Hoarding of International Reserves in China: Mercantilism, Domestic Consumption and US Monetary Policy (Digest Summary)

China’s international reserves have accumulated rapidly and are concentrated in U.S. dollar assets. The authors believe the fast buildup is a result of the economic objectives of the Chinese and U.S. governments. For China, the objectives are fast GDP expansion and labor mobilization, and for the United States, the objective is high household consumption. The authors’ model explains the persistence of Chinese foreign reserve accumulation in spite of the high associated cost, and it explains why a reversal of policy would probably have a negative impact on employment in both countries.

It is useful for investors to have an understanding of a range of possible economic scenarios and outcomes. The authors’ starting point for their argument is the interdependence of policies, which contributes to the debate on global imbalances and the advocacy for global rebalancing. Their model supports the view of a symbiotic relationship between official U.S. and Chinese policy goals. In the United States, the goal is to preserve a high level of individual consumption by maintaining large public budget deficits and encouraging low household saving. In China, the goals are to pursue high export-led GDP growth and mobilize the rural labor force to move to industrial employment in the urban centers. Accumulating foreign reserves and maintaining an undervalued currency are not China’s goals per se, but they are outcomes of mutually complementary policies in the two countries.

The authors show that the length of time of China’s currency being undervalued accompanied by the buildup of foreign reserves is influenced by the relative importance the Chinese authorities put on maintaining a competitive lead in tradables at the expense of domestic consumption. This symbiotic relationship also depends on the United States maintaining a relatively loose monetary policy stance, as well as on the standard of living the Chinese government decides to guarantee its citizens. Using resources to increase Chinese domestic consumption would reduce consumption opportunities in the United States, and given that the nontradable sector in the United States employs the majority of the labor force, it would also increase unemployment in both countries. But this paradigm might actually change if the Chinese authorities lose their ability to sterilize the reserves through domestic financial repression or to control capital flows and credit allocation.

Other potential risks to the current scenario would be an unlikely deflationary process in the United States. A more probable risk is a regime change in China and a new political leadership that would assign a higher importance to household consumption than in the past.

The authors use a two-period, two-country economic model. The model assumes the production of only three goods—an internationally tradable good, a U.S. nontradable good, and a Chinese nontradable good. The nontradable goods are produced and sold only domestically. The Chinese authorities control the nominal exchange rate and financial transactions. China’s objective is to maximize GDP within the constraint of an acceptable level of household consumption. The U.S. goal is to maximize household consumption. The authors consider two time periods—the present (Period 0) and the future (Period 1).

In Period 1 with a given U.S. monetary policy, employment increases in China and decreases in the U.S. tradable sector by depreciating the real exchange rate. The U.S. authorities influence China’s policy via the money supply. By keeping its money supply high, the United States makes it more convenient for China to accumulate U.S. assets and to specialize in tradable production. In Period 1 equilibrium, the United States would inflate its external debt until China stops accumulating U.S. assets and decides to increase its current consumption and move production toward the nontradable sector.

For Period 0, the authors assume some persistent unemployment and alternative economic objectives. An increase in China’s minimum standard of living leads to an appreciation of the Chinese real exchange rate, thus creating a negative impact on employment in both countries. If the United States were to target total employment instead of consumption, it would still have to induce the Chinese to accumulate U.S. financial assets and maintain an undervalued exchange rate. In this way, the domestic demand in the United States can be more expansionary and produce net benefits in terms of total domestic employment; jobs lost in the U.S. tradable sector would be more than offset by employment growth in the U.S. nontradables sector.

The study uses a simple stylized model to shed light on the symbiotic economic relationship between China and the United States. The conclusions are quite intuitive but have important implications for current debates on the sustainability of U.S. monetary policy, the undervaluation of the Chinese currency, and potential changes in the goals of the Chinese government regarding economic growth and domestic standards of living.