The limited value of foreign reserves

An article in the Financial Times today explains how domestic public opinion in China constrains the government’s ability to contribute to a Eurozone bailout, even if it wanted to. China spends about the same on health care as Greece did before the crisis (but has 120 times the population). It is therefore hard to convince a Chinese patient waiting for hours in an under-resourced hospital that some of the nation’s foreign exchange reserves should go to helping out the Greeks.

The article briefly but importantly makes the point that the nation’s vast foreign exchange reserves – $3.2 trillion at the last quarterly count and probably nearer $3.5 billion by now – cannot help domestic health spending. This is worth explaining further.

Foreign exchange is a claim on foreign central banks. It can be converted into real goods and services by buying imports or funding the acquisition of real assets in the foreign country (or reducing foreign liabilities but China has few of those). So these are definitely a form of wealth from the point of view of the country which owns them. In that sense, each Chinese person has a notional ownership of around $2,700 worth of foreign resources.

But this doesn’t help in creating domestic resources, for healthcare, pensions or anything else. If Chinese hospitals need more staff, better facilities, more drugs (actually it sounds as if there are too many drugs at present) then the reserves don’t help. The dollars accumulated by the People’s Bank of China in its SAFE (State Administration of Foreign Exchange) subsidiary were bought from Chinese companies and institutions which had acquired them by exporting to the rest of the world. They were and are required to sell their forex to the PBOC in exchange for Yuan (domestic Chinese currency). They can then go and spend that money in the domestic economy. If the PBOC reversed this process, by selling the forex for Yuan, it wouldn’t add any real income to the domestic economy. If it spent the Yuan it received it would simply add to the domestic money supply. It could do this already, since central banks can print money at will (though they often try hard not to, to avoid damaging confidence in the currency, which risks inflation in normal times – the US and Europe are currently NOT in normal times ).

This is a familiar problem. When the UK discovered gas and then oil in the North Sea, it started to accumulate large amounts of foreign exchange which pushed up the UK pound exchange rate close to 2.4 to the dollar in the early 1980s, which was damaging to British companies’ competitiveness. The UK government abolished exchange controls, which allowed UK investors to fully invest abroad, reversing the inflow of dollars and bringing down the exchange rate (eventually). There were calls at the time to use the oil wealth in various ways, including investing in the UK’s crumbling infrastructure and outdated manufacturing industry. The point was that only if new resources were imported (as they might well have been) would the oil wealth have directly helped. It would not have added to the amount of concrete in the UK (a largely domestically sourced material) though it could have bought some nice German machine tools.

So, China could buy Euro bonds if it wanted, which would not be at the expense of domestic resources. I put this argument to some Chinese economists in Beijing in February, back when such a deal could really have helped the Euro problems to mutual benefit. They replied on the difficulty of a poor country helping rich ones, to which my response was that the money was currently invested in an even richer economy, namely the US.

Anyway it’s academic now, since China would be nuts to put any money into the Euro area until the dust has settled after the forthcoming disaster that German politicians and bankers seem determined to bring about.

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