By Martyn…

By the end of 2005, China is expected to hold foreign exchange reserves in excess of US$900 billion, replacing Japan as the country with the largest foreign reserves. In 1995, China had US$75.4 billion, rising to US$610 billion last year. Compare that to the US? reserves of US$79.5, Britain? US$48.1 and the Philippines US$17,7 (June, 2005).

The big question is, what should China actually do with these forex reserves?
From today’s (unlinkable) South China Morning Post:

How China chooses to invest this money will have a profound effect on interest rates in the US and the level of the dollar.

Since it opened its doors to the outside world in 1979, China has been careful in hoarding foreign exchange. But in the past three years, the volume has grown beyond all expectations.

What should China do with all this money? It holds more than US$200 billion in US treasury bonds and an unknown amount of instruments in other currencies, including the euro, yen, sterling, Hong Kong dollars and Swiss francs.

Some commentators in the US argue that China will reduce its US Treasury bond holdings for commercial reasons related to the weak dollar. The US would then have to raise interest rates, they warn.

In a more dramatic scenario, some fear that in a trade war or a conflict over Taiwan, the mainland would take a political decision to sell. But neither of these moves is likely in the foreseeable future, just as Japan never exercised such options, even when trade relations deteriorated sharply.

Most economists expect China to remain a major holder of treasury bonds, while it diversifies its holdings of instruments of other currencies.

Some Chinese officials argue that the money would be better spent recapitalizing the state banks or to import oil and build up strategic reserves, of which it has none. Others say the money should be used to fund overseas acquisitions by Chinese firms.Conservatives want to keep the money in financial instruments. They say, quite rightly, that the inflow of hot money is only a temporary phenomenon and point to the billions of dollars of liabilities in bad loans held by the state banks, pension and welfare liabilities and debts owed by securities firms.

There is also the possibility of trade disputes or a trade war with the US or the EU, which would sharply reduce the trade surplus, or a financial crisis at home or in Asia.

China’s wealth is not as substantial as it appears; in per capita terms, it’s still very poor. The country needs the reserves to absorb financial and other shocks that lie ahead.