Focus on foreign exchange reserves

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Who owns the US debt? (Source: CSIS China Power)

You have probably read or heard that China “owns” the United States by holding a considerable amount of its public debt. With just under $1 trillion in US dollar-denominated treasuries, it is true that China holds one of the largest international claims on US debt. To be precise, it is the second creditor, just behind Japan. But there is one major difference: the state of diplomatic relations between Uncle Sam and Xi Jinping.

Beyond an economic weapon, the large holding of US debt also helps keep the yuan artificially low, thus favoring Chinese exports by making them comparatively cheaper than US exports.

What are foreign exchange reserves?

Foreign exchange reserves are the currency reserves of a central bank. Foreign exchange reserves are generally held in the form of treasury bills and foreign government bonds, which allows these reserves to generate interest and therefore a certain yield while remaining extremely liquid. A notable exception is that gold reserves are included in the composition of foreign exchange reserves. Strictly speaking, gold is a store of value. Thus, the European Central Bank – ECB – holds in its coffers a mountain of dollars, yen and renminbi, special drawing rights (a tool created by the IMF based on a basket of currencies) and gold.

To constitute these foreign exchange reserves, a central bank has two possibilities:

  • The first method is purely arbitrary and simply involves buying foreign currency against its base currency. The goal is to build up reserves in foreign currency or gold – since gold is mostly denominated in USD. For the most curious, it is possible to follow the gold stocks of the different central banksor for ECB assets.
  • The second method is more passive, as it relates to the central bank’s role as a stockbroker of last resort. Let’s take an example. When a company exports goods or services, say LVMH, it receives payments in foreign currencies. The French group sells a significant part of its goods to China and the United States. Because of these international sales, LVMH receives payments in euros but also in US dollars and renminbi (or yuan, or CNY). Once the payments have been received, LVMH will probably choose to keep a small part of these currencies to cover its own operations and investments abroad, but will probably convert the bulk of its foreign currency income into euros. It is the currency in which the group pays its taxes and its employees, dividends, debts, interest and certain suppliers. To do this, LVMH will turn to its banks, which will serve as intermediaries between their central bank and LVMH in foreign exchange transactions.

But what are foreign exchange reserves really used for?

Foreign exchange reserves play several roles in the global economy and are linked directly or indirectly to exchange rates and inflation. Foreign exchange reserves also have a strategic dimension by ensuring solvency and liquidity while playing a potential cushion role in the event of a crisis. In short, the applications are numerous. Let’s go into a bit more detail.

Foreign exchange reserves can be used for:

  • Control – at least partially – the value of the national currency. In the case of an exporting country like China, there is a logical interest in keeping a currency weaker than that of its export markets. This makes exports cheaper for the client country, thus making exported goods and services more competitive than domestic goods and services in the importing country. To ensure this, China will buy large quantities of this foreign currency as it did between 2000 and 2010 with the dollar, to keep the renminbi relatively low. It is simply a supply and demand mechanism. This mechanism is also why Japanese stocks rise when the yen falls: the Japanese economy is largely outward-looking, and a competitive currency is supposed to help that. Well, that does diminish to some extent: the beneficial effects begin to fade when the yen weakens too quickly, as it is currently. But this is another story.
  • Control – at least indirectly – inflation. As we have just seen, by playing with its foreign exchange reserves, a country can manipulate its exchange rate. It is therefore possible for a country to create artificial inflation by depreciating its currency, making exports more competitive but also imports more expensive. But the mechanism for controlling the value of the national currency can also work in the opposite direction. For example, the Japanese central bank may commit to selling large amounts of US dollars against yen in order to boost the value of its currency (increased demand = higher prices). A central bank like the BoJ therefore always plays a delicate balancing act: it must maintain the value of its “low” currency in order to favor exports without making it too low, in which case excessive inflation on imports – on which the Japanese domestic demand is very dependent – would severely punish Japanese economic agents.
  • Ensure good liquidity for the country’s economic agents, in particular to protect strategic imports. For example, Bank-Al Maghrib (Moroccan Central Bank) announced at the end of August 2020 that it would hold $36.23 billion in foreign exchange reserves at the end of 2020, i.e. nearly 7 months of imports of goods and services. Holding large foreign exchange reserves allows a country to maintain sufficient liquidity for certain key imports such as foodstuffs or hydrocarbons essential to the population. As these are traded on the world markets mainly in US dollars, the economic agents of the country must always have dollars on hand. In the event of economic stress, the central bank must be able to assist them, otherwise the country risks finding itself unable to import these essential resources!
  • Act as a shock absorber to absorb severe unforeseen economic shocks, whether major recessions, wars or earthquakes. These types of events dry up exports and therefore currency inflows, which can compromise imports of strategic resources in the event of a liquidity crisis. Foreign depositors also tend to flee countries subject to these events and will withdraw their capital to safer countries. This is the phenomenon of risk aversion or “flight to safety”. For example, after Fukushima, depositors withdrew their dollars from Japan at an alarming rate. To reassure the markets, international investors and industrial partners, it is therefore essential that a sovereign authority has a reserve capable of absorbing these shocks. To meet financial obligations and ensure solvency. Many developing countries – for example Uganda or Vietnam – have currencies that historically do not really invite the confidence of foreign investors – because their states print money at will, depreciating it in the process. When these states borrow on international markets, they must therefore do so in US dollars or euros to satisfy their creditors. It is therefore essential that their central banks maintain stocks of US dollars or euros to ensure the settlement of their obligations at all times. A very high US dollar, as is currently the case, will therefore make the cash flow value of a bond – repayment of principal but also interest – much higher in local currency. This increases the debt burden: this is the current problem for emerging countries, which are seeing the cost of their debt increase. Conversely, Japan and China, which as we have seen are the main holders of US debt, benefit from larger flows once converted into reference currencies. In the same spirit, large foreign exchange reserves can also support a country’s economic development by serving as collateral to borrow in USD to finance major infrastructure programs. Indeed, it will necessarily require US dollars because the international contractors who will come to build roads, dams or bridges will not want to be paid in local currency.
  • Finally, foreign exchange reserves are also used as a hedge to diversify a central bank’s assets and ensure a better return on its assets. Since a central bank is still a bank, it has a vested interest in ensuring that its assets – in this case, its liquidity – produce the best risk-adjusted return. Central banks with large amounts of US dollars will therefore probably be satisfied with their allocation policy in the current context, the US dollar being better paid than the euro or the renminbi.

The case of China

Going back to the American debt held by China, this reserve was mainly built up thanks to the large Chinese trade surpluses. Thus, the Chinese central bank – BPC – received large amounts of US dollars through the transactions of Chinese companies under its governance. China’s central bank has accumulated large foreign exchange reserves which it has used to buy US dollar-denominated assets, mainly treasury bills – that is, US debt. These assets are highly liquid and are included in foreign exchange reserves. But what if China sold all the US debt it holds?

First of all, the amount of US debt held by China is certainly impressive in absolute terms, but it is still acceptable compared to the total US debt. Still, if China were to start very aggressively selling US debt, it could, in the worst case, lead to a sell-off in the market. A sudden liquidation could also lead to a sharp increase in the value of US debt, which could have a negative impact on US economic growth. Such a sell-off could also cause the US dollar to fall against the yuan, making Chinese exports more expensive. And a weaker dollar would mean that China would make less money on its bond sales. Going further, a sale would also lead to a fall in the market value of US debt, leading to significant financial losses for China and making US debt cheaper for the US to buy back, especially using its denominated currencies. in yuan. reservations. The relationship is much more complex, but it gives you a glimpse of the range of possibilities. Still, it’s important to understand that a US debt liquidation would likely be as bad for China as it is for the US.

For all these reasons, the management of foreign exchange reserves is a real instrument of sovereignty, but also a very subtle balancing act, the many issues and economic and political repercussions of which are, for us mere commentators, totally unknown.