Relaxed rules on forex will reduce dollar reliance

The downgrade of the US credit rating by Standard & Poor’s triggered concern in Beijing over the disproportionate amount that the dollar accounts for of China’s forex reserves, and how to combat this issue.

The requirement that domestic companies exchange the majority of their forex earnings for yuan, coupled with the lack of capacity in the domestic market to soak up this extra yuan, has been a major contributor to inflation.

Admittedly, the boost in overseas trade from the 1980s and the building up of China’s forex reserves was initially seen as a success, but has now become a burden for the country and its residents. The problem is largely a result of China’s archaic foreign exchange policies.

The country’s insufficient support of and even restrictions on imports has only left more yuan converted from foreign earnings flowing in to the domestic market, while also pushing up forex reserves; plus there is too much reliance on US debt to maintain the value of these reserves.

To address this, Chinese enterprises that have generated profits in foreign currency should be allowed to retain them, rather than having to convert them into yuan, which can be only used in the domestic market. This non-yuan-denominated profit could then be invested in their overseas ventures, the purchase of foreign firms, or on importing goods and commodities.

China’s support for its exporters coupled with its restrictions on imports, has meant domestic enterprises are less likely to put efforts into the latter, also contributing to the surplus of yuan in the domestic market.

China has preferred to purchase US sovereign bonds, which were considered the safest assets in the world several years ago. As we all know, less risk means less profit. The annual profit of China’s US bonds is estimated to have remained below 3 percent on average over the last several years, far lower than China’s domestic inflation rate, which has averaged somewhere between 4 percent and 5 percent over the same period.

At the same time, the US dollar’s value is also slumping, decreasing the purchasing power of dollar-denominated forex reserves used to buy imports from non-US markets.

To combat these problems, restrictions on the holdings of forex by individuals and enterprises in China should be relaxed. Chinese people should be encouraged to go overseas and spend this forex on consumption, and enterprises should be given more support in making overseas investments and import using their forex holdings.

Meanwhile, China should also work to establish an investment house staffed with specialists in overseas investment to help place the country’s forex reserves, just as Singapore-based Temasek Holdings does for its own country, and diversify China’s forex holdings.

The author is an economics commentator.