The global economy has three problems on hand: European debt, the US fiscal situation and, thirdly, massive Chinese surplus liquidity. While the former two are widely known and discussed, the third is brushed under the carpet. It can burst into a major crisis.
China's liquidity surplus is, in fact, a mirror image of US debt. Through persistent under-pricing of its currency over decades, China has earned a current account surplus year after year. This meant inflow of dollars and other foreign currency into China.
To keep the price of its currency low in the face of such unrelenting inflows, the Chinese central bank—the People's Bank of China— has bought up the exporters' earnings and built its over $3 trillion foreign exchange reserves. But that is not the end of the story.
The Chinese central bank has mopped up the liquidity it created while picking up the excess dollars from the market through the central bank's debt instruments and higher reserve ratios.
Technically, this is called a sterilisation operation. As a result, exactly to the tune of its exchange reserve, the Chinese central bank has accumulated a massive chest of domestic liability and liquidity — and it is not quite clear how the central bank is going to unwind this domestic corpus. These aspects have been studied by Nicholas Borst of the Peterson Institute of Economics.
CENTRAL BANK'S DEBT
Borst writes: “Sterilisation liabilities are now approaching 50 per cent of the (Chinese) GDP, with the PBoC required to pay interest on these reserves. Going forward, any policy to unwind sterilisation intervention will have to take into account the effect of freeing up this massive pool of money on inflation.”
Locking away excess liquidity through issue of central bank debt instruments is also an indication of the indebtedness of the PBoC. After all, these are liabilities the bank is carrying, even though as a central bank it can print money and meet its liabilities, unlike other banks.
To find this out, Borst has looked at the leverage ratio of the PBoC, that is, the ratio of its liabilities to its own funds (capital) in its balance sheet. While between 1997 and first quarter of 2002, the leverage ratio stayed flat and under 100 per cent, from 2002 it started going up as the pressure of surplus started building up.
At the end of December 2010, PBoC's leverage ratio stood at close to an astronomical 1250:1. The other major central bank in the world, the US Federal Reserve Bank, has a leverage ratio of 49:1.
The question here is not the solvency of the PBoC, but how the central bank can pare this huge excess liquidity without upsetting the macro-economic balance.
Typically, one option for unwinding the locked surplus is to use these for overseas transactions. China has started exploring that option by pushing Yuan bonds and offering credit lines to different countries for trading. This creates assets for the central bank and helps it earn a little interest — however small this might be on political or other considerations. Eventually, if pushed vigorously, these early beginnings could pave the way for the Chinese currency to emerge as an alternative reserve currency. China has already started negotiations with Britain for developing London as an offshore hub for Chinese Yuan bond trading.
YUAN LOANS ON OFFER
It is in this broader context that we should examine the recent government decision to allow Indian companies to borrow an aggregate of $1 billion Yuan. So far, Indian corporates were allowed to raise external commercial borrowing in four currencies, namely, dollar, pound sterling, Euros and Yen. Yuan borrowing should ordinarily help increase Indian companies' purchase of Chinese products, which is already very high. The rates of interest on such loans will also be low.
However, for Chinese currency loans to be acceptable widely, China will have to do much more towards making its currency market-based, and not stick to its current practice of a managed peg. Besides, Yuan should be more freely tradable across wider geographies. In words, the current restrictions on the Chinese currency have to go.
MARKET ECONOMY STATUS
China's approach to currency reforms is a matter of great import for the rest of the world. However, China is fully aware that it is not a “market economy”. Essentially, China remains a command economy in at least one critical aspect: its prices (from interest rates, to product to exchange rates) are controlled. In its interface with the rest of the free market economies, a command economy can take advantage through manipulation of prices as China has done. These have now been stretched pretty far.
Therefore, in its bargain to offer help to Eurozone to overcome the debt crisis, China has urged EU to recognise it as a “market economy”. That will have large trading implications. If, however, China implements an altogether new policy of market-based exchange rate for the renminbi, this will have deep implications. The huge trade deficit of US with China should become moderate, China's recurrent trade surplus should surely come down, and as a result the asymmetry in global balance could get corrected over time.
A correction of the Chinese exchange rate is thus fundamental to weaving a new balance in the global financial architecture.
(The author is a Delhi-based commentator.)