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.