Jake van der Kamp in the SCMP explains central bank balance sheet basics. Lest you think that is incredibly boring, Jake demonstrates that the "People's" Bank of China's massive foreign reserves (and those of many countries) is mostly owed to banks and private entities, not the Government (and thus, in theory, the people). Happily, there's one place that is an exception to this rule. Read on to find out where...

Mainland's soaring foreign reserves a treasure chest of fool's gold

My colleague, Mark O'Neill, who is based in Shanghai, contributed an interesting column yesterday about how the authorities in the mainland are deliberating what best they can do with their massive foreign reserves.

As he pointed out, those reserves of US$711 billion are now the second largest in the world after Japan's and, at the rate they are growing, could exceed Japan's by the end of this year. Most of the money is parked in US dollar debt instruments, predominantly treasuries, and the question in Beijing is whether it should stay there, be diversified into other currencies, be used for corporate acquisitions abroad or be repatriated for domestic uses.

Let us put one thing in perspective immediately. Asian countries generally have a mania about foreign reserves with a total of US$2.5 trillion of them at present. For an indication of how maniacal this can be, note from the first table that Singapore has more foreign reserves than the United States.

But I think O'Neill's analysis should be taken one step further as many people misunderstand what a country's foreign reserves constitute. They are technically the balancing item on the balance of payments and do not represent the net savings of government.

For an example of what I mean, look at the second table, which sets out the balance sheet of the mainland's central bank.

Foreign reserves are invariably held by central banks and you can see them here as net foreign assets, the first item in the assets side of the balance sheet. Although they constitute the largest single item in assets, take note that there are others.

What interests me more, however, is how these assets are financed and for this look at the liabilities side of the balance sheet. The largest single item here is reserve money. This constitutes the backing for note issues plus deposits made by banks and other financial institutions. Then we have the central bank's issuance of bonds, its foreign liabilities and the usual other liabilities.

All are distinguished by the fact that they are obligations to entities other than the national government or to the central bank. The only items that you could possibly consider as representing national savings here are government deposits and the bank's own capital and they amount to only 11.6 per cent of assets or liabilities.

In fact, even that 988.5 billion yuan in government deposits is questionable as public savings. The national government generates no surplus to deposit with the central bank. It has operated in deficit for the past 20 years.

If it puts money with the central bank you can be sure it also owes that money to others in some way. All that really exists as public savings here is the bank's own capital and that constitutes only 0.25 per cent of the total.

In other words, these massive foreign reserves are not really owned by the people of China overall. If the central bank were to liquidate itself, almost all of what it holds would have to be paid out to banks or private entities.

It is thus an illusion to treat China's foreign reserves as a publicly owned treasure chest. If the authorities wish to play with the money, they can do so but in the end they owe it back to others and those others are not the public of China.

This is, in fact, true of foreign reserves everywhere. For instance, the government deposits and capital of Taiwan's central bank amount to only 7 per cent of its total assets and Korea's only 4.3 per cent. In both cases there is again reason to quibble with how free of encumbrances the government deposit share of this is.

But let us end on a bright note.

Do the exercise for Hong Kong and of $1.06 trillion in assets in our Exchange Fund, about 68 per cent is attributable to government deposits and accumulated surpluses. Those are unencumbered government deposits, by the way.

We in Hong Kong might conceivably have the luxury to talk as the bureaucrats in Beijing talk. They, however, are probably fooling themselves.