Download Report on China's Foreign Exchange Reserves

Report on China's Foreign Exchange Reserves
Xijun Zhao Shujia Zhang
School of Finance Renmin university of China, Beijing, PR.China, 100872
Abstract: Since 2001, China's foreign exchange reserves have entered a stage of substantial growth. By
the end of March 2006, China's foreign exchange reserves have reached 875.07 billion U.S. dollars, top
1 in the world, accounting for more than 18% of the world's total reserves at the same period. The huge
foreign exchange reserves have become one of the major factors affecting China's economic
development.The increasing foreign exchange reserves have contributed a lot in enhancing China's
comprehensive national strength and promoting rapid economic growth. However, the article consider
that the sustained rapidly growing surplus, an imbalance in the balance of payments, has brought new
problems and challenges, which mainly include losing the independence of monetary policy, bringing
the macroeconomic impact because the excess liquidity, aggravating the imbalance in economic
structure, missing the financial and opportunity cost, causing the RMB appreciation.To find a solution to
decrease the pressure of rapidly increasing foreign exchange reserves, the article suggest that not only
impel the reforms of foreign exchange administration system further but also improve the foreign trade
conditions reasonably. At the same time, reserve assets management deserves attention as the
supplement.
Key Words: Foreign exchange reserves, cost-benefit analysis
Ⅰ. The basic situation of recent China's foreign exchange reserves
Since 2001, China's current account and the capital & financial account in the balance of payments
statement all show a huge surplus and foreign exchange reserves have entered a stage of substantial
growth. From 2001 to 2005, the annual increase in China's foreign exchange reserves amounted to
46.591 billion U.S. dollars, 74.242 billion U.S. dollars, 116.844 billion U.S. dollars, 206.681 billion U.S.
dollars and 208.94 billion U.S. dollars respectively. By the end of March 2006, China's foreign exchange
reserves have reached 875.07 billion U.S. dollars, top 1 in the world, accounting for more than 18% of
the world's total reserves at the same period. The huge foreign exchange reserves have become one of
the major factors affecting China's economic development
Chart: China’s foreign exchange reserves growth process
January 1994-March 2005
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China's foreign exchange reserves growth
(January,1994-March,2005)
100 million US dollars
10000
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
4
6
8
0
2
9
9
9
0
0
9
9
9
0
0
1
1
1
2
2
Source: Based on data released by the State Administration of Foreign Exchange
4
0
0
2
6
0
0
2
（Unit : 100 million U.S.
Table :The ratio of China's foreign exchange reserves to the world's total reserves
dollars
）
Year
1999
2000
2001
2002
2003
2004
2005
1546.75
1655.74
2121.65
2864.07
4032.51
6099.32
8188.72
China
17837.14
19407.47
20523.66
24077.1
30276.64
37384.06
43580.21
Global
ratio
8.67
8.53
10.38
11.9
13.32
16.32
18.79
Source: Collated according to the related data of State Administration of Foreign Exchange and the
International Monetary Fund
％
：
Since 2001, China's foreign exchange reserves changes have shown the following characteristics
(i). the total foreign exchange reserves stably remained ultra high-speed growth
From 2001 to March 2006, China's foreign exchange reserves increased by more than 700 billion U.S.
dollars, the average annual growth rate of foreign reserves (compared with a year earlier) reached 38%
。
Chart: Growth rates of China's foreign exchange reserves (1994 – 2005)
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Growth percentage compared with a year earlier
Growth rates of China's foreign exchange reserves
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Source: Based on the Balance of Payment between 1994 and 2005 from the State Administration of
Foreign Exchange
(ii). China’s continuing Balance of Payment Double Surplus leads to high growth rate of foreign
exchange
The above-trend growth of China's foreign exchange reserves is a direct result of balance of payments
double surplus, that is, surplus at not only current but also capital & financial accounts.
Table: China’s current account surplus and the capital & financial account surplus between 1994
and 2005(Unit: 100 million U.S. dollars)
The
The
contribution
contribution
rate of
the capital
The increase
Gross
rate of the
Capital &
current
&
foreign
Balance of
in foreign
current
financial
account financial
Year
exchange surplus to the account
payments
exchange
surplus
account
reserves
reserves
surplus to
growth in
surplus
growth in
foreign
foreign
reserves
reserves
1994
305.27
76.58
326.44
304.21
516.2
25%
107%
1995
224.81
16.18
386.75
219.77
735.97
7%
176%
1996
316.43
72.42
399.67
314.32
1050.29
23%
127%
1997
357.24
369.63
210.15
348.61
1398.9
106%
60%
1998
64.26
314.71
-63.21
50.69
1449.59
621%
-125%
1999
85.05
221.14
51.8
97.16
1546.75
228%
53%
2000
105.48
205.19
19.22
108.99
1655.74
188%
18%
2001
473.25
174.05
347.75
465.91
2121.65
37%
75%
2002
755.07
345.22
322.91
742.42
2864.07
46%
43%
573
2003
1170.23
458.75
527.26
1168.44
4032.51
39%
45%
2004
2063.64
686.59
1106.6
2066.81
6099.32
33%
54%
2005
2070.16
1608.18
629.64
2089.4
8188.72
77%
30%
Source: Based on the Balance of Payment between 1994 and 2005 from the State Administration of
Foreign Exchange
(iii). Speculative capital flows at a higher speed and bigger size.
This is mainly reflected in the rapid growth in foreign debt of the "other investments" item, especially
short-term debt, continuously rising in the proportion of short-term debt and abnormal movement in the
net errors and omissions item. According to data released by the State Administration of Foreign
Exchange, the balance of China's short-term foreign debt in the first quarter of 2006 (still remained)
stood at 161.043 billion U.S. dollars, accounting for 55.94% of the total amount of foreign debt, nearly
30 percentage points higher than the international safety line, 25%.
Ⅱ.The cost-benefit analysis of holding a large volumes of foreign exchange
reserves
(i). the benefit of maintaining a great volumes of foreign exchange reserves
Balance of payments surplus and an increase in foreign exchange reserves have always been regarded as
an important indicator of enhancement in Comprehensive National Power. The gains to maintain
massive foreign exchange reserves mainly include the following five aspects: first, to ensure our nation's
international liquidity and capacity to keep balance of payment. Second, it will help maintain the
stability of RMB exchange rate. Third, it will provide a solid foundation for promoting capital account
liberalization and the free convertibility of RMB. Fourth, to strengthen the ability of the country's
economy to resist risks, including coping with external shocks and fluctuations of foreign & domestic
economies. At last, the strategic gains of reserves, including promoting the impact in international
financial markets and the right to speak.
ii The cost of maintaining massive foreign exchange reserves
The highest foreign exchange reserves in the world have contributed a lot in enhancing China's
comprehensive national strength and promoting rapid economic growth. However, the sustained rapidly
growing surplus, just like deficit, also an imbalance in the international balance of payments, has
brought new problems and challenges, which mainly include the followings:
1
Loss of the independence of monetary policy
First, the currency issue is becoming increasingly dollarization. In recent years, due to a rapid increase
in foreign exchange reserves, the base money release on the basis of foreign currency circulation has
become a major channel for central bank’s release of base money. During 2000-2005, the increase in
foreign currency reserve amounted to 664.196 billion U.S. dollars, and if then converting it into RMB at
the exchange rate of that year and estimated with 5 as the currency multiplier (empirical data), the
aggregate money for release amounts up to 18.84709 trillion RMB (not considering “write-off"). During
the period, the balance of money supply (M2) increased by 19.91091 trillion RMB, the contribution rate
of the money release caused by the increase in foreign exchange reserves to money supply reached
94.66%. China’s currency issue can be said to have been almost fully dollarized, similar to Hong Kong.
Second, it will have a negative impact on the independence of China’s monetary policy. The rapid
growth in foreign exchange reserves has increased the difficulty and complexity of the implementation
of monetary policies by central bank and has caused the gradual loss of independence. Under the
situation of tight monetary policy, the increasing of the monetary issue caused by the substantial
increase in foreign exchange reserves will greatly weaken the central bank's monetary policy-tightening;
under the situation of expansionary monetary policy, the increase in foreign exchange reserves will
enhance the policy effect, bringing inflation pressure
Third, it will increase the operating costs of the monetary policy and operational difficulties. To
eliminate the increase in money supply due to the increase in foreign exchange reserves, the central
bank has to take out RMB on the open market so as to offset the impact on monetary policy. The central
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bank should adopt regular "hedge" operation to take out money from the financial markets to reduce
money supply. At present, China's central bank recovers base money by means of issuing notes in the
open market. In 2005, the central bank issued notes as much as 2.7882 trillion RMB for "hedging". If
calculating by the interest rate of one-year central bank bills 1.9%, the central bank has to pay huge
operating costs for annual "hedging" operations. In addition, these "hedging" operations, designed to
weaken the negative impact of massive base money release, are operated passively, limiting the control
room and initiatives of the central bank's monetary policy, and can affect the effectiveness.
In addition, the large increase in foreign exchange reserves has limited the use of other means of
tightening policy. In the current somewhat overheating economy, a common macroeconomic control is
to raise interest rates, but now the government is cautious to raise interest rates, mainly due to the
pressure from the appreciation of RMB. If the central bank raises interest rates, more foreign capital will
flow into China, bringing pressure on China to revalue the RMB, and the significant appreciation of
RMB is opposite to the benefit of the government. Therefore, the increase in foreign exchange reserves
also hinders central bank’s regulation of the economy by increasing interest rates.
2
Macroeconomic impact of the excess liquidity
Currently, the whole world is facing the problem of excess liquidity. The current excess liquidity is
fundamentally due to the large number of dollars exported by the United States, and it is these dollars
from a huge trade deficit with the United States that brought about the excess liquidity in the form of
dollars. The excess liquidity of local currencies formed after the output dollars were converted into local
currencies. The excess liquidity of RMB was also triggered by the large increase in China's foreign
exchange reserves. As base money, the large-scale release of foreign currency, under the money
multiplier mechanism, caused multi-fold expansion of the money supply and rapid expansion of market
liquidity. Excess liquidity triggered series of negative consequences such as profit downturn, the
overheated investment, inflation and even the bubble economy. Currently, the excess liquidity has
become a conspicuous structural contradiction in China's financial operation, a thorny issue facing the
macroeconomic policy-making departments.
3 Aggravating the imbalance in economic structure
A rapid increase in foreign exchange reserves led to imbalance in dynamical structure of economic
growth, unfavorable to achieving the transform to domestic-demand-led economic growth mode. Under
the background of weak domestic demand and lack of realization of consumption fueling economic
growth, China's foreign exchange reserves surge through exporting large volumes of primary resource
products, at the cost of damaging the resources and the environment. Continually relying on export
products with structure of such a low level and the style of extensive growth and large quantity to
maintain the current account surplus, continually maintaining the dynamical structure of economic
growth which is primarily dependent on export and investment, are not only unfavorable to implement
the scientific concept of development, realization of the objective to establish a resource-saving and
environmentally sound society, but will also undermine economic growth potentiality and staying power,
not conducive to economic health and sustainable development.
4) Financial cost and opportunity cost
Financial cost means the financial losses for holding extra foreign exchange reserves. This kind of
financial losses include both losses of return on reserve assets and potential losses caused by changes in
the exchange rate. At present, US dollar takes correspondingly higher percentage in foreign exchange
reserves of China, so the depreciation of either US dollar or yield of US Treasury Notes will bring down
the value of return on reserve assets of China as well as the yield.
In another aspect, holding huge volume of foreign exchange reserves will also bring high opportunity
cost. At the same time of holding huge volume of reserve assets, selling bonds to foreign counterparties
as well as introducing foreign capitals both in great amounts, equals to transferring domestic funds with
lower prices abroad to be utilized by foreigners and to introducing foreign funds with higher prices
simultaneously, which means that the potential cost may not be neglected. By the end of 2005, the
foreign exchange reserve of China reached 818.9 billion dollars; to calculate as if the interest rate of US
Treasury Notes (a great part of foreign exchange reserves has been invested to buy US Treasury Notes
currently) is 3 percent lower than that of loan offers, there would be 24.5 billion dollars less in the form
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of interest income. By the end of 2005, the balance of foreign debts of China reached to 281 billion
dollars (of which commercial banking loans amounted to about 100 billion dollars); as the interest rate
of loan from foreign commercial banking is usually 2 to 3 percent higher than that of deposits, to
calculate with 2 percent, there would be 2 billion dollars more in the form of interest payment. In this
way, there would be nearly 26.5 billion dollars loss by less income and more payment for one year,
which means that the cost of foreign exchange reserves is extremely huge. Moreover, foreign exchange
reserves which exist as financial assets have not transformed into any factors of production such as
technology, equipment and material production etc., so that can not be employed to enlarge investment
and can not increase national income. The cost of foreign exchange reserves increases just along with
foreign exchange reserves themselves increase in great extent.
(5) Pressure of RMB appreciation
The increase of foreign exchange reserves will certainly be accompanied by the appreciation of
domestic currency, so that foreign exchange reserves with extra-scale will consequently enlarge the
pressure of RMB appreciation. The fact that foreign exchange reserves of China increased in great
extent shows that the supply of foreign currency is higher than the demand of it in the domestic foreign
exchange market, which will certainly lead to the depreciation of foreign currency and the appreciation
of domestic currency. Therefore, the more foreign exchange reserves one country has, the higher
domestic currency appreciation pressure is; the anticipation of RMB appreciation will increase inflows
of foreign funds as well as balance of payment surplus, and moreover enhance the pressure of RMB
appreciation.
III. Conclusions and Suggestions
Firstly, the quick rise of foreign exchange reserves is essentially a comprehensive reflection of both the
imbalance of payment and the factors that lead to the result of imbalance; therefore, comparing with
monetary policy, foreign exchange reserves policy obviously doesn’t have strong independence.
Secondly, the nature of funds decides its purpose. As foreign exchange reserves of one country is a kind
of reserve assets, its security must be more important than its profitability, which means that the security
and liquidity of foreign exchange reserves in huge volume should be completely ensured before the
profitability of that being considered, and then is the problem of moderate scale determined by the
demand of foreign exchange reserves.
Based on the consideration above, the following countermeasures might be taken into account in order
to regulate the problems of foreign exchange reserves exist at present.
(i) Further impel the Reforms of Foreign Exchange Administration System
At present, the key point of further impel the Reforms of Foreign Exchange Administration System is
how to open capital account gradually and systematically. Opening capital account is a gradual process,
and the selection of this process will definitely influence both balance of payment and status of foreign
exchange reserves in China.
From the experiences of developing countries in the process of opening capital accounts in recent years,
a general sequence is: firstly loose the control of long-term inflows, and then that of short-term inflows.
This sequence is according with the reality of China. Under present foreign exchange administration
system of China, there seems to have a strict regulation of international capital flow on the surface,
while in fact the intensity of regulation needs to be strengthened. For example, many short-term funds
flow into China in the name of trading in recent years, while in fact these speculative funds with high
liquidity have made a great impact on foreign exchange market.
From the international view, no country relaxes its own regulation of short-term capital completely, so
that this problem should not be neglected. On the other hand, in the sequence of opening capital account,
China should firstly loose the control of capital outflows (such as policy of QDII), and then loose that of
capital inflows, combined with the situation of China, which will help to relieve the increasing pressure
of foreign exchange reserves of China in short term.
Generally speaking, before the conditions of perfect financial market and enterprise system get ready, it
is hard to open capital account completely. It is a gradual process for China to open its capital account,
and in this process, the exchange rate regime will gradually transfer from virtual fixed exchange rate
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regime to elastic exchange rate regime with finite interval, during which the marketization degree of
exchange rate regime will be enhanced gradually. Moreover, it is necessary for China to adjust policies
of introducing funds in order to improve the quality and benefit of foreign direct investment, and to
relax purchase policy of foreign exchange, increasing amounts of selling foreign exchange, in order to
realize foreign exchange held by the people step by step. Finally, after the current account has already
been opened completely, to control the over-fast increase of both current account and capital account,
measures such as further reform of taxation system (export tariff rebates etc.) might be taken.
(ii) Reasonable improvement of foreign trade conditions
In recent years, the overall situation of foreign trade of China is that trade balance with continuous
surplus accompanied by the imbalance of foreign trade structure. The formation of the status of trade
balance has profound and intrinsic reasons, which is different from changeability of capital account,
including economic development degree, population structure, international industry distribution and
systematic factors of economy in China etc..
In the short-term view, the prominent problem of foreign trade in China is the trade balance with
continuous surplus that leads to pressure of RMB appreciation as well as problems of international trade
frictions etc.. In the long-term view, the essential matter of foreign trade in China is the imbalance of
foreign trade structure.
From the aspect of trade balance structure, China continues to have a surplus on commodity trade and a
deficit on service trade with high added-value. From the aspect of commodity trade structure, China
exports mainly labor-intensive products, which results in slow adjustment of industrial structure in
China. In addition, from the aspect of trade body, foreign investment enterprises have already taken
more than half of the total amount of foreign trade in China, which seems to show that China has a
surplus on this kind of exportation while in fact it is a kind of foreign low-end industry transformation.
At the same time, foreign investment enterprises have taken higher than 80 percent of exportation of
high-tech products.
Therefore, China should consider reducing the surplus of foreign trade through optimizing the structure
of foreign trade other than simple appreciation of RMB. (In fact, after the 2.1-percent appreciation of
RMB took place in Jul 21st, 2005, the surplus of trade balance in China has increased remarkably
instead of decreased, compared in the same term length.)
Approaching 50 percent, high saving rate is right corresponding to high balance of foreign trade. Hence,
to decrease the trade surplus of China needs to enlarge internal demand as well as to lower domestic
saving rate. However, intrinsic reasons of high saving rate need to be analyzed in detail.
From the view of enterprise, high saving rate reflects the imperfect of capital market and the
inconvenient of external financing channel. From the view of resident, high saving rate shows the
distemperedness of social security system, relatively young population structure and the imbalance of
social income distribution. From the view of government, high saving rate represents the great increase
of government taxation and irrationality of payment structure.
On the other hand, the low saving rate of USA, especially the great amount of public deficit, is an
important reason for the imbalance of world economics in global view, so that to improve the surplus of
trade balance in China also needs to consider international economy policy coordination and
cooperation, based on the condition of high trade balance between China and United States.
To sum up, surplus of trade balance, as an important source of foreign exchange reserve increment, can
not be regulated completely by adjustment in RMB exchange rate, which means that the real structure
problems and the deep-seated contradicts will not be resolved simply by adjustment in exchange rate.
(iii) Reserve assets management: scale and approach for usage
It is a complex problem to define the moderate scale of foreign exchange reserve. Currently, both the
increasing velocity and the scale of foreign exchange in China are the outcomes brought by economic
growth under Foreign Exchange Management System in China; to reduce the amount of foreign
exchange reserves compulsively is not the measure to control the scale of foreign exchange reserves to
be theoretically moderate. The rise of foreign exchange reserves is only one kind of external imagery,
while more attention should be paid to the fact that there will be negative influence to the imports and
exports structure of China or economic development if the imbalance both inside and outside of China
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continues, such as excessive foreign dependency of economy system. Therefore, the scale of foreign
exchange reserves can not be considered simply by the amount, but should be considered from the view
of economic development, economic structure improvement and national stratagem benefit. The nature
of national foreign exchange reserve assets decides the approaches for usage, which means that the
security is more important than profitability. At the same time of discussing the using approaches of
foreign exchange reserves, not only the economic benefit but also the strategic benefit should be paid
attention to, for example, China has spent great amount of foreign exchange reserves in purchasing US
Treasury Notes, which could be considered as one kind of strategic investment.
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