Putting China’s Kitty in Perspective

(Stephen Poloz, Export Development Canada)

There is continuing angst around China’s vast accumulation of foreign exchange reserves. What will they do with all that money, buy the crown jewels? Switch into euros? No one really knows.

Back in 2006, the level of angst skyrocketed as China’s reserves approached the $1 trillion mark. But by the end of 2007 China’s reserves were up to $1.5 trillion, more than 40% higher than a year earlier. Back in 2000, China only had $166 billion, so this number has been rising fast.

The key driver of this accumulation of Chinese wealth is America’s trade deficit, which has begun to recede but was still $713 billion in 2007. China, as one of the biggest trade surplus countries, and accounting for about one-third of America’s trade deficit, accumulates a lot of U.S. dollars through foreign exchange, and invests a lot of those dollars in U.S. treasury securities. Hence the popular shorthand, which is that China is financing America’s overspending.

It is worth remembering that a similar issue emerged in the 1980s, when Japan was the world’s biggest trade surplus country and was accumulating a large kitty of reserves. Japanese investors made a lot of investments around the world during that era, raising concerns that they would someday own the world. Of course, it did not happen, because Japan’s rapid development included rising domestic wages – once their wages caught up to those of other major economies, they became a bigger importer. This will happen in China, too, eventually.

In the meantime, how do we put China’s growing kitty into perspective? $1.5 trillion sounds like a lot of money, and over $400 billion of that is held in the form of U.S. Treasury securities. But these figures are dwarfed by America’s private sector presence abroad. U.S. foreign assets were nearly $14 trillion in 2006 (the latest figures), over $12 trillion held in private assets. Sales by U.S.-owned foreign affiliates run at around $4 trillion per year, from some 23,000 establishments.

These figures underscore that the main underlying driver of reserve accumulation is not the U.S. private sector, which is highly globalized, but the U.S. government. Even so, the U.S. fiscal deficit is quite small relative to global savings. Global savings amount to around 20% of global GDP in most years, and usually at least one-quarter of that would find its way into U.S. dollar assets; even when the U.S. fiscal deficit was up at around 4% of U.S. GDP, it amounted to less than 1% of global GDP, or at most one-fifth of the total global demand for new dollar assets.

Furthermore, the recent descent of the U.S. dollar back to 1996 levels, is beginning to have its effect. That, combined with the U.S. slowdown now underway, will produce a significant narrowing of the U.S. trade deficit, even with China. U.S. imports from China grew 30% in 2004 and 2005, 20% in 2006, 13% in 2007 and the trend was around 7% towards the end of the year.

The bottom line? In today’s globalized world it is very hard to know who owns what and it doesn’t really matter much, anyway. Global imbalances can be a problem, so a degree of angst is appropriate, but natural adjustment processes are always running in the background.