“China indeed faces a real dilemma. Not only does it have a large stock of dollar reserves, but that stock is growing. Yet the value of that stock is also likely to fall in the future. China’s over $500 billion in reserves are currently equal to about 1/3 of China’s GDP, so a 33% real appreciation of the yuan would generate capital losses equal to 10% of China’s GDP. That is a big loss, by any measure. .”
Defending the peg right now requires reserve accumulation of $150 billion a year (in the third quarter, China’s reserves increased by almost $45 billion). If that continues, in four years, China’s reserves would easily exceed $1.1 trillion. China’s GDP is rising too – if the exchange rate stays constant and the IMF’s growth path is right, GDP will be @ $2.35 trillion in 2008. Reserves would then be equal to about 47% of China’s GDP. 33% real appreciation and reserves to GDP of 45% produces a capital loss of 15% of GDP. But that probably underestimates China’s future losses, since over time, the scale of the real appreciation China needs also is rising. China’s economy is becoming more productive very quickly -- and remember that Japan’s economic miracle in the 50s, 60s and 70s was accompanied by substantial real appreciation in yen. A 50% real appreciation produces a capital loss of above 20% of GDP. That is real money, even for fast growing China.”
The only get out that I can see would be for China would be to inflate the trouble away. If it stokes up inflation in the US, so it is greater than it is in China, it can engineer a real exchange rate appreciation of the Yuan without taking nominal losses on it dollar holdings. This is of course provided that the reserves are no long held as bonds – in other words China should buy up assets with its stash of dollars. Of course ideally those assets should not be dollar denominated but their purchase should increase the rate of inflation in the US. Buying Oil would be one option – it’s a real fungible assets and its appreciation will increases inflation in the US? The only question is then whether its more inflationary for the US than China its self – which is possible given Chinas lower car utilitsation. Food for thought.