Foreign exchange reserves are no insurance against financial crisis

That should be obvious enough, though apparently there are many who believe it. We haven’t time to go through all the arguments now, but want to note this bit from Niall Ferguson:

The experts insist that there can’t be a Chinese financial crisis because the People’s Bank of China has accumulated such vast quantities of dollars in the past few years. But that is to exaggerate the importance of central bank reserves. China is certainly not going to suffer a currency crisis of the sort that hit Thailand and Malaysia in 1997; the pressure on the renminbi is upward not downward, as speculators anticipate a further revaluation of the currency after July’s tiny move.

There are other kinds of financial crisis, however. The United States had ample gold reserves in 1929 – the biggest in the world. That did not prevent the banking panics that were the key drivers of the Great Depression. And let’s not forget the protectionist pressures building as China’s exporters erode ever more sectors of US and EU manufacturing.

We have noted on many occasions that China’s growth is primarily dependent on export growth, and that has limits due to protectionism and market saturation. China’s growth is secondarily dependent on vast amounts of foreign and domestic investment, much of which fails to earn back its cost of capital. This is a merry-go-round which must slow down, at least for a while, at least at some point. We have already seen sectoral recessions and reversals in China, such as in the steel industry, and in dry cargo rates as well. In countries with as large a disconnect between the real and financial sectors as China (or the US in the 1920’s) there must be a shakeout at some point to relieve the imbalances. Huge forex reserves are helpful to ameliorate such a shakeout, but can not prevent it.

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