China's move to cut foreign reserve will have global impact

A recent statement by Zhou Xiaochuan, governor of China's central bank, that China's foreign exchange reserves "exceeded reasonable requirements" has generated consternation in global financial circles.

This opinion has been repeated with increasing candour in recent months in China's academic and policy circles, generally considered very close to the government, if not under its direct control.

However, to date, the Chinese authorities have acted with restraint for fear of disrupting global financial markets.

China's foreign exchange reserves crossed the $3 trillion mark in March 2011, driven by an annual trade surplus of $200 billion, which is considerable, even if lower than in previous years.

Since the reserves are mostly dollar-denominated, it makes China vulnerable to a decline in the dollar's value.

To hedge against this possibility, the Chinese authorities have diversified their portfolio by increasing their exposure to Asian and European debts, although in quantities not large enough to alarm financial markets.

For the first time, China has eased its tight restrictions on export earnings, which required exporters to repatriate all hard currency earnings.

Informed analysts place China's optimal reserve requirements anywhere between $800 billion and $1.3 trillion.

China has already initiated steps to rationalise its present corpus to these levels.

Though plans to invest the foreign exchange to develop domestic infrastructure have been shelved for fear of stoking inflation and adding to overcapacity, Chinese authorities are pursuing other avenues such as buying high technology (both civilian and military), buying strategic resources, expanding overseas investment and increasing domestic social-sector spending. The benefits are evident.

China's restraint so far is largely a manifestation of enlightened self-interest.

Dollar depreciation would diminish the value of its holdings, lead to higher interest rates in the US and raise commodity prices, stoking inflation the world over.

It could easily derail the nascent global economic recovery and even trigger another recession.

Such an outcome will disproportionately hurt China, considering its economy is closely intertwined with world economy.

The unilateral moves by China are, thus, a sign of the growing impatience with the US' unwillingness to get its act together.

The US' public debt has reached 100 per cent of GDP and shows no sign of a let-up.

China is also signalling its willingness to confront the US, if it is required to protect its interests.

Enlightened self-interest of another kind would be needed to ameliorate the precarious global situation.

The US will have to do everything possible to curb its public debt and trade deficit.

On the other hand, China will have to increase its share of domestic consumption in GDP. To be fair to the Chinese authorities, they have made an honest attempt to undertake reforms that would spur domestic consumption.

These include the abolition of agricultural taxes in rural areas, expanding the scope of credit markets and lowering consumption taxes.

It would be unrealistic to expect the renminbi to appreciate significantly from current levels.

Exports (along with investment) remain a very important component of China's economy.

More importantly, the employment they generate holds the key to social stability.

Regardless of the actual steps taken to reduce the size of the forex tranche, a $2 trillion reduction is bound to have global ramifications.