Thursday, April 05, 2007

China-The World's Largest Foreign Aid Donor

Today, the Chinese government, for the sixth time in just 10 months decided to raise reserve requirements by 0.5%:points, to 10.5%. If they keep this up, fractional reserve banking will be ended in China by 2033!

Seriously though, that is of course not likely to happen. The background for this policy action is one that I've explained to regular readers of this blog repeatedly. Namely, that China's irrational decision to keep the yuan grossly undervalued requires it to amass such enormous amounts of foreign exchange reserves that creates massive excess liquidity.

The natural response to this problem would of course be to stop accumulating more foreign exchange reserves and so allow the yuan to appreciate in value. This would solve the problem and reduce both monetary inflation and price inflation, while at the same time reducing both the risk of and the vulnerability in case of more protectionist measures from America or the EU. The traditional counterargument is that it would cost Chinese jobs, at least in the short-term, but that is no different from the effects of for example increased reserve requirements.

Thus, it would produce only advantages with no negative sideeffects at all for China to allow a significant yuan appreciation. Which makes it really puzzling to me why the Chinese government won't do it. Interestingly, many China-haters are also calling for a massive yuan appreciation, even though it would strengthen China.

China's irrational monetary policy mix is in fact in effect a massive foreign aid program. If China decided to reduce excess money supply growth by the more effective mean of yuan appreciation it would not in fact reduce output even in the short-term, it would only shift it from the export sector to domestic sectors. Meanwhile, it would significantly reduce its cost of imports and so in effect increase its terms of trade. A 10% increase in the value of the yuan compensated by less of the clumpsy tightening measures currently used would directly reduce the cost of imports by the equivalent of $60-70 billion, while not reducing nominal output. The fact that the Chinese uses their current approach thus in effect constitutes a $60-70 billion foreign aid program.

But the total implicit foreign aid cost is actually more than that. Both becuase the yuan is likely undervalued by a lot more than 10%. So just looking at trade directly, we're talking about more than $100 billion a year. And also, because the undervalued currency are achieved by investing in foreign assets denominated in currencies which eventually will fall in value, China are in effect giving away a lot of their export revenues. Assuming the very modest estimate (It will likely be even more) of $300 billion in additional foreign exchange reserve accumulation and assuming a 20% undervaluation of the yuan, we're talking at least $60 billion of Chinese export revenues in effect being given away. All in all, China's currency policy probably cost the country at least $160 billion, probably more like $200 billion per year.

Being a beneficiary of China's foreign aid program myself, I'm not really complaining. But I can't help being puzzled as to why the Chinese government would want to squander so much of the poor citizen's hard earned earnings and give it away to wealthy Westerners.

It might be that they're just as confused as China-bashers like Charles Schumer and don't understand the absurdity of their policy. Because of the structural strengths of the Chinese economy, the well being of their citizens are growing rapidly despite the governments' irrational policies. However, as their policy leaves them overly dependent on exports to the U.S., Charles Schumer and his friends could get turn out slowing the Chinese economy a lot more than what the Chinese government is comfortable with, when China inevitably gets blamed in Congress for the likely coming U.S. recession. At that point, the foolishness of China's monetary policy will be so apparent that not even the Chinese leaders will be able to ignore it.


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