Little Wiggle Room for China's Foreign Exchange Reserves

By Ouyang Xiaohong, Zhang Bin, Zhao Yuxin
Published: 2009-03-26

Cover issue no. 411, March 23, 2009
Translated by Liu Peng
Original article:

China's foreign exchange reserves could become dangerously illiquid if the yuan depreciated and hot money began pouring out of China, a report from a Ministry-backed research institute said.

Despite that China had accumulated over 1.9 trillion US dollars in reserves, no more than 500 billion US dollars of it was actually liquid, with the rest locked up in investments and agreements, the report estimated.

The report, which was being circulated to policymakers, advised that the remaining disposable funds be used to help Chinese companies go abroad or invested in resources.

Liquidity Concerns
A source familiar with the report told EO that up to 1.2 trillion US dollars of the reserves had already been invested in US Treasury and corporate bonds.

On top of this, China had also signed a series of currency swap agreements with neighboring countries, and must set aside a portion of the reserves to stabilize exchange rates and be ready for any large-scale retreat of foreign funds from the country, the above source added.

Wang Zili, a senior research official from China's central bank told the EO that he agreed with the report's conclusion, but held that even less was liquid--he put the figure at 300 billion US dollars.

Adding to the argument for prudent use of the reserves, the report went on to say that the recent steady ballooning of the reserves had probably come to an end.

Over the past several years, the reserves had increased around 200 billion US dollars a year. But official data showed a more recent abatement. For example, according to China's Ministry of Commerce, actual usage of foreign currencies in China in the first two months of 2009 tumbled by over 26% to nearly 13.4 billion US dollars from a year earlier.

Against this backdrop, the report suggested the government offer support for Chinese firms heading abroad, while being especially cautious in purchases of other products. "Top priority should be given to energy and resource products," the report said.

The source familiar with the report said if China's reserves were to experience a liquidity crunch, the government would probably sell off its long-term US bonds at great losses.

Dilemma of China's Foreign Reserves
China had held 739.6 billion US dollars in US Treasury bonds (T-bonds) by the end of January, making it the US's largest creditor country, according to the Treasury data.

One Chinese official told the EO that China had yet to find another safer and more suitable product to invest in than the T-bonds, and since China was working to help stabilize the international financial markets it would not sell off those bonds easily.

However, the March 18 announcement by the US Federal Reserve Board that it would purchase T-bonds worth 300 billion US dollars would likely make an impact on China's foreign reserve security, as the announcement incurred a sharp depreciation of the US dollar and would contract returns on bonds.

According to the US Treasury Department, the government would issue up to 2.56 trillion US dollars in T-bonds this year. Therefore, whether and how to purchase the US T-bonds would be extremely important for China's foreign reserve investment strategy.

Ha Jiming, chief economist of China International Capital Corporation (CICC), a Chinese investment bank, said China should buy short-term treasury bonds (T-bonds) while also investing long-term in resource products. In addition, he said China should encourage domestic firms to head abroad for acquisition and resources by increasing the flexibility of the yuan's exchange rate.