When I first moved to Singapore in 2000, Chinese foreign reserves stood at $165billion. This was 10 times more than they had held in 1995, and the authorities were struggling to deal with the realities of day-to-day Reserves Management (for example, collecting and reinvesting coupons). Fifteen years later, foreign reserves stand in excess of $4trillion, a direct implication of the mostly-fixed exchange rate regime that the country has been operating since Deng Xiao Ping’s modernisation program began.
For a young, developing economy, foreign investment and capital inflow is critical. China’s fixed exchange rate regime coupled with capital controls were policies which ensured that foreign investment remained in the country, that capital could not take flight, and set the stage for sustained long term growth. This is exactly what has happened. Now, it seems, the joint policy of a fixed exchange rate and capital controls is being rethought.
First, the Chinese leadership must be asking whether $4trillion in foreign reserves is worth growing? Foreign reserves are claims on foreign assets which lie-in-wait for some future use, but which in the meantime earn a rate of return. How much is enough? There are many rules of thumb driving optimal reserve analysis (e.g.1 year’s import expenditures, 5 standard deviations of capital flows), but none will deliver the prescription that $4trillion is the right amount. $4trillion is more than adequate to defend a speculative currency attack.
Second, the Chinese leadership must also be thinking of encouraging a two-way flow in investment. Where previously China had been capital importer, it may well become a capital exporter. Capital controls are a clear hindrance to outward bound investment since, basically, domestic companies are not allowed to send money offshore.
So what are the recent changes in the policies determining the Yuan all about? Contrary to the popular press, my view is that freeing up the Yuan has nothing to do with “short term stimulus” – currency devaluations don’t provide trade advantages as has been clearly evident with almost instantaneous currency declines across neighbouring Asian economies. Nor does it have anything to do with being accepted as a reserve currency – the benefits of which are nebullous at best.
My view is that the new procedures set the stage for (i) curtailing the growth in foreign reserves, (ii) protecting existing reserves and (iii) facilitating outward bound private investment flows. Allowing the Yuan’s price to adjust, rather than the foreign reserve position, achieves these goals. It doesn’t matter whether the Yuan is officially recognised as a reserve currency or not. Purchasing power is the key.
Freeing up the Yuan fosters an outward looking investment policy, which is just the next step in China’s path to World Domination.