How Did China Accumulate Over $2 Trillion of International Reserves?
By the end of 2010, China had accumulated more than $2 trillion of international reserves, and its international reserves are expected to keep growing in the near future. How did the Chinese get their hands on this vast amount of foreign assets? After all, China is not yet a rich country. The answer is that China pegged its exchange rate to the U.S. dollar at a fixed rate of 8.28 yuan (also called renminbi) to the dollar in 1994. Because of China’s rapidly growing productivity and an inflation rate that is lower than in the United States, the long run value of the yuan has increased, leading to a higher relative expected return for yuan assets and a rightward shift of the demand for yuan assets. As a result, the Chinese have found themselves in the situation depicted in panel (b) of Figure 16.2, in which the yuan is undervalued. To keep the yuan from appreciating above Epar to E1 in the figure, the Chinese central bank has been engaging in massive purchases of U.S. dollar assets. Today the Chinese government is one of the largest holders of U.S. government bonds in the world. The pegging of the yuan to the U.S. dollar has created several problems for Chinese authorities. First, the Chinese now own a lot of U.S. assets, particularly U.S. Treasury securities, which have very low returns. Second, the undervaluation of the yuan has meant that Chinese goods are so cheap abroad that many countries have threatened to erect trade barriers against these goods if the Chinese government does not allow an upward revaluation of the yuan. Third, the Chinese purchase of dollar assets has resulted in a substantial increase in the Chinese monetary base and money supply, which has the potential to produce high inflation in the future. Because the Chinese authorities have created substantial roadblocks to capital mobility, they have been able to sterilize most of their exchange rate interventions while maintaining the exchange rate peg. Nevertheless, they still worry about inflationary pressures. In July 2005, China finally made its peg somewhat more flexible by letting the value of the yuan rise 2.1%. The central bank also indicated that it would no longer fix the yuan to the U.S. dollar, but would instead maintain its value relative to a basket of currencies. However, in 2008 during the global financial crisis, China reimposed the peg, but then dropped it in June of 2010. Why have the Chinese authorities maintained this exchange rate peg for so long despite the problems? One answer is that they want to keep their export sector humming by keeping the prices of their export goods low. A second answer might be that they want to accumulate a large amount of international reserves as a “war chest” that could be sold to buy yuan in the event of a speculative attack against the yuan at some future date. Given the pressure on the Chinese government to further revalue its currency from government officials in the United States and Europe, there are likely to be further adjustments in China’s exchange rate policy in the future.