Why China increasing US dollar reserve?

Sumit Roy: For the past 20 years or so, China has been buying dollars in international currency markets with its own currency to maintain the yuan’s devaluation and sustain China’s booming manufacturing and export sectors. As a result, China has accumulated trillions upon trillions of dollars which it uses to buy mainly dollar-denominated debt and US Treasuries. This has always been a concern for US policymakers, but the concern has become especially acute recently as new research shows that China is actually hiding its dollar reserves, which are nearly double the official figures from the People’s Bank of China. So, this article will explain why China loves the dollar, how they hide it, and why it poses a systemic risk to the global economy.
Why does China love US dollar?
So, this story probably started in the late 90s or early 2000s when China went from being a net importer to a net exporter. Prior to this, China, like many other developing countries, had an overvalued currency in the 80s and 90s. It pegged its currency, the yuan, to the dollar at a higher rate to ensure that China would be able to export its imports. However, in the 1990s, the CCP realized that an undervalued currency actually had an economic advantage as it made China’s exports more competitive and benefited China’s manufacturing sector. And this is why China dramatically devalued its currency from 1.6 yuan to the dollar in 1980 to 5.8 yuan to the dollar in 1993 and then to 8.3 yuan to the dollar in 1995. As the yuan was devalued, China began running larger and larger trade surpluses. Meanwhile, with the yuan cheap Chinese consumers can’t buy as many things from abroad, allowing Chinese manufacturers to produce goods really cheaply, undercutting foreign manufacturers and creating huge demand for Chinese exports. This means that China started exporting more than it imported, hence creating a trade surplus. (I have already posted about the history of Yuan).
Now according to standard economic theory, trade flows should balance over time. Because if a country like China runs a trade surplus, it means that there is a lot of demand for the yuan because other countries need to buy Chinese goods. This would cause the yuan to appreciate, make Chinese exports more expensive, and increase China’s purchasing power and hence imports, ultimately reducing the trade surplus. But China didn’t want that and instead wanted to retain China’s manufacturing and export industries. So they deliberately devalued their currency against the dollar by using billions of yuan to buy dollars on the international market. This process really accelerated in the early 2000s and as a result, China began accumulating tons and tons of dollars in what is known as the country’s dollar reserves.
Concern for the US
From 2002 to 2012, China’s central bank was active in currency markets almost daily, devaluing the yuan to preserve China’s economic model. Maintaining China’s devalued currency was a feat in itself. To buy this many dollars, the People’s Bank of China had to print a lot of yuan, which usually creates a risk of domestic inflation. But the PBOC essentially forced Chinese banks to limit their lending to reduce inflation. China then uses these dollars to buy US-valued financial assets, particularly US Treasuries. In practice, this means the US government is borrowing a lot of money from China. This became a concern in the Obama administration, and former Treasury Secretary Lawrence Summers said that the United States and China were caught in a balance of financial terror. Essentially, China was dependent on the US for its export needs, and the US was dependent on recycling those dollars into the Treasury for financing. The Obama administration was concerned that if Sino-US relations deteriorated, China could dump all its Treasuries to raise US interest rates or sell its dollar reserves to devalue the dollar. While this would ultimately hurt the Chinese economy, which depends on US demand for its exports, it would first cause economic chaos in the US, which is what Obama was concerned about.
After the 2008 financial crisis, the balance of power shifted in America’s favor, mainly because the United States realized that it did not need China to finance its deficits because the country could essentially print dollars and use them to buy Treasuries. can And it doesn’t seem likely to generate much domestic inflation. Recently, however, American policymakers have again become concerned about US economic interdependence with China, and this is because China has apparently begun to hide its reserves.
How does China hide dollar?
Analysts first began to doubt this in the 2010s, as the People’s Bank of China’s government reserves suddenly stagnated. But new research by Brad Setzer at the China Project shows that the actual size of China’s reserves is much larger than anyone imagined. According to Setzer, China has stashed another three trillion dollars in semi-public banks and institutions, perhaps most notably the China Development Bank, or CDB, and the Export-Import Bank of China, known as Exim. Although they are not the same as central banks so they do not appear on China’s official reserve sheet, they are effectively controlled by the Chinese government. This is a huge number. According to IMF data, the world’s second-largest reserve holder is $3 trillion larger than the entire reserves of Japan and nearly four times larger than Switzerland.
A systemic risk to global economy
Why are these things important now? Because such a huge pile of dollars creates the risk of a “dollar avalanche” or party avalanche (the economists’ term). And this risk is difficult to predict because China has hidden dollar reserves. Chinese banks are holding more dollars than they actually need, because the Chinese state tells them to do so. This is fine at the moment because the dollar is rising. But if the dollar begins to decline, such as if the US central bank or the Fed starts to cut interest rates or if the Chinese economy revives and creates demand for yuan over dollars, these banks may decide to start getting rid of their dollars.
Normally, this is no problem, but with Chinese banks holding so many dollars, it poses a systemic risk to the global economy. If Chinese banks dumped billions or even trillions of dollars at once, they could create a dangerous feedback loop whereby their dollar dumping pushes down the value of the dollar, encouraging more dumping and pushing the dollar down even further. This would create a rapid devaluation of the dollar with unforeseen consequences for the US and world economies. All in all, China’s large dollar holdings pose a systemic risk to the global economy, and especially because of the opaqueness of the Chinese banking system, which is difficult to predict.