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Home >> Opinion
UPDATED: 09:25, June 02, 2006
Risks mount as forex reserves bulge
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An article on Wednesday's People's Daily overseas edition warns four risks of China's staggering forex reserves build-up and urges actions on defining the caliber of appropriate forex reserves, improving the efficiency of the use of the forex reserves and slowing down the sharp increase.

The author, Xia Bin, is chief of the financial institute under the State Council Development Research Center.

The 870 billion US dollar of forex reserves by the end of March has made China the largest forex holder in the world. It is resulted from the country's fast growing economy and suggests the significance of China's economy in the global economic system.

As liquid assets which are owned by the government and freely convertible, forex reserves do not impact the security of an economy directly. However, there are four looming risks if the sharp increase in China's forex holdings continues.

Firstly, it makes independent monetary policy difficult. Too much forex reserve leads to excessive money supply. Although the central bank's hedge efforts can recover surplus money, inflation, which is immediately reflected by housing price hikes, will be triggered in the case of insufficient hedge under certain circumstances.

However, if the hedge is rising too sharply, that will push the interest rate costs of the government up on one hand and buoy the interest rates on the market on the other. Higher interest rates, in turn, bring foreign capital flooding into China and that makes the hedge efforts less effective.

If inappropriate macro-control measures are taken, like imposing higher capital adequacy on banks, commercial banks will suffer from shrinking profit and then the reform process of the banking sector will be influenced.

Secondly, constantly rising forex reserves makes the economic operation less efficient. The huge forex reserves indicates the absence of a part of the national deposits from the national economic operation.

However, China also faces huge capital shortfall due to lingering problems. Those issues, among others, the development of the agriculture (and farmers as well as the rural areas), the tight capital source of small and medium enterprises, and social security program, all need massive investment.

Given that, it constitutes squander for China to lend its money to foreign countries at a low interest rate.

Thirdly, China's forex reserves are exposed to risks of weaker dollar as dollar takes up the largest slice of the reserve portfolio. It is foreseeable that the dollar dominance internationally will remain unshakable for the next twenty to thirty years or even longer.

The U.S. always tends to cast the interest of any other country to the winds. It has its currency revalued to fix its own economic problems.

If China holds massive dollar assets, possible damages will be notable in the case of sharp depreciation of the dollar.

Last but not the least, huge forex assets sparkle international pressure. Trade wars, interest rate wars, as well as other sanctions by individual countries, do not help create a favorable international economic environment which China needs for its peaceful rise.

The solution lies in the reform to relax the strain on the issue of RMB revaluation and squeeze speculative bubbles out of the reserves.

The solution also lies in progressive deregulation of the capital account and more effective foreign exchange management.

The policy encouraging capital inflow but restricting outflow should be changed to loosen the outflow control.

The part of the forex hoard which is identified as the "excessive" should be held by the public and support businesses to invest internationally.

Forex reserve kept at the appropriate level will still be used on the principle of security, liquidity and profitability.

In conclusion, Xia proposes that, by drawing up experience from the state investment firm Central Huijin, improvement be made on the existing corporate structure or a central government controlled institution dedicated to forex investment be set up.

He also suggests that equity investment, including overseas investment, be expanded and derivatives be introduced to fence off risks and keep value.

By People's Daily Online

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