THE DIMINISHING RETURNS TO ACCUMULATING FOREIGN RESERVES: IMPLICATIONS FOR CHINA, THE USA, AND THE WORLD

Abstract

This paper uses the fourth generation of Bi-Directional Reiterative Truncated Projected Least Squares (BD-RTPLS4) to estimate the dollar change in exports due to the accumulation of an additional dollar of foreign reserves, ∂(exports)/∂(foreign reserves), for Australia, Bangladesh, China, Hong Kong, India, Indonesia, Japan, Kazakhstan, Pakistan, Singapore, South Korea, Malaysia, New Zealand, the Philippines, Taipei, Thailand, and Vietnam for 1995–2011. The dollar return in exports due to the accumulation of an additional dollar of foreign reserves is falling for most of these countries. Most notably, China's ∂(exports)/∂(foreign reserves) fell from 1.875 dollars of exports in 1995 to 0.493 in 2009 but rose to 0.589 in 2011. An implication of these results is that the current international financial system is no longer sustainable. China, currently weaning itself off of its dependence on exporting, is taking serious action to create consumption driven growth in China, and is gradually losing its capital controls. Once these actions have borne enough fruit, China could buy its own currency on the international market paying for it with its holdings of US dollars (estimated at 1.78 trillion dollars), driving up the value of the Chinese yuan and consequently, causing the value of the dollar to plummet. This might cause the world to switch from using the US dollar as a reserve currency to using the Chinese yuan, and, thereby, lead to China displacing the US as the world's dominant nation.