I've posted the whole article here because the paper is subscription only and this explanation is important. Almost everyone seems to think that China's enormous 2 trillion in foreign reserves is accumulated wealth, which they could spend any time, and proof that China owns the US. It doesn't work like that, as this article explains.

Foreign exchange reserves cannot be viewed as wealth
Michael Pettis
Aug 23, 2008
Early this week, perhaps prompted by a research note issued by JP Morgan, the stock market surged on rumours of a fiscal stimulus package from the central government. According to the rumours, the government plans to spend as much as 400 billion yuan (HK$456 billion) to forestall an economic slowdown.

The feverish speculation that followed included proposals on how China's almost US$2 trillion of foreign exchange reserves might be used for these purposes. Among the proposals were suggestions that the mainland might invest foreign currency reserves in physical and social infrastructure, or that it place reserves in a special fund to stabilise the stock market.

Whatever the merits of increasing infrastructure spending or supporting the stock market, these kinds of proposals are based on a misunderstanding of how foreign reserves can be used. In the popular imagination, even among analysts and policymakers who should know better, foreign exchange reserves represent the unencumbered wealth of a country and this wealth can be spent at will on any project on which the country chooses to spend it.

However, reserves are not wealth and they cannot be spent domestically.

Foreign currency reserves are simply assets which the central bank has acquired by borrowing local currency at home and using the money to purchase foreign currency. Reserves are not even a proxy for wealth. The richest country in the world, the United States, has perhaps US$40 billion in reserves; other rich countries have far less, even as a share of gross domestic product, than China does. Poor and middle-income countries, on the other hand, often have large reserves relative to the sizes of their economies.

This is because reserves are a form of insurance against a loss of credibility. The central bank borrows in local currency and buys foreign currency as a way to guarantee that, if there ever is an interruption in external financing, it still has the foreign currency it needs to service its foreign obligations and to import necessary goods. Furthermore, some countries, such as China, intervene to keep their currencies from strengthening and so are forced to accumulate foreign currency reserves whether or not they want to. Conversely, countries that intervene to keep their currencies from weakening are forced into losing foreign currency reserves.

Consequently, any proposal to use foreign currency reserves to invest in domestic infrastructure or to support the stock market is meaningless. How can China possibly use its foreign currency reserves to spend on domestic programmes? Assume for a moment that the government decides to take US$1,000 from the People's Bank of China to hire more nurses in Gansu province. Since the nurses must receive yuan for their living expenses, the government effectively must sell the US$1,000 and buy yuan before it can deliver the money to the nurses.

But to whom will it sell the dollars? The final buyer of dollars in China is the People's Bank of China, and it must be the ultimate counterpart to any selling of dollars for yuan, whoever the seller and whatever the reason. After giving US$1,000 to the government agency responsible for paying the Gansu nurses, the PBOC must buy the dollars back so that the agency can pay the nurses in yuan, and to pay for the purchase of those dollars which it had previously granted, it must borrow yuan in the local markets. The net result, of course, is that the PBOC has just as many dollars before the nurses were paid as it did afterwards. There is no net change in foreign currency reserves.

So, where did the money come from? From borrowing domestically or from raising taxes. To pay the nurses, the PBOC or some other government entity had to raise yuan locally in the domestic market, either by borrowing the money, raising taxes, or simply having the PBOC create additional money (which is a form of taxation, albeit a very inefficient one).

There's the rub. If the mainland government wants to increase infrastructure spending or buy stocks in the domestic market, it can only do so by borrowing in the local markets (and increasing its net debt) or by raising taxes (and so counteracting the stimulus). The foreign currency reserves play no direct role in this process. All domestic spending must be paid for domestically.

China is getting richer rapidly, but this rising wealth is not indicated by its rising reserves. On the contrary, not only is the country's wealth far greater than its reserves, but the accumulation of reserves is actually an indication of a financial imbalance, and the more reserves grow, the worse the imbalance becomes. Anything that causes reserves to decline, or at least to grow more slowly, would be a good thing for China, but spending the reserves domestically to stimulate the economy is not an option. Its foreign currency reserves cannot be spent in the country.

Michael Pettis is professor of finance at Peking University
Subscription
http://www.scmp.com/portal/site/SCMP/menuitem.2af62ecb329d3d7733492d9253a0a0a0/?vgnextoid=521feb8de3beb110VgnVCM100000360a0a0aRCRD&ss=Columns&s=Business

They could buy oil with it or iron ore or copper, on international markets, couldn't they?

http://www.nytimes.com/2008/09/05/business/worldbusiness/05yuan.html?_r=2&re&oref=slogin
=================

By KEITH BRADSHER
Published: September 4, 2008

HONG KONG — China’s central bank is in a bind.

It has been on a buying binge in the United States over the last seven years, snapping up roughly $1 trillion worth of Treasury bonds and mortgage-backed debt issued by Fannie Mae and Freddie Mac.

Those investments have been declining sharply in value when converted from dollars into the strong yuan, casting a spotlight on the central bank’s tiny capital base. The bank’s capital, just $3.2 billion, has not grown during the buying spree, despite private warnings from the International Monetary Fund.

Now the central bank needs an infusion of capital. Central banks can, of course, print more money, but that would stoke inflation. Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.

The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts. This could heighten trade tensions with the United States. The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

<snipped>

http://www.theaustralian.news.com.au/story/0,,22487560-36375,00.html?from=public_rss
===============

Richard McGregor, Beijing | September 27, 2007

THE Battle of Waterloo. The deaths of six US presidents. The rise of Adolf Hitler. The deflation of the Japanese bubble economy, the 1997-98 Asian financial crisis and even environmental destruction in the developing world.

In a new Chinese bestseller, Currency Wars, these disparate events spanning two centuries have a single root cause: the control of money issuance through history by the Rothschild banking dynasty.

Even today, claims author Song Hongbing, the US Federal Reserve remains a puppet of private banks, which also ultimately owe their allegiance to the ubiquitous Rothschilds. Such an over-arching conspiracy theory might matter as little as the many fetid tracts that can still be found in the West about the "gnomes of Zurich" and Wall Street's manipulation of global finance.

But in China, which is in the midst of a lengthy debate about opening its financial system under US pressure, the book has become a surprise hit and is being read at senior levels of government and business.

"Some senior heads of companies have been asking me if this is all true," says Ha Jiming, chief economist of China International Capital Corp, the largest local investment bank.

The book also gives ammunition, however haywire, to many in China who argue that Beijing should resist pressure from the US and other countries to allow the yuan to appreciate.

The book's publisher, a unit of the state-owned CITIC group, says Currency Wars had sold almost 200,000 copies, with an estimated 400,000 extra pirated copies in circulation as well.

Song, an IT consultant and amateur historian who has lived in the US since 1994 and is now based in Washington, says his interest was sparked by trying to uncover what lay behind the Asian crisis in 1997. After he began blogging some of his findings, his friends suggested he find a publisher for a longer work. He professes himself surprised by the book's success.

"I never imagined it could be so hot and that top leaders would be reading it," he says during a book tour in Shanghai. "People in China are nervous about what's going on in financial markets, but they don't know how to handle the real dangers. This book gives them some ideas."

<snipped>