Tuesday, February 23, 2010

Implication of China's Foreign Reserves

Michael Pettis has another brilliant post explaining the nature of foreign reserves. He cuts through the myths and confusion that surround this topic. The most interesting thing he discusses is the role of foreign reserves in a domestic debt crisis. While foreign reserves protect a country against foreign creditors, they actually worsen a domestic crisis. This was one of the challenges faced by the U.S. during the Great Depression. At the time, the U.S. was the world's largest surplus nation, and had stockpiled more reserves (in gold, at that time) than anyone else.

The reason foreign reserves are a problem is because they are a sign of mismatched assets and liabilities. Every purchase of dollar assets by the PBoC is financed by a liability from borrowing or printing renminbi. By definition, these must always be in balance at the time of creation. By having a huge liability in Renminbi, the central bank is limited in the amount of domestic debt it can take on its balance sheet without raising interest rates.

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