Significance and Issues of China's World's Largest Foreign Reserves

Oversized Foreign Reserves

It has been observed within China that its foreign reserves are actually excessive. China has the world's fattest foreign reserves, but it also carries about US$300 billion in foreign debt. There are arguments in favor of taking a portion of the foreign reserves and using it to reduce foreign debt.

It is said that that for a developing country to engage in smooth international trade, it is empirically important that it hold the equivalent of six-month import proceeds in foreign reserves. However, it is nearly impossible for China, which had adopted the policies of dollar-peg and exchange concentration for a long time, to optimize its scale of foreign reserves. As high economic growth continues, trade surplus and the inflow of foreign direct investment are putting pressure on the Chinese yuan to appreciate. To avoid such appreciation, the People's Bank of China (the Central Bank) is intervening in foreign exchange on a daily basis. In the end, rather than the stabilization of foreign exchange the result of this has been a rapid increase in foreign reserves.

On the other hand, in order to manage the risk of foreign debt it is important to suppress the short-term debt ratio. However, public foreign reserves cannot cover the cost of the private sector's debt. Moreover, considering its weak financial systems, China does not have the strength to manage foreign reserves domestically.

Rather than discuss whether or not it is good news for China that its foreign reserves are the world's largest, it is first necessary to examine the background and issues.

On July 21, 2005, China appreciated the yuan's exchange rate by 2.1%. However, an appreciation of a currency's exchange rate does not necessarily mean that trade imbalances will immediately be corrected. China's exports have been continuing to expand since July of last year. As a result, the 2005 trade surplus reached US$101.9 billion, easily exceeding the 2004 surplus by US$32 billion. Looking at the current situation of the Chinese economy, it is difficult to believe that its competitive edge increased three-fold in strength in one year. There should be other factors involved.

First of all, with their eyes peeled on foreign exchange trends, the minds of exporters are changing. In other words, exports are being accelerated based on the expectation that the yuan will be appreciated.

Secondly, to avoid capital-flow regulations, speculators are watering exports of Chinese exporters and sending foreign currency to China in the form of export proceeds. Therefore, of the US$100 billion trade surplus at least 20-30% should be regarded as speculative funds from this watering.

Thirdly, as a result of a three-year domestic over-investment, China's production potential has far exceeded domestic demand, and the tightening of the economy in 2004 has left no choice but to push the excess of domestic production potential towards exports.

According to IMF predictions, at this rate China's foreign reserves will exceed US$1 trillion and its foreign exports will overtake Germany to become the most in the world by the end of 2006. In the first fiscal quarter, economic growth was recorded at 10.3% despite tightening government policies. Furthermore, the second quarter saw a rapid increase in capital investment around the country and economic growth reached 11.3%. Meanwhile, the central bank's competency is being questioned as fiscal policy becomes increasingly dysfunctional.

Difficulty in Steering Policy under High Economic Growth

During President Hu Jintao's visit to the US on April 20, President Bush requested that the yuan's flexibility be increased. In response, President Hu Jintao pledged to continue reforms but did not offer a concrete timetable. The next point of focus will be whether or not the US labels China as a "manipulator of currency exchange".

If trade deficits with China are not reduced it will be even more difficult for the Bush administration to weather the midterm elections. After paying a visit to Washington, President Hu Jintao directed the commerce cabinet minister and pursued a large-scale course of buying that reached US$16.2 billion. This move, however, did not serve to rectify the trade imbalance.

On the other hand, the climate in China is also problematic. The export of goods like shoes and dress shirts is being faced with anti-dumping in western countries. Most of all, without a reduction in the trade surplus that exceeds US$100 billion, both domestic and international pressure will only become stronger.

Given this situation, the People's Bank of China currency control division announced that it would allow investment in foreign securities (QDII) by financial institutions. In other words, it is attempting to offset current account surpluses, which are not easily resolved, with the export of capital.

The solution to the problem is not that simple. Increases in foreign reserves are the result of trade surpluses and foreign direct investment as well as the flow of speculative "hot money", which was first recognized by the National Bureau of Statistics in August. According to the Bureau, the influx of “hot money” from February to May of this year exceeded US$20 billion.

In light of this situation, the Chinese government is implementing various measures such as allowing investment in foreign securities (QDII) by domestic institutional investors and limiting real estate investments from foreigners (nonresidents). These measures, however, are nothing more than short-term treatments, not fundamental "health reform". This is because in the background of dramatic increases in trade surpluses lies domestic over-saving. There is no choice but to direct left over domestic production potential towards exports as a result of under-consumption (from excessive saving) in the context of economic growth driven by investment. Consequently, a nominal appreciation of the exchange rate cannot rectify trade imbalances. Furthermore, given the weak financial systems, the influx of speculative "hot money" will increase. Instead of short-term measures, fundamental "health reform" – in other words, the reform of financial systems and the development of a social security system – are critical.

In conclusion, in terms of the outlook for the yuan's exchange rate, even if it is slightly appreciated it will do nothing to curb the influx of "hot money". While it is difficult to believe that that the trade surplus will double again, it is likely that a surplus of around US$100 billion will remain for the foreseeable future. It is important to increase imports in order to stop further bloating of the foreign reserves, but that is expected to be difficult with a lack of domestic demand. In the end, there is really no choice but to strengthen the capability to export capital. However, allowing large-scale foreign securities investment within a weak financial system is to invite a moral hazard and an increase of bad loans. Financial authorities in China are faced with a difficult course of action.