China's Foreign Reserves: Which Button to Press?

By Wang Biqiang
Published: 2009-03-13
From page 3, issue no.409, March 12, 2009
Translated by Tang Tang
Original article:

Chinese premier Wen Jiabao on March 13 voiced concern over the safety of Chinese investment in US government debt during a press conference.

"We have loaned huge amount of capital to the US ..... To be honest, I am worried," Wen said.

Speaking to reporters after closing the nine-day National People's Congress in Beijing, Wen also urged the US to keep its committment in restoring the country's economy and safeguard Chinese assets.

China's concerns stemmed from it being the biggest buyer of US treasury bonds. A vast majority of China's 1.95 trillion US dollars in foreign reserves are invested in bonds and commercial papers issued by public institutions backed by the US goverment.

As the global financial crisis persisted and returns on US government debt declined, China has been looking into how best to tap its reserves to spur domestic growth and demand. 

To better understand the management and evolution of China's foreign currency reserves, the Economic Observer interviewed Wu Xiaoling, vice-president of the National People's Congress financial and economic affairs committee.

She was also the ex-deputy governor of China's central bank, and former chief of the State Administration of Foreign Exchanges (SAFE).

Below is an abridged version of the interview, in which Wu explain that the reserves were a form of liability that could not be directly used for public spending.

She believed China should scale down its foreign reserves, perhaps by way of setting up a Renminbi equity investment fund, or expanding trade and foreign investment.

Foreign Reserves: A Liability
Economic Observer: Through what means has China built up its 1.95 trillion US dollar reserves? How did that figure evolve?

Wu Xiaoling: In 1994, China adopted a reform in foreign currency management system, which prescribed that companies needing or having foreign currency in hand must exchange it at the bank.

Later in 1996, China introduced foreign currency current accounts, which allowed companies to buy foreign currency from banks based on need, keep some cash in foreign currencies within a limit set by SAFE. Beyond that limit, companies were required to sell the extra foreign bills to banks.

Since 2003, SAFE has widened the scope of companies permitted to open foreign currency accounts, and raised the foreign currency balance limit. However, with the Renminbi poised to appreciate, companies and individuals have been eager to off-load their foreign currency.

Under SAFE regulations, companies may keep foreign currency balances up to the sum total of 80% of last year's incoming funds and 50% of last year's spending in their current accounts.

In 2003, the corporate sector's total balance in foreign currencies amounted to 51.9 billion US dollars; by year-end 2008, the balance was 98.8 billion US dollars. The growth rate was 13.7%, far behind China's exports and imports growth rate of 24.7% for the same period. This shows the corporate sector was not keen to keep foreign currency. In recent years, China has been recording surpluses in both its current and capital accounts.

When companies and individuals exchanged foreign currency at banks into Renminbi-denominated savings and cash, the commercial banks may not have enough Renminbi supply, so they would have to sell the incoming foreign currency to the Chinese central bank, which in turn build-up its foreign reserves.

On the central bank's balance sheet, foreign reserves were recorded as assets, which corresponded to the deposits and commercial papers that commercial banks deposited in the central bank. Foreign reserves thus reflected the Renminbi-denominated savings held by companies and individuals. To safeguard the interest of depositors, the central bank must strive to maintain and even add value to its foreign reserves.

Safety, Profitability, and Liquidity
The EO: Facing the global financial crisis, what are China's main principles in managing foreign reserves? And why have US treasury bonds formed such a big chunk of China's foreign reserve?

Wu: The main principals are to ensure safety, profitability and liquidity.

Though the foreign currency reserves are an asset of the central bank, they are also a liability--the central bank is indebted to society, and must be safeguarded.

Since it is a liability, the central bank must pay interest to savings and commercial papers held by commercial banks, and to do so, the reserves must be profitable.

Besides, companies and individuals may use their Renminbi to buy foreign currency at any point, thus, it is important to ensure foreign reserves maintain liquidity to cater to such demand.

In adherence to the above principals, it is common for a country to buy foreign government bonds from countries that issued the currencies it held, or to buy bonds issued by public institutions with high credit ratings.

To manage risk, a country would stock multiple types of currencies and bonds with varied maturity dates; also taking into consideration a country's preferred or active trade and investment destinations.

With the above principals in mind, China's central bank has adopted a conservative strategy for its foreign currency management.

The country's reserves comprised of bonds issued by Fannie Mae and Freddie Mac, as both are public institutions backed by the US government and that provided a sort of investment guarantee.

In recent years, the returns on US treasury bonds have declined, and many central banks around the world have been actively looking for and investing in substitutes, but these types of substitute investment still only take up a very small portion.

What Button to Press?
The EO: Some have suggested distributing foreign currency reserves to the public to stimulate consumption. Is that feasible?

Wu: As I explained earlier about the source and makeup of the foreign reserves, they cannot be distributed freely nor used for public welfare spending.

The EO: How may the reserves be use for spurring domestic demand then?

Wu: In a broader sense, it is possible. For instance, the Ministry of Commerce recently led a procurement delegation to Europe to buy some 13 billion US dollars worth of high-tech products. If the purchases comes through, the payments will be settled in foreign reserves.

The EO: Can the reserves be use in resource investments or equity investments?

Wu: The government has been encouraging businesses to acquire resource-based products and assets abroad in recent years. However, the Chinese central bank cannot engage directly in investment activities. The reserves it holds is a liability, a debt to the people.

When companies and individuals wish to invest abroad, they would use Renminbi to buy foreign currency and shoulder the investment risk.

Given that the reserves could potentially shrink drastically if companies and individuals decided to buy foreign currency en-mass, which could lead to a balance of payments crisis, each country has some restrictive regulations on foreign currency investment.

With a reserves amounting to 1.95 trillion US dollars, the likelihood of a balance of payments crisis in China is slim.

Another way to use the reserves is by establishing a Sovereign Wealth Fund (SWF). Most of the SWFs are funded by governments through the purchase of foreign currency, the investment risk of which is borne by the government.

For instance, China issued 1.5 trillion yuan of treasury bonds in 2007, and used the funds to buy 200 billion US dollars to inject into China Investment Corporation (CIC), the Chinese SWF.

Recently, there have been suggestions to establish resource investment funds, and this is a feasible idea, provided the fund was set up by using foreign currency purchased with Renminbi.

Where does the Renminbi come from to establish these funds? If it is coming from the government, it can be from the treasury or even funds raised through government bonds.

If it is from the corporate sector, it can be from corporate capital or bank loans.

We should encourage businesses to pool resources into forming a Renminbi Equity Investment Fund, which can then buy foreign currency and embark on investment abroad.

To reduce investment risk, the government may alternatively set up an industrial fund to help businesses to explore oversea market.

Risk Control: Reducing the Reserves
The EO:
In 2008, China's current account surplus declined by 27% year-on-year, which slowed the growth of foreign reserves. How will this impact China? What are the risk-control measures?

Wu: The best way to minimize risk is to scale down the size of foreign currency reserves.

At present, China's foreign currency reserves tops the world. However, with the global financial crisis aggravating, we face greater risk. It is not as simple as the more, the better. The flow and ebbs of foreign reserves reflected the intensity of economic activities, and the flow of capital is a natural outcome of a globalized economy.

So, we need not panic over a slower growth in foreign reserves. This is in fact the direction to follow, to adjust the economic structure of the country, to reduce dependency on external demand. The way forward is to expand trade and foreign investment, and to reasonably reduce the size of the reserves.