Myths About Chinese Foreign Exchange Reserves
This is however not true. To understand why, let's recall that first of all, an exchange rate is determined by the demand and supply for a currency. Demand and supply is in turn a function of first of all foreign demand for domestic goods (goods& services market demand for the domestic currency), domestic demand for foreign goods (goods and services market supply of the domestic currency), foreign demand for domestic assets (asset market demand for the domestic currency) and domestic demand for foreign assets (asset market supply of the domestic currency). For simplicity we can simply use net demand for foreign goods (the trade or current account balance) and net demand for foreign asset (capital flow balance).
At the same time we must remember the balance of payments identity, that the current account balance must be financed (or finance) a capital flow balance of the opposite sign, so that the total balance is zero
Where CA is the current account balance and CF net capital (in)flows. If we rewrite this by subtracting CA on both sides it becomes:
The exchange rate is the thing that changes whenever the current account balance moves independently of the capital flow balance so as to ensure that for example increased net exports by some is counterweighed by decreased net exports by others or an increase in net capital outflows.
In the context of China and other countries that pursues a fixed exchange rate policy, a further distinction must be made, namely between private capital flow balance and government capital flow balance (The build up or depletion of foreign exchange reserves). This would create this new balance of payment identity (by subtracting private capital inflows from the rewritten balance of payment identity):
GCF is of course government capital flow and PCF private capital flow. If a country then has a current account surplus and net private capital inflows this means that there must be net government capital outflows, or in other words that foreign exchange reserves (or sovereign wealth funds in other countries than China) must increase.
Or in other words, whenever foreigners increase supply of their currencies by buying more domestic goods or assets, this means that this must be counteracted by increased government purchases of foreign currency. So, whenever some one buys either Chinese goods or services or Chinese assets this means that the Chinese central bank will expand its foreign exchange reserve.
Let us then analyze the effects on foreign exchange reserves from different policies. If China kept the exchange rate fixed and established that the policy was credible, then this might result in a big current account surplus that would be counteracted by big Chinese foreign asset purchases.
If the exchange rate started to appreciate, then the Chinese current account surplus would probably decrease, but as this would create expectations of further appreciation it would also increase private capital inflows into China. The increase in private capital inflows could very well be larger than the decrease in the current account surplus, meaning that foreign exchange reserves would have to grow.
So, despite the fact that this currency appreciation would make China's currency policy less mercantilist in the sense that its current account surplus would shrink, its foreign exchange reserves might just grow even faster. Because of these dynamics, it is simply not true that the change in foreign exchange reserves in an indicator of whether or not the currency policy is mercantilist or not. Samuelsson and others who believe that implicitly assume that private capital flows doesn't exist or aren't affected by exchange rate expectations, assumptions which are false.
A related myth is that the change in foreign exchange reserves is an indicator of whether or not the currency is cheaper than it would have been under a floating exchange rate system. Leaving aside for now the issue of whether this should be considered an ideal, it can be said that while it is not quite as misleading as whether or not the policy is mercantilist, it is still misleading.
Assume for the sake of argument that the current yuan/dollar exchange rate is basically identical to the one that currently would have present under a floating exchange rate system, and that in the future the average exchange rate would by chance have stayed basically unchanged. Assume then that the central bank would ensure that it appreciates 5% per year. This would greatly increase private demand for yuans, forcing -in order to limit current currency appreciation- the Chinese central bank to increase its demand for foreign currencies. In this case, the yuan would become overvalued relative to the exchange rate it would have had under a floating exchange rate system, even as Chinese foreign exchange reserves would increase.
This is not to say that the current policy is ideal, it certainly isn't, and while a free float (or a big one time revaluation) would be associated with disadvantages, it would be a lesser evil for China and the world compared to the present system. However, it is misleading to say that the amount of foreign exchange reserves measures how over- or undervalued it is, and because of the above mentioned factors, a gradual appreciation of the yuan would probably not reduce the problem of excessive foreign exchange reserves.