http://www.bnn.ca/News/2011/4/15/Chinas-3-trillion-in-reserves-more-a-bane-than-a-boon.aspx

Reuters | April 15, 2011

China's foreign exchange reserves have topped $3-trillion-and-counting, stoking inflation, knocking the economy off kilter and leaving the country's money managers with an impossible assignment.

At first glance, the eye-watering stockpile appears to be a symbol of China's fast-growing wealth. But on deeper inspection, the vast cash holdings are an unflattering testament to much that is wrong in the world's second-largest economy.  They reveal how undervalued the yuan is, how inflation could soar in the future and how much more the government could be investing at home to engender sustainable growth, analysts say.

The People's Bank of China said on Thursday that its foreign exchange holdings, already the world's biggest, increased by $197 billion US in the first quarter to $3.05 trillion. They are now nearly triple Japan's holdings, the world's second-biggest official currency reserves.

"It's clearly too much, it's clearly excess to needs, and more importantly, it's damaging to the economy," said Stephen Green, an economist at Standard Chartered. In the last decade, China's gaping trade surpluses and its incessant buying of dollars to suppress the yuan's value have led the reserves to balloon 17-fold.

For every dollar that goes into reserves, China prints about 6.5 yuan, adding even more cash to its economy. This is worrying since China is already at pains to drain excess money, with inflation running near its fastest in three years.

"Every new dollar of foreign exchange reserves is every new dollar of base money. And that drives up inflation," Green said.

"TOO HIGH A COST"

To neutralize all the money that has been created, China has conducted what are known as "sterilization operations." Its primary weapon has been to increase banks' reserve requirements, forcing them to lock up cash that they would otherwise lend.  Required reserves are already at a record 20 percent of deposits for China's biggest banks, denting their profitability, and analysts believe that the room for further increases is limited.

By most estimates, China only needs about $780 billion of reserves. That would be sufficient to pay for three months of imports and to cover all of China's short-term foreign debt—the standard metrics of how much countries should hold in reserves as a form of insurance in case of a financial crisis.

Yet the stockpile has grown so big because China refuses to let the yuan rise faster for fear of hurting its exports, much to the frustration of its trading partners, especially the United States.  But it is also a problem domestically. It runs directly counter to China's need to boost consumption to cope with tepid growth in its major export markets, said Li Jie, a researcher at the Central University of Finance and Economics.  "It is too high a cost to pay to let the whole domestic economy suffer from high inflation just to protect exporters," he said. "China cannot afford to sacrifice its internal economy as it has a vast domestic market."

China's net exports accounted for just 4 percent of the country's total output in 2009; consumption and investment were 48 percent each.

WHERE TO PUT IT?

Then there is the perennial problem of finding a safe place to invest $3 trillion. Its monstrous size precludes China from most markets except U.S. Treasuries, leaving Beijing vulnerable to a struggling dollar. 

Efforts to boost China's returns on its reserves by spinning off state investment arms misses the point, said Li.  "Any fund manager in the world would find it difficult to look after such a huge pile of reserves," he said.  "The point is not how successful they were in their investments. The real failure is the lack of an exchange rate regime that is fully dictated by market forces."

China's accumulation of foreign exchange reserves also represents an opportunity cost. Given China's high savings rate over the past decade, it was bound to have a high rate of investment.  Had China let its currency rise, that investment could have taken place at home with the building of sorely needed schools and hospitals. Instead, much of that investment ended up parked in assets like U.S. Treasuries. 

China is the biggest foreign holder of Treasuries, with $1.15 trillion at the end of January.

NOT FAST ENOUGH

Yet China's strident rhetoric about how the yuan is not undervalued and how it needs to rise slowly belies a growing belief at home that the currency is simply not strong enough.  Increasingly, the Chinese realize that a firmer yuan can help them fight imported inflation and give them more bang for buck when they invest abroad.

"The government is moving too slowly toward a more flexible yuan exchange rate. They should definitely quicken the pace o appreciation," said Zhang Bin, an economist at the Chinese Academy of Social Sciences.  

Some economists say that concerns about exporters are overdone. They, too, would benefit from cheaper imports of raw materials and other components.  

"We know that the foreign exchange reserves accumulate because of the exchange rate regime. It's not because we absolutely need it," said Tao Wang, an analyst at UBS.  "The fundamental thing is to adjust the economic structure so that we don't accumulate so much. We need to consumer more and reduce the savings rate."

In a sign that China might finally be starting to move more aggressively on the yuan—potentially capping the rise in reserves—the central bank has steered the currency to a succession of record highs against the dollar in recent days.