Forex in excess

The losses may be debatable, but most economists and officials agree that China's forex reserves are "excessive."

Central bank Governor Zhou Xiaochuan said at a financial forum on April 18, 2011, the forex reserves surpassed the reasonable level China needs. Excessive reserves have led to increased liquidity in the market and placed a hedging burden on the central bank.

Such a large forex stockpile was never the Central Government's intention, but rather the result of various mutually affected factors. In 1978 China's forex reserves totaled $1.67 billion. From 1979 to 1989 the forex reserve balance did not surpass $20 billion. After further reform measures in 1992 China began to adopt policies to encourage exports and attract foreign direct investment with preferential policies. Since then China's forex reserves have grown rapidly, surpassing $1 trillion in October 2006 and breaking the $3 trillion mark in March 2011.

Larger forex reserves, Zhou said, are conducive to avoiding outflows of capital and maintaining stable exchange rates. It can also be used to cope with future uncertainties with international payments and ensure normal imports and expenditure in repaying debts. Moreover, sufficient forex reserves will ensure a country can effectively cope with financial risks caused by external impact. Excess reserves, however, will have an adverse impact on various parts of the macro-economy.

According to Zhou, under the present mechanism for exchange sales and settlements, the central bank has to issue more money to purchase the newly increased foreign exchange balance, thus pushing up circulation of basic currency and compressing the space for monetary policy control. Excessive liquidity has also added fuel to inflation and induced an inflow of international capital that will ultimately be accumulated in the country's forex reserves.

Now, public comment on the matter is focused on the following aspects.

First, the scale of China's forex reserves is excessively large. Keeping the yuan exchange rate at its current level will cause these reserves to continue to increase and, more importantly, it will also bring expectations and actual pressure of further yuan appreciation.

Second, diversified assets are needed since most of China's forex reserves are in U.S. dollars. Although exact figures are not made public, it can be estimated from Bank for International Settlements reports that around 70 percent of China's reserves are in dollars, 10 percent in yen and 20 percent in British pounds.

Third, despite the large holdings of U.S. treasury bonds, substantial reductions in these holdings could cause turbulences in the global financial market.

Preserving the value

Economists are considering China's options—let the forex reserves stay at the central bank or make overseas investments—to increase or at least preserve the reserves.

Guo Tianyong, Director of China Banking Industry Research Center of Central University of Finance and Economics, said China can try to gradually reduce its holdings of U.S. dollars or purchase treasury bonds from other less risky countries with better liquidity, gold reserves or energies and resources China lacks.

From the capital composition, transferring U.S. dollar assets into assets denominated with other currencies will be conducive to increasing the safety and profitability of China's reserve assets, Guo said. But if the scale of the transfer is too big, the U.S. dollar will be inevitably depreciate and China will suffer losses of asset devaluation.

According to an analysis report released by the Beijing-based research company Anbound Group, China's excessive forex reserve holdings are rooted in its economic and trade structure. To avoid reserve asset losses, economic restructuring will be necessary. China should gradually reduce and abolish subsidies to exporting companies and those outdated and inefficient exporting companies. Cuts like this are the price China must pay to improve the overall competitiveness of its economy.

To manage the $3 trillion in forex reserves, revisions are needed to the foreign exchange administration rules, said Xia Bin, Director of the Research Institute of Finance of Development Research Center of the State Council. First, the government must maintain necessary liquidity of foreign exchange in order to satisfy the demand of balanced international payments. Second, the government should use some foreign exchange to intervene in the foreign exchange market to satisfy the demand of regulating the exchange rate. Third, the use of forex reserves must serve sustainable economic growth and obtain strategic benefits. Fourth, spare reserves can be used for financial investment of higher yields.

Xia also suggested relaxing controls on foreign assets held by residents and eliminating restrictions on investment in foreign financial products. China should also actively participate in rebuilding the international monetary system and making the yuan an international currency. This is an effective way to solve the forex reserve problem, release Chinese wealth from the bonds of its U.S. dollar assets and ensure Chinese financial security.