A mountain too high

China foreign currency reserves have been growing rapidly since 1997. The total reserves in April this year is a staggering USD1.8T. What causes it to rise, is it good or bad and what will be the economic consequences if the size of reserves continued to ballooned further or if the balloon burst midway? Below is my summary on the subject.

A mountain of reserves

Here are some hard facts about China's foreign exchange reserves. In 1997, foreign exchange reserves is only USD2.3b. It reaches USD1T in Oct 2006 and since then it has reached USD1.8T in April 2008. China's reserves is about 20% of world's total reserves of USD8.7T. Most of this monies are stockpiled in US Treasury bonds and other foreign assets. At present levels, China can finance for about 1 1/2 years worth of its imports (generally it is recommended to have 3 - 6 months buffer). In April itself (inflow of USD74.5b), China attracts approximately USD103m of inflow per hour! The rise can be explained by 3 main reasons: 1) increase in trade current account surplus, 2) Inward FDI flows and 3) speculation on RMB appreciation. According to Lehman Brothers, April's FDI and trade surplus account for only USD24.3b. It suggested the balance of USD50.2b is due to surge in speculators taking positions on the rising Chinese interest rates and an appreciating yuan.

Sterilization process

In theory, flows of foreign monies into China should push up the yuan. If left unchecked it would also give rise to higher inflation, increased money supply and over investment. To avoid these undesirable consequences, what the Chinese government did was to go through a process known as "sterilization" ie by buying up the surplus foreign currency by issuing bonds (to banks, insurance and securities companies) to mop up the yuan it has paid for the dollars.

What to do with the reserves?

So far, the Chinese government has been very prudent with the management of the reserves. In the main, the reserves have been invested in low yielding US Treasury bonds, and US government companies' bonds like Fannie Mae and Freddie Mac and other foreign assets. Some of the reserves were also given to China Investment Corp to manage which to date were quite "unlucky" to have invested in Morgan Stanley and Blackstones. There were arguments whether these reserves could instead be used to further benefit the poor and maintain subsidies.

A mountain of 'debts'?


Having too much of a good thing will always lead to a problem. As China aggressively sterilize its ever increasing foreign reserves, the government bonds issued were also rising correspondingly. This is a problem as China will not be able to raise interest rate too much which could handily be used to fight inflation. I believe China was left to fend inflation by raising its banks reserves ratio. China has been raising its Reserve Ratio Requirement for the last 16 times, the next one will be June 25 to 17.5%. Notice also the lending rates remains unchanged for the passed half year or so at 7.47% and deposit rate is at 4.14%. Question is how long can China last without raising interest rate in view of the rising inflation? If it does, cost of capital would be increased compared to the low yielding bonds invested by China overseas. Another worry is, what if USD drops further, will the lower value of investment in US Treasury bonds give rise to liquidity problem to China in the future?

What has been done?

So far, China has done the following to reduce its reserves but without much success. There has been cut in export subsidies, slight appreciation of RMB; yuan has risen 20% since 2005(ie after abandoning its RMB peg), introduction of overseas investment vehicle; CIC, hike in banks Reserve Ratios, relaxation of foreign currency control to invest overseas and curbing over lending(to curb speculation) and over investment in properties and business.

Speculation

Due to China's current monetary policy, speculation plays a large part why the reserves went up so much. This "big one way bet on the currency" has been around since 2001 when China was admitted into WTO. Off late, the "size of unexplained" rise of reserves is a grave concern. The concern is what would happen it the speculators completely do a u turn and pull out the monies out of China. The outflows could damage the country's economic, financial and foreign exchange stability. It could also drag the economies of other countries doing business with China along the way.

What can be done now?

So far, many analysts including the ones from World Bank, believe a one off revaluation of yuan is the best way to deal with the speculators on the currency. How much revaluation is the question. Is 15%, 20% etc sufficient? The other solution was to change China's monetary policy of a managed float on a narrow band to a policy of greater foreign exchange rate flexibility. Some form of capital controls may be also be introduced. It will be interesting to learn how the Chinese will overcome this 'happy but thorny problem' which needs to be address sooner than latter. In the meantime, China will just live for another day living dangerously.


* World Bank raised China's full year inflation forecast to 7% from 4.8%.


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