Chinese goods have in fact become so cheap that many companies in both developing and developed countries are going bankrupt because they cannot compete with prices of Chinese-made goods and that too this is after including the freight and duties paid on them.

The Chinese did loosen the peg in the mid-2005 after an intense outcry from the US, which bore much of the brunt of Chinese goods though it can be argued that the US also benefited from cheap Chinese goods. The yuan was trading at around 7.57 to the dollar (on August 29) but it is widely estimated to be still ‘undervalued’ but there are no clear estimates by how much.

Side-effects

This undervalued currency has, however, had an unintended side-effect. Because the yuan became so undervalued, many currency speculators started to transfer money into China and converted them into yuan. Their hope was that when the currency started appreciating, they would make a lot of money. Note that this is opposite to a currency crisis when people start taking their money out in hordes to avoid a lowering in value of their monies. This phenomenon of people bringing in money specifically to benefit from an appreciation in the currency is a very rare one indeed. This inflow of money has added to the pile of reserves. As mentioned earlier, China has had very large FDI inflows and that too has added to the pile and it has also had massive FII inflows too in the recent past.

Advantage

To answer the question about whether China’s reserves are a threat or an advantage, I will do so strictly from a Chinese perspective. Put simply, it is both. The IMF says that the ‘optimal’ level of foreign reserve holding should be equivalent to six months’ worth of imports. Given mobile international capital flows, reserves should also cover all short-term debt as well as some level of FII inflows. China’s reserve levels are way above all three included. This is the advantage of having this sort of level of reserves because of the protection it affords.

Downside

The downside of China’s foreign reserves is two-fold. One is because of the high level of reserves. Holding reserves is an expensive business. Forex reserves have a very high opportunity cost. This is because foreign reserves are usually held in ‘treasuries’ or sovereign debt which typically has very low yields. The alternative is to invest these monies elsewhere which would yield, on average, a higher return.

Since central banks prefer to hold these reserves in safe sovereign debt, there is a high opportunity cost to holding reserves. The second downside arises because of the rate of growth of foreign reserves. It should be understood that every time a single unit of foreign currency enters the domestic economy, it adds to the monetary base and by extension the money supply.

Inflation threat

The definition of inflation is “too much money chasing too few goods” and therefore every time there are large-scale inflows, the threat of inflation arises. To ward off this threat, the central bank sometimes sterilises this inflow by issuing bonds and sucks out the equivalent amount from the money supply. Though the Chinese central bank sterilises inflows, it cannot possibly sterilise every inflow. Consequently, a lot of ‘un-sterilised’ foreign money has come in and China’s biggest downside from these inflows is that it has both created asset bubbles as well as steadily increased the inflation rate.

Spending abroad

China is now trying to head this off by spending the money abroad on various things, such as buying equities, so that money is taken out of the country. To this end, they have created a fund to do these activities. However, these measures are just temporary since they haven’t addressed the primary problem, which is record levels of money inflows. If these inflows aren’t curbed, then whatever measure China takes will prove to be only temporary and it will only build pressure.

The quickest way for China to reduce the growth of foreign reserves is to let the yuan appreciate or strengthen but that is a course of action that they loathe, because they view their exchange rate policy as a cornerstone of their economic success.