Analysis

By Steve Schifferes

BBC News economics reporter



China's currency is undervalued, say many of its trading partners

As of 1 October, China's central bank announced that its reserves were $987bn - and they are growing by $18bn each month.

That sum is the largest holding of foreign exchange reserves in the world - and more than the annual value of economic activity in all but a handful of the world's big economies.

The huge surplus is a product of China's success as an exporter to the world.

China's trade surplus, the difference between the amount it sells and buys from the world, has topped $100bn, with the imbalance especially marked with the US.

As a result, China receives more and more foreign currency each year, which it puts in its reserves.

But China's currency reserves are now so large that some economists fear they will unbalance the entire global economy.

Grip on US

Foreign currency reserves are generally seen as a good thing - it is the lack of reserves that means that countries might suffer runs on their currency, as Britain did in the 1970s.

But China's surplus is much more than China needs to cover its exports, or pay for its own investments abroad.

And China has mainly invested its foreign currency reserves in long-term US Treasury bonds and other government securities.

Brad Setser, a former US Treasury official, estimates that China now holds $700bn in US long-term bonds, enough to lower US long-term interest rates by 1.5% - which helped stimulate the recent housing boom.

But those holdings are a double-edged sword.

If China attempted to diversify its holdings, it could cause a collapse in the value of the dollar and higher inflation in the US.

That would also lower the value of China's own reserve assets - so China is only slowly moving out of dollars and into other currencies such as the euro.

However, it also ties the fate of the US economy to China.

Worries for China

In economic theory, China's currency should rise in value since it has such a big trade surplus and currency reserves.

The world wants China's cheap goods - and is paying in dollars

But China's economic growth is highly dependent on exports and investment, with relatively little coming from domestic consumption.

So the Chinese government wants to keep the value of its currency, the yuan, fixed at a rate tied to the US dollar (with a 3% variation allowed).

This helps boost foreign investment but makes it more difficult to control inflation.

In the long term, China wants to switch the emphasis in its economy to domestic demand.

But that will take time - and in the meanwhile the currency reserves could double to reach $2 trillion in a few more years.

Foreign investment

Some economists argue that the pattern actually benefits both the US and China.

The US gets a cheap and stable source of funding for its trade deficit, allowing the economy to continue to grow as consumers purchase cheap foreign goods - whose low prices keep inflation in check.

And China is able to maintain its export-led economic growth, generating jobs for its growing urban population, while continuing to attract foreign investment.

But others argue that it may not be sustainable - and the attempt to unwind these huge imbalances could destabilise the world economy.

Brad Setser believes that unless China rapidly revalues its currency, it will face increased pressures on its domestic economy - with over-investment (now approaching 50% of GDP) eventually collapsing, putting pressure on the banking system.

Fred Bergsten of the Institute of International Economics argues that the problems of adjustment - and the huge trade imbalance - will generate growing protectionist pressures in the US and Europe, undermining support for free trade.

The IMF and the OECD also see this adjustment as the central problem of the world economy.

And unless it is tackled, the prospects for future world economic growth might well be derailed.