The Myth of China's Foreign Reserve Strength

China's currency peg makes it a hostage to US monetary policy...

MONETARY POLICY in China is far from tight, writes Greg Canavan at the Daily Reckoning Australia.

Sure they have raised interest rates a few times to cool speculation but inflation has been on the rise too. This means REAL interest rates (which equal the nominal rate minus inflation) are already very low or even in negative territory.

One of the big myths about China's apparent strength is the size of its foreign exchange reserves. At US$3.2 trillion Dollars, many people mistakenly believe China can use this 'war chest' to spend its way out of trouble. What China hopers don't realize is that there are liabilities that match the size of those assets.

Those liabilities are effectively reserves of the Chinese banking system. The explanation gets a little complicated, but this all comes back to China's currency peg with the US Dollar.

The US has run a very loose monetary policy for years. To maintain a fixed rate to the Dollar, China's central bank has had to print Yuan to buy Dollars. The freshly printed Yuan (to the extent that they are not absorbed by the process of sterilization) flow into the Chinese banking system. They are additional fuel to the fire that is (actually, was) the Chinese credit boom.

So selling the foreign exchange reserves is not really an option.

Can't China just run up big fiscal deficits to prop the economy up? Maybe that is a short-term option. But China's debt is much larger than most people think. Officially it's around 35% of GDP, according to the IMF. Unofficially it's closer to 80%.

This is a result of combining all the bad local government debt with the debt of various ministries (for example, the bankrupt Railways Ministry has debts equivalent to 5% of GDP), which the central government will need to stand behind.

So while China can potentially run large budget deficits to offset the credit bust, its existing debt load is already quite high for a developing economy. China doesn't really have the fiscal scope to do any major stimulus. It doesn't mean they won't try, but it will be difficult to pull off in size.

And don't forget, with the currency peg China is still hostage to US monetary policy. Ben Bernanke hasn't pulled the QE3 rabbit out of his hat yet but it will come at some stage. When it does, it will have an inflationary impact on China (just like QE2 did) making it that much harder for China to manage its credit-induced slowdown.

The West is in a credit depression. From where we're sitting, China looks like joining that unhappy bunch in 2012.