KEY POINTS:
In the old days, countries accumulated treasure. The Roman empire was led by an elite which accumulated wealth by invading countries and sending their hard assets - gold, silver, precious stones and other materials - back to Rome.
But Rome's real wealth was not based on such a
policy. Rather, the peace and transport infrastructure built by the legions enabled Rome to become a centre of trade, which underpinned the city's prosperity. Much of this trade was in the hands of foreigners - Greeks, or Italians from the south of the country, where the Greek influence was strong. The actual treasure accumulated on military campaigns by Roman generals proved to be far less important as a source of wealth.
China faces a similar problem. The country has one of the biggest treasure hoards in history: vast foreign currency reserves of almost US$1 trillion ($1.5 trillion) which looks good, smells good, feels good. But like the treasures hoarded by the kings of the past, China can't, or won't, touch its glittering pile.
In fact, China's "treasure" very much proves the old adage that all that glisters is not gold.
There are a couple of problems with China's forex reserves: firstly, in the way it has been accumulated; and secondly, whom it actually belongs to.
It's undisputed that China's undervalued currency, while on the one hand permitting the sale of cheap exports to the rest of the world, is one leg of the problem. As China accumulates the foreign currency paid to it by the foreign buyers of its goods, it can't convert it back to renminbi (RMB) to invest in China (in huge infrastructure projects, for example) because that would cause the value of the RMB to increase - thereby making exports more expensive and defeating the purpose of having an undervalued, export-friendly currency.
So far China has been content to buy US dollars, a declining asset class. The Chinese would love to diversify into other asset classes but they face the same dilemma. By buying US dollars, they maintain the value of the US dollar against the RMB. This helps Chinese exports to be cheaper in US dollar terms. Selling off the dollar to invest in some other asset class would cause the dollar to plunge against the RMB and raise the cost of China's exports.
Let's also take a moment to think about what "wealth" the forex reserves actually represent.
Remember that a country's budget is normally supported by tax income. Unlike the forex reserves, tax income clearly belongs to the Government to use as it sees fit. Tax income is naturally denominated in the country's own currency, and prevents the foreign exchange problems encountered by the forex reserves. Rising tax incomes are a sign of healthy economic development, an efficient administration and a complaisant population.
The forex reserves, in contrast, are actually a liability in the accounting sense. The central bank may use them (put them on the asset side of the balance sheet by turning them into loans, for example) but like any other commercial bank, the greater the deposits it receives, the greater the liabilities. In other words, it's the successful Chinese exporters and foreign institutions bringing in foreign currency and placing it within the Chinese banking system who actually own the money.
That brings us to the great weakness of foreign exchange reserves: they can disappear quickly for a multiplicity of political and economic reasons.
Even the UK, a country in the top five richest countries in the world, was facing a financial meltdown when it was kicked out of the European Exchange Rate Mechanism in the early 1990s. Any country seeing crisis newspaper headlines will see capital flight.
China, of course, has the currency controls to prevent something like that happening - in theory, at least. In practice, academics have shown that when local Chinese and foreign businessmen want to shift money in or out of China, they succeed.
People have short memories. In the run-up to the 1997 Asian financial crisis, countries such as Thailand, Malaysia, Korea and Hong Kong all had large foreign exchange reserves. But while the word "reserve" implies something as practical as a store of ammunition, to be used in hard economic times, the forex reserves turned out to be a fragile means of support. Not surprisingly. If a soldier is involved in a shoot-out, it's not a good idea for him to be relying on somebody else's bullets.
The only sure-fire way for a country to circumvent economic trouble is at the tax and budgetary level; that is, to make sure that business is booming, thus helping to drive up tax receipts. It's those economic fundamentals, of course, that investors looked at during the Asian financial crisis.
Thailand's widening current account deficit was more worrying than her superficially impressive forex reserve was a reassurance.
That's where the real treasure lies: sound economic management rather than the chimerical notion that other people's money is a reflection of your own wealth.
* Eye on China is based in Beijing.
