by Bill O’Grady
We often get questions about China’s foreign reserves. The fear is that China’s massive “pile” of foreign exchange reserves is a risk factor for U.S. markets. In the first part of this report, we will discuss the evolution of foreign reserves from gold to the dollar, with a historical focus. In Part II, we will use the macroeconomic saving identity to analyze the economic relationship between China and the U.S. In Part III, using this analysis, we will discuss the likelihood that China will “dump” its Treasuries and potential repercussions if it were to do so. From there, we will examine the impact of such a decision by China to reallocate its reserves. Finally, as always, we will conclude with market ramifications.
Until August 15, 1971, the foreign financial system rested, to varying degrees, on gold. However, the gold standard had been eroding since the end of WWI. Political philosophers such as David Hume noted the “price-specie” relationship; essentially, wealth didn’t necessarily reside in the accumulation of gold. In nations that acquired gold from American colonies, the end result was mostly higher prices. As the money supply rose, if there wasn’t a commensurate rise in the supply of goods, the end result was inflation.