An Embarrassment of Riches!: China’s ‘Trillion Dollar’ Foreign Exchange Reserves

If current trends are any indication, the global financial system will witness a unique ‘first’ in mid-October when China’s foreign exchange reserves are expected to cross US$ 1 trillion.

According to China’s central bank, the People’s Bank of China, which issues official figures on the nation’s foreign exchange reserves on a quarterly basis, foreign exchange reserves totalled $ 941.1 billion at the end of June 2006. Buoyed by trading surpluses and capital inflow, reserves rose by a further $ 13.4 billion to reach $ 954.5 billion at the end of July 2006. If current trends are any indication – an average monthly growth in forex reserves of $ 19.4 billion in the first seven months of this year – the $ 46 billion required to reach a trillion can be accumulated by the middle of October. These figures translate into a 30.3 per cent growth from $ 732.7 billion computed from the end of July 2005 to the present.

The management of this large accumulation of foreign exchange is undoubtedly a challenging task as reflected in opinions expressed by Chinese officials and economists alike. In an undated essay that has been widely cited and carried on the official web site www.studytimes.com.cn, the Vice President of China, Zeng Qinghong has said that China will continue to “perfect” the yuan exchange rate mechanism as part of work to be done in the second half of this year. Adopting a cautious approach, he said China “should use comprehensive measures to control further large gains in its forex reserves” and should expand the use of forex reserves by increasing imports for reserves of “important strategic resources.” Zeng also called for the utilisation of the large forex holdings to hasten the transformation of key state enterprises and to encourage individuals to hold more foreign exchange. To allay fears of an ‘overheating’ of the economy, he has recommended that China “pay strong attention to structural macroeconomic adjustment to shift its growth model.” In his view, “the foreign exchange reserves have reflected China’s growing economic power but on the other hand they have increased exchange rate risks and added upward pressure on the yuan.”

The question uppermost in the minds of policy makers, analysts and observers is indeed a very basic one. What does China propose to do with a trillion dollars as forex reserves? Are the strong reserves driving China’s acquisition of energy and mineral assets all over the globe? In the words of Peng Xinyun, an economist at the Chinese Academy of Social Sciences, the top government think tank, “the US has rich oil resources but it still purchases a lot of crude oil. If they can do it, why not us?”

The accumulation of large forex reserves by China has the potential to be a double-edged sword for the region. In an indirect acknowledgement that the lessons of Asia’s 1997 financial meltdown have been learnt (although China escaped the consequences), China’s experience in generating trade surpluses is having a salutary effect all over Southeast Asia with countries of the region competing with one another to generate trade surpluses and higher economic growth. The flip side of strong currency reserves is that currencies of the region will increasingly opt for full convertibility, that in the very first place generated the financial crisis of 1997. In China’s case, the debate has been for quite some time on whether the renminbi is accurately valued or not. Since China revalued its currency by 2.1 per cent in July 2005, ending the currency’s decade-long peg to the dollar, the yuan has risen only at a snails pace, sparking fresh demands for more rapid change. To keep its currency stable, China has to absorb foreign capital, that conversely increases the supply of money in its domestic economy. This calls for some fiscal juggling by central bankers to avoid an inflationary spiral that could wreck the very foundation of China’s ‘socialist market economy.’

Some attitudes do seem to be changing within China and there has been a growing chorus of calls from Chinese economists and officials to allow the yuan to strengthen at a faster rate. To the chagrin of China’s central bankers, reserves are growing by $ 200 billion a year and without a dramatic shift in China’s economic structure they will surpass $ 1.4 trillion and approach $ 1.5 trillion in 2008. According to Ba Shusong, vice head of the financial research institute at the cabinet’s Development Research Centre, the central bank faces the choice of achieving real appreciation either by letting the yuan fluctuate within a wider range or accepting higher inflation. While China says that it will allow more flexibility in its forex management regime, it also feels that it must move at its own pace rather than risk a major shock to its financial system. It claims that it has already taken significant steps towards reforming its currency and will continue to do so on a gradual basis and will not be pressured into making dramatic changes – reflecting a strong ethos of ‘financial sovereignty.’

However, some observers believe that China could be forced into further change sooner rather than later, since the massive fund inflows accompanying the trade surplus pose enormous policy challenges under a rigid exchange rate regime. Some Chinese officials argue that the money would be better spent recapitalising the state banks or by importing oil and building up strategic reserves, of which it currently has none. Others say the money should be used to fund overseas acquisitions by Chinese firms. Conservatives want to keep the money in financial instruments. They say, quite rightly, that the inflow of hot money is only a temporary phenomenon and point to the billions of dollars of liabilities in bad loans held by the state banks, pension and welfare liabilities and debts owed by securities firms.

It is surmised that how China invests this accumulated reserves will definitely influence the monetary policy of several industrialized countries, most notably the United States. From its forex reserves, it holds more than $ 200 billion in US treasury bonds, according to the South China Morning Post, and an unknown amount of instruments in other currencies, including the euro, yen, sterling, Hong Kong dollars and Swiss francs. The possibility of China offloading some of its treasury bonds leading to a rise in US interest rates does find favour with a few commentators. These rather alarmist interpretations speak of a tighter monetary policy and the beginnings of an economic slow-down that could spread all over the industrialised world, should China take such a drastic step. Just as how Japan did not abandon its US investments after the crash of its ‘bubble economy’ in the late 1980s, so too the Chinese might not want to risk by short selling their US Treasury bonds.

What is clear from the debate on what to do with an embarrassingly large forex reserve is that China is heavily dependent on cheap exports as part of its booming economy and any sudden strengthening of the yuan would only end up damaging local export industries and hurt the country’s financial system. That in turn might create higher unemployment – and engender social unrest. Beijing is most likely to adopt a policy of ‘gradualism’ as witnessed in its year on year increase in providing economic aid to neighbours and exercise its options by spreading its leverage and influence to emerge as Asia’s fulcrum from a financial point of view.