There's just one effective cure for China's $3.2bn headache

The bulk of China's $3.2 trillion official foreign reserves - more than 60 per cent - is denominated in dollars, including $1.1tn in US Treasury bonds. Petar Kujundzic / Reuters

While the downgrading of the top-tier US credit rating shocked global financial markets, China has more reason to worry than most: the bulk of its US$3.2 trillion (Dh11.75tn) in official foreign reserves - more than 60 per cent - is denominated in dollars, including $1.1tn in US Treasury bonds.
So long as the US government does not default, whatever losses China may experience from Standard & Poor's downgrading will be small, although the dollar's value will fall - imposing a balance-sheet loss on the People's Bank of China, the central bank. But a falling dollar would make it cheaper for Chinese consumers and companies to buy American goods.
If prices are stable in the US, as is the case now, the gains from buying US goods should exactly offset the People's Bank balance-sheet losses.
The downgrading could, more-over, force the US Treasury to raise the interest rate on new bonds, in which case China would stand to gain. The downgrading, however, was a poor decision, taken at the wrong time.
If America's debts had truly become less trustworthy, they would have been even more dubious before the agreement reached on August 2 by legislators and the president to raise the government's debt ceiling.
That agreement allowed the world to hope that the US economy would embark on a more predictable path to recovery. The downgrading has undermined that hope. Some even predict a double-dip recession. If that happens, the chance of a US default would be much higher than it is today.
These new worries are raising alarm bells in China. Diversification away from dollar assets is the advice of the day. But this is no easy task, particularly in the short term.
If China's central bank started to buy non-dollar assets in large quantities, it would invariably need to convert some current dollar assets into another currency, which would inevitably drive up that currency's value, thus increasing the bank's costs.
Another idea being discussed in Chinese policy circles is to allow the yuan to appreciate against the dollar. Much of China's official foreign reserves have accumulated because the central bank seeks to control the yuan's exchange rate, keeping its upward movement within a reasonable range and at a measured pace.
If it allowed the currency to appreciate faster, China would not need to buy large quantities of foreign currencies.
But whether such appreciation will work depends on reducing China's net capital inflows and current-account surplus.
International experience suggests that, in the short run, more capital flows into a country when its currency appreciates, and studies have shown that gradual appreciation has only a limited effect on countries' current-account positions.
If appreciation does not reduce the current-account surplus and capital inflows, then the yuan's exchange rate is bound to face further upward pressure.
That is why some people are advocating that China undertake a one-shot, big-bang appreciation - large enough to defuse expectations of further strengthening and deter inflows of speculative "hot" money.
Such a revaluation would also discourage exports and encourage imports, thereby reducing China's chronic trade surplus.
But such a move would be almost suicidal for China's economy. Between 2001 and 2008, export growth accounted for more than 40 per cent of China's overall economic growth.
That is, China's annual GDP growth rate would drop by 4 percentage points if its exports did not grow at all. In addition, a study by the China Center for Economic Research has found that a 20 per cent appreciation against the dollar would entail a 3 per cent drop in employment - more than 20 million jobs.
There is no short-term cure for China. The government must rely on longer-term measures to mitigate the problem, including internationalisation of the yuan. Using it to settle China's international trade accounts would help China to escape America's beggar-thy-neighbour policy of allowing the dollar's value to fall dramatically against trade rivals.
But China's $3.2tn problem will become a 20tn-yuan problem if Beijing cannot reduce its current-account surplus and fence off capital inflows.
There is no escape from the need for domestic structural adjustment.
To achieve this, China must increase domestic consumption's share of GDP. Unfortunately, given high inflation, structural adjustment has been postponed, with efforts to control credit expansion becoming the first priority.
This enforced investment slowdown is itself increasing China's net savings, while constraining the expansion of domestic consumption.
Real appreciation of the yuan is inevitable so long as Chinese living standards are catching up with US levels.
Indeed, the Chinese government cannot hold down inflation while maintaining a stable value for its currency.
The central bank should target the yuan's rate of real appreciation, rather than the inflation rate under a stable yuan. And then the government needs to focus more attention on structural adjustment - the only effective cure for China's $3.2tn headache.
 
A Yao Yang is director of the China Center for economic research at Peking University
* Project Syndicate