What is foreign exchange reserve of a country? Should the American policymakers be worried about Chinese foreign exchange reserves crossing one trillion dollar mark as the following editorial from New York Times indicates?
The G7 countries of the world are USA, Canada, Germany, U.K., France, Italy and Japan. Before the collapse of colonialism, they formed a block as the most powerful countries of the world. They created a system by establishing International Monetary Funds and World Bank to manage the values of currencies of the rest of the world. The value of a nation's currency determines the wealth of the nation, at least as judged by economists in G7 nations. Wealth of a nation gives the country the wherewithal to buy merchandise in the international markets to stay competitive.
Any country that is unable to produce (say, oil) as much as it needs to survive has to import from international markets by paying funds in terms of a currency that the global sellers can accept. For example, when Indonesia could not produce (food and oil) as much as it needed to survive in 1997, its currency rupiah collapsed from 2500 rupiah per dollar to 20000 rupiah per dollar within the latter half of that year after the international banks had drained 140 billion dollars of reserves the country had by early that year.
The precise international wealth transfer mechanism through arbitrage trading is detailed in a book, entitled "Prosperity: Optimal Governance, Banking, Financial Markets, Global Trade and Exchange Rate." The adverse ramifications on humanity due to rigged currency arbitrage trading to transfer wealth from developing countries to few individuals residing in G7 nations is also narrated in this book. [Buy the book to support such research in the best interest of humanity.]
The myopic greedy strategy of a few to become richer through usurious wealth transfers from the rest of humanity is not sustainable forever. In fact usurious enrichment of a few by driving the multitude penurious will likely create instability even within G7 nations because the same schemes for transfer of wealth are engaged everywhere through lopsided pre-Great Depression era laws designed by the same few to facilitate such transfers. It is not a question of the mighty being right. It is a question of the mighty designing and perpetuating lopsided laws - which are protected by the government of the majority - to facilitate usurious transfer of wealth from the majority to the few designer of those laws. This system banks on naivete of the majority to support a government to protect laws designed to transfer their wealth surreptitiously to a few. How else can we justify that a vast majority of American households have (i) piled up debt of about $12 trillion on their own, (ii) allowed the governments (local and federal) to borrow another $10 trillion of debt, and (iii) owned equity of corporations who have borrowed another $17 trillion? It is mind-boggling naivete. Every dollar borrowed has been lent and the system seems unstable and unsustainable as made clear in a letter to President Bush.
The few lenders of the staggering debt of the world (primarily USA) are a few individual households based in G7 countries. The NYT editorial simply misguides readers that the problem is due to China building its reserve of $1 trillion. The problem is due to America's $850 billion of trade deficit per year wrought by a rigged currency exchange mechanism based on the concept of G7 versus the rest. A novel currency exchange system that cannot be easily rigged by a few greedy individuals based on G7 countries is proposed in "Prosperity."
To see why China's foreign exchange reserves are not the problem, faced by USA, let's understand what foreign exchange reserves are and why G7 countries do not hold reserves of currencies of developing nations. Central banks of developing countries have been thrust on a system in which they hold reserves of G7 countries. Why? The developing countries were colonially subjugated and so could not develop as well industrially as the G7 countries did. Even after decolonization, they have remained dependent on imports of industrial goods, especially defense equipment, to remain competitive and to defend their borders against intrusion of neighbors supported by G7 nations. G7 countries and the nations that depend on them for defending borders do not hold foreign currency reserves of the developing countries. In particular, USA does not hold Chinese renmimbi as reserves.
How are the foreign exchange reserves created? When, for example, Wal Mart buys $1 billion worth of merchandize from a merchant (often based in USA) importing from China, the merchant deposits at least a part of the sum (say, $200 million) in his acount in China for payment to Chinese workers and materials. The merchant based in USA keeps $800 million, mostly as profits, and pays $200 million for imported goods from China. The Chinese commercial bank that receives the $200 million check from one of its depositors submits the same to Peoples Bank (central bank) of China which creates 1580 million renmimbis as credit for the Chinese commercial bank. The Peoples Bank then deposits the $200 million check in its account in the U.S. Federal Reserve Bank of New York. The FRB maintains the account of the U.S. commercial bank that had issued the $200 million check from the account of the U.S.-based merchant. The FRB debits the account of the U.S. commercial bank which then debits the account of the merchant by $200 million to credit an equal sum as reserve for the Chinese central bank. This is how China and other developing nations are building their foreign exchange reserves: their reserves are mostly the values of labor and material actually expended in developing countries.
Most of the actual profit from international exchange and trade is actually stored in the accounts of merchants based in U.S.A. who have become net creditors to the multitude of heavily indebted American households. This is how the few net creditor American households have amassed $37 trillion of credit on the rest of the society. This system of creation of credit by a few as debt on the rest is not sustainable, especially when the same merchants are transporting away jobs from USA to the developing countries to become even richer.
Some solutions are presented in "Prosperity: Optimal Governance, Banking, Financial Markets, Global Trade and Exchange Rate.
New York Times Editorial
China’s Milestone, Our Millstone
Published: October 21, 2006
http://www.nytimes.com/2006/10/21/opinion/21sat2.html
The Chinese sell a lot of merchandise in the United States and, in the process, accumulate a lot of dollars. They then loan many of those dollars back to the United States in exchange for all manner of American i.o.u.’s, including Treasury bonds, federal agency bonds, and private-sector debt.
America’s indebtedness to China, as a result, is staggeringly high, although the Bush administration — which needs foreign loans to help finance the budget deficit — seems unfazed. But there is reason for pause. The Wall Street Journal reported this week that China’s holdings of foreign currency and securities would soon top $1 trillion, a fivefold increase since 2000. Roughly 70 percent of that is believed to be in dollars or dollar-based assets.
Of course, $1 trillion does not confer significantly more clout than, say, $990 billion. But the size and growth of China’s holdings mean increasing vulnerability for the United States.
For several years, China’s loans have helped to keep prices and interest rates low in the United States, and to finance big tax cuts. If the lending began to dry up — because Chinese officials decided to diversify into other currencies or to spend more at home — prices, interest rates and taxes in the United States would very likely rise. If the loans dried up quickly — a worst-case scenario — the result could be a sharp financial crisis. A gradual shift could mean a long downward trend in American living standards as a higher cost of living took its toll.
China might never pull back in a way that harmed the United States. But the fact that it could already makes the global financial system more volatile. Investors and traders are hypersensitive to any hint that Beijing may switch allocations.
The Journal also reported that administration officials are concerned that developing nations, unhappy with conditions on loans from the International Monetary Fund, may decide to borrow directly from China. That would give Beijing more influence over emerging markets and their governments.
To its credit, the Bush administration has repeatedly stressed that the rise of China is not to be feared or begrudged. But excessive borrowing during the Bush years has made the United States unnecessarily vulnerable.
