3 - The Impact of the Global Financial Crisis on Chinese Foreign Exchange Reserves and China's Responses

Summary

Introduction

In many respects, the world is driven by major crises. The recent global financial crisis, which was triggered by the U.S. subprime mortgage crisis, is bound to bring dramatic changes to the world economic structure and international finance architecture. As a rising developing economy, China certainly could not escape the effects of the crisis. Its export-led development strategy is facing a serious challenge after the outbreak of the crisis. The shrinkage of external demand has led to the weak performance of Chinese's export growth, which hampers economic growth and labour employment. Because of income distribution inequality among sectors and inside households, as well as the underdevelopment of social public goods such as education, medical care, and a social safety net, household consumption is constrained at a very low level. Although the Chinese Government could ensure short-term economic growth by stimulating fixed asset investment, the fast growing investment will turn into much more serious excess capacity in the next three to five years not only in the manufacturing sector, but also in the infrastructure area, without the parallel growth of internal and external final demands. The enlarging excess capacity will result in a decline of profitability of Chinese corporations, a surge of non-performing loans on the balance sheet of Chinese commercial banks, and consequent deflationary pressure. If the Chinese Government does not make necessary structural readjustments to its old growth model in time, sustainable economic growth cannot be achieved.

This chapter will not focus on the real economy, but on the financial side of the story. Due to its export-led and FDI-led development strategies, China has accumulated huge foreign exchange reserves. While this may be a valuable national asset, it is also a reflection of tremendous resource misallocation that has led to twin surpluses of both China's capital and financial accounts. A large proportion of China's foreign exchange reserves is invested in U.S. dollar- denominated assets, especially U.S. treasury bonds.