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UPDATED: January 28, 2013 NO. 5 JANUARY 31, 2013
A Dip in Growth
A slower rate of growth in China's foreign exchange reserves could be good for an economy in transition
By Lan Xinzhen

Money management

China's forex reserves are much larger than necessary to ensure forex liquidity and security. Therefore, a more urgent problem is not the impact of slower growth in forex reserves but the reserves' security and investment returns. The SAFE has established SAFE Co-Financing, a new department responsible for innovative management of the country's reserves.

The SAFE said in a statement that with growing overseas investment by Chinese companies, the demand for foreign currency loans is increasing. By providing entrusted loans with forex reserves, the SAFE can both satisfy corporate demands for foreign currency loans and get higher investment returns.

SAFE Co-Financing has provided a beneficial environment for the financial institutions and forex market participants, facilitated foreign trade and investment and diversified the investment scope of forex reserves.

Lu Zhengwei, chief economist at the Industrial Bank Co. Ltd., said China used to utilize most of its forex reserves to buy U.S. treasury bonds. U.S. dollar assets accounted for 60-70 percent of China's forex reserves. But the investment return rate of U.S. treasury bonds is only about 2.5 percent. By establishing SAFE Co-Financing, the administration offers new investment channels, which will help to make up for the depreciation of forex reserves and aid international operations of Chinese enterprises.

In May 2010, the SAFE and China Development Bank signed the first forex reserve entrusted credit agreement. Since then, the SAFE has also carried out similar cooperation with the Export-Import Bank of China and some other commercial banks. Till now the investment returns of these entrusted credit agreements are all higher than the returns on U.S. treasury bonds.

Potential risks

Wang thinks China's central bank is facing various challenges in the management of forex reserves. For one, while seeking a balance between the returns and the risks of reserve investments, the central bank must also coordinate the possible conflict between the targets of forex reserve management and domestic monetary policies. When the forex reserves keep growing but the annual growth rate declines, such conflict deserves attention.

The most important task of the central bank is to maintain financial stability. These tasks restrain to a degree the management of forex reserves in order not to disturb the aims of domestic monetary policies. At a time when the United States is printing massive amounts of money, China's central bank needs to cope with soaring monetary sterilization costs and the declining investment returns of forex reserves, which may raise concerns regarding the sound operation of the central bank.

According to Wang, what could embarrass the central bank is the potential threat forex reserves pose to financial stability. If the central bank invests a large amount of forex reserves into risky assets, financial bubbles will emerge. Even if the central bank adopts the most conservative strategy regarding forex reserve investments, it cannot avoid risks in the financial market.

Email us at: lanxinzhen@bjreview.com

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