Making Sense of China’s Excessive Foreign Reserves

Large uninsured risk, severe borrowing constraints, and rapid income growth can create excessively high household saving rates and large current account surpluses for emerging economies. Therefore, the massive foreign-reserve buildups by China are not necessarily the intended outcome of any government policies or an undervalued home currency, but instead a natural consequence of the country’s rapid economic growth in conjunction with an ine¢ cient …nancial system (or lack of timely …nancial reform). A tractable growth model of precautionary saving is provided to quantitatively explain China’s extraordinary path of trade surplus and foreign-reserve accumulation in recent decades. Ironically, the analysis suggests that without a well-developed domestic …nancial market, the value of the renminbi (RMB) may signi…cantly depreciate, instead of appreciate, once the Chinese government abandons the linked exchange rate and the massive amount of precautionary savings of Chinese households are unleashed toward international …nancial markets to search for better returns. Keywords: Current Account, Foreign Reserve, Trade De…cit, Bu¤er Stock Saving, Global Imbalance, Incomplete Markets, Uninsured Risk. JEL Codes: E21, F11, F30, F31, F32, F34, F40, F41, O16. I thank Chris Carroll, Chris Neely, David Wheelock, Xiaodong Zhu, and seminar participants at the 2010 Conference on Chinese Economy (Fudan) for comments, and Judy Ahlers for editorial assistance. The usual disclaimer applies. Correspondence: Yi Wen, Research Department, Federal Reserve Bank of St. Louis, St. Louis, MO, 63104. Phone: 314-444-8559. Fax: 314-444-8731. Email: [email protected].