vast trade gap between China and US in a meaningful way. For China to buy its most wanted high technologies and sophisticated weapons from US is out of question, considering current geopolitical conditions (see, for example, Article 6). Some in US claim that if Chinese government crack down on illegally pirated DVD's and CD's, US is going to gain hundreds of billions dollars a year, thus be able to close the trade gap and make the expansion of China's foreign currency reserve much slower. Let us entertain this claim for a while. Let us make an exaggerated assumption that every one of 1.2 billion Chinese buys 5 DVD's and CD's a year in average and each of such pirated disks costs one US dollar at street corners of China. The total amount of Chinese consumption of those disks will amount to 6 billion dollars a year. Those US claimers must be assuming that a legal copy of US made disk can be sold for $30 to Chinese and thus bring in 180 billion dollars a year. We must point out that the average price of an entertainment disk in US retail stores is less than $15, and probably more than 50% of the price is due to the overhead of retail chains, not the actual price that entertainment producers are entitled to. US can gain like 50 billion dollars at most if Chinese government cracks down on pirated disks 100%. However, it is ridiculous to think that Chinese consumers will spend 50 billion dollars, about 7% of China's total consumer spending, just on US made entertainment disks! If a total crack down on pirated disks is really undertaken by Chinese government, in short term US can gain, in a most optimistic scenario, just a few billion dollars a year, a drop in the bucket on the way to slow down China's rapidly expanding foreign currency reserve. In long term such a stern action of Chinese government on pirated disks will induce the emergence of China's entertainment industry due to the sudden eightfold jump in the price of an entertainment disk in China. Not long after we will see very inexpensive, computer generated "made in China" entertainment disks flood into USA, battering US entertainment industries and further fueling the growth of China's foreign currency reserve. In principle, Chinese government can loan the dollars at hand to Chinese corporations to buy up US corporations and commercial real estates to dent its foreign currency reserve. However, such purchases, if the targets are viable corporations and real estates, will encounter stiff public backlash in US, so such transactions cannot be expected to rise to the degree that is capable of slowing down the accumulation of dollars in the foreign currency reserve of China in any significant way.
From the above discussions it should be clear that the only reasonable way for China to manage its vast foreign currency reserve is to keep most of its reserve in dollar-denominated securities as it is doing presently. However, there is a real risk to US economy even for China just passively holding dollar denominated securities; economists and analysts mostly overlook this risk. Currently China's dollar-denominated securities are mainly in US treasury notes and mortgage-backed securities issued by US government-sponsored agencies. Those securities are long-term debt instruments in nature. US Federal Reserve Board (abbreviated as FED) has been rising short-term interest rates for more than two years in order to slow down US economy to a more sustainable pace. For this plan of US FED to work, long-term interest rates need to rise in tandem with short-term interest rates. The persistence of China to buy long-term dollar denominated securities is one of the major reason that the long-term interest rates are kept below the short-term interest rates, a phenomenon called "inverted yield curve" and is also dubbed as the "interest rate conundrum". The reason of China's behavior is quite apparent. China does not want to see US economy to slow down since a subdued US economy means a slow down of China's exports to US and a dangerous slowdown of Chinese economy. Therefore, China is buying long-term dollar denominated-securities to hold US long-term interest rate down even at the risk of annoying US FED. This confrontation between US FED and China is forcing FED to raise short-term interest rates to a higher level and for a longer period than under a normal situation. This incident should be compared to the way Japan's management of its 800+ billion dollars of reserve. Japan's reserve is mostly in short-term US treasuries so that any excess liquidity pumped into the market by its buying can be safely drained away by FED, and the long-term interest rates will not be pushed down against the wish of FED. If FED wants to stimulate US economy by lowering short-term interest rates in future, Japan will shift its holding to long-term US treasuries such that long-term interest rates will come down as FED desires. In other words Japan is yielding back the power of US monetary policy to FED, but China is not due to the consideration of its own interests. In 2005 China's foreign currency reserve expanded by 200 billion dollars. In 2006 the reserve probably will expand by about 250 billion dollars. With this kind of rate of expansion, China's foreign currency reserve will reach 2 trillion dollars by 2010 and approach 4 trillion dollars by 2015. In that occasion every movement in US monetary policy needs to be cleared with Chinese Government beforehand. Thus Chinese Government will replace US FED as the agency making US economic policies, a scenario rapidly approaching the situation as depicted in Article 7, titled as "globalization utopia".