China has been hiding roughly three trillion Dollars from the United States through its state-owned banks and Belt-and-Road lending initiative. At least, that is if we are to believe groundbreaking new research by economist Brad Setser from the Council of Foreign relations.
This has three big implications for the balance of power in the global monetary system. First, it means that China’s official war chest of foreign exchange reserves could potentially be twice as big, making China’s currency much more resistant to a collapse, caused by for example sanctions. Second, it means that if China will need to defend its currency, it might quickly try to sell its Belt and Road assets, leaving these countries in crisis. Finally, it means that, in hindsight, even though many economists believed China had stopped suppressing the value of its currency, it had actually just found a way to manipulate it without officially being labeled a currency manipulator.
So, how did China hide three trillion Dollars? And, what does that mean for the global monetary balance of power?
Well, as it turns out, the key to answering these questions is to figure out
How China obtained so many Dollars
in the first place.
The simple answer is that the Chinese earned these Dollars over the course of the last 20 years or so by exporting way more than they imported.
You see, while China’s issues its own currency, the Renminbi, it relies almost exclusively on the US Dollar for its imports and exports.
After all, if its citizens want to import something, their foreign suppliers typically prefer to be paid in US Dollars because these can be used all over the world. Similarly, since foreigners typically don’t have access to Renminbi accounts, Chinese exporters mostly ask to be paid in US Dollars whenever they export something.
But, since Chinese traders need Renminbi at home, they will typically use their banks to exchange Renminbi for Dollars if they are importers or the other way around if they are exporters. Similarly, since most Chinese banks do most business in China, they would then go exchange Renminbi’s for Dollars at the Chinese central bank, the People’s bank of China, if they had too many importer clients and they might go and ask it for more Renminbi if they had a lot of exporter clients.
The kicker is that, on average, the People’s Bank of China, would end up with a lot of Dollars if there are a lot of exporters and it might risk running out of Dollars if there are a lot of importers.
Okay, I hope that this sounds somewhat simple. Lots of export, means lots of Dollars accumulating in the People’s Bank of China and lots of imports means that it might run out of Dollars.
But, given that China has its own strong currency,
Why did it need to keep a pile of Dollars?
Well, as mentioned by ex-Federal Reserve chairman Ben Bernanke, the primary use for a pile of foreign exchange reserves, also known as a war-chest, is to be able to defend a currency from a crash, which could cause sky-high of inflation.
The way this works is actually really simple. If your currency is crashing, you just start buying your own currency with your war chest.
The only trick then is to it is to figure out how big your war chest needs to be. But, one thing is certain, if you have a solid export industry like China, at some point, a your war-chest is expected to be big enough.
And, at that point, in the ideal world that economists like to dream about, the People’s bank of China would have no use for a big pile of Dollars that earn only a very low interest rate. So, logically, it would then start selling any additional Dollars it accumulates through exports for Renminbi on the foreign exchange market. Selling Dollars to buy back Renminbi would then drive up the price of the Renminbi versus the Dollar.
A stronger Renminbi would then make Chinese exports more expensive and therefore less competitive on the global market. On the flipside, it would make American goods cheaper in China, making them more competitive.
Therefore, as the Renminbi rises, China’s importers will start to outnumber its exporters. To supply these importers with the needed Dollars, it’s central bank will then buy these on the foreign exchange market with freshly printed Renminbi, driving the price of the Renminbi down, making China’s exporters more competitive again.
And, this beautiful simple balancing mechanism, is why the global economy is so balanced.
Yeah, back in the real-world manufacturing powerhouses like China, but also oil exporters like Norway, Kuwait, and others, have for decades now been exporting more than they import, while the United States has largely imported the difference.
And, according to many US economists, these countries have been able to do this because they manipulate their currencies by just accumulating more and more Dollars, rather than selling them. This keeps currencies like the Renminbi artificially low against the Dollar. And while this means that American consumers get to buy a lot of cheap stuff, it also means that more and more factories will be built in China, leaving factories in the United States abandoned, and voters in its industrial heartland angry.
So, it was only a matter of time that U.S. politicians like Donald Trump began to accuse China of currency manipulation and threaten to slap its exports with tariffs in retaliation.
However, at that time in 2016, it seemed that China had pulled a magic trick. Its official reserves shrunk and then stabilized, despite its trade surpluses remaining high and the Renminbi weak.
The preferred explanation for this at the time was that there was a mass exodus of money by wealthy Chinese individuals looking for better returns abroad.
But, as it turns out, there was more to the story – a scheme to hide trillions of dollars from American economists, while keeping the Renminbi low without being labeled a currency manipulator.
So, this raises the question:
How did China hide so much money from America?
The key to understanding China’s strategy is to keep in mind that the core underlying idea remains that China wants to keep its currency low, even though its exporters keep bringing in Dollars. So, these Dollars cannot be sold.
However, to avoid detection by economists who were watching its official foreign exchange reserves, the central bank had to come up with an innovative way to keep hoarding Dollars. The obvious solution was that the Dollars the exporters bring in, should go elsewhere. However, to decide where, China wanted to keep some control over these Dollars to potentially defend its currency to avoid ending up as Iran in 2012, after it was hit by American sanctions.
The solution that China came up with was two-fold. First, it started channeling Dollar assets that it got from its exporters to the various big state-owned banks such as the Bank of China, and China Construction Bank.
As expected, this strategy didn’t immediately attract the attention of Western economists who are just not accustomed to viewing the banking sector as a tool of the state. After all, if the Bank of England were to try this strategy and sell Dollar reserves to Barclays or Lloyds. There wouldn’t be any guarantee that these wouldn’t just sell them for pounds if that served their interest. Similarly, these banks wouldn’t just selflessly step in to defend the British pound if this wasn’t in their own commercial interest.
However, the Chinese state is much more powerful. So, while China’s central bank governor could now claim that China’s exchange rate was determined by market forces, upon closer inspection, mr. Setser found that after getting these reserves, China’s state-owned banks would no longer operate them like commercial banks would. Instead, they would start acting as extensions of the Chinese central bank. So, yes China’s exchange rate is determined by market forces, that happen to be largely state owned.
Smart. But, China wasn’t done.
You see, around 2008, China realized that while having your state banks own Dollars in the form of foreign deposits, or foreign bonds, was effective, it did still mean that China was effectively financing the West and its banks.
So, after the great financial crisis of 2008, China increasingly started channeling Dollar assets into development banks like the China Development Bank and the Export-Import Bank of China which would invest them in neighboring countries under the banner of the Belt and Road Initiative, which was meant to link China to Europe.
So, now, not only were the Dollars China accumulated not showing up in reserve statistics, they were now actively supporting China’s international interests by securing crucial commodities, buyers for Chinese goods, and geopolitical allies.
And so, there you have it, this is how China was keeping its currency down without alerting Western economists that tend to think about banks and development banks as operating much more independently from the government.
So, I think mr. Setser’s study has revealed that looking at China’s official reserves is just not enough. Something that is an important lesson for any international economist because countries as diverse as Norway, Kuwait, and Singapore are also stashing large sums of foreign currency in investment funds rather than official reserve assets. Similarly, countries like Turkey, Argentina and Taiwan have also been known to use private banks to manipulate the value of their currencies.
It’s just that China is the biggest and most important country to do this. Just to illustrate how important it now is, while China already had the largest war chest in the world, this research reveals that it could have had twice as much, which roughly five times as much as the second country, Japan.
But, yeah, what do you think, should economists update their framework to include all policy institutions? And, should China stop undervaluing its currency or is this just how the Dollar system works, making it wrong to blame China? Let me know in the comments or join the discussion on Discord after supporting the channel via Patreon.