Opinion

How to better use forex reserves

By Liu Shengjun (China Daily)
Updated: 2010-01-13 07:58

China's foreign exchange reserves reached $2.27 trillion by September 2009. That huge amount helped the nation buffer the impacts of the global recession and create a stronger voice in international affairs. Nevertheless, effective management and usage of such a large amount of capital is a major topic that needs to be deeply mined.

As the world's second largest economy, Japan accrued $1.07 trillion in foreign exchange reserves by November 2009, less than half of China's total. General consensus says that a suitable scale of foreign exchange reserves should be maintained in a volume equivalent to imports of three to four months. China's gross import volume amounted to $711.1 billion during the first nine months of 2009 - foreign exchange reserves should thus stand at approximately $320 billion.

Despite accounting for the large sum of money remitted from foreign-funded enterprises and considering the large-scale foreign direct investment (FDI) into China, as well as foreign debts and other factors, the current foreign exchange reserves are still remarkably high.

There are two major challenges for China and its foreign exchange reserves: How to utilize the current amount and how to reduce the total to a reasonable level.

Currently, China's foreign exchange reserves are playing a role mainly through the following channels:

The first is through the operation of China Investment Corporation (CIC). CIC was established in 2007 with approximately $200 billion of assets. Its assets now exceed $300 billion. The corporation mainly engages in long-term equity investment involving overseas financial institutions, real estate, mining, electricity, new energy and other sectors.

The second channel is the management of the State Administration of Foreign Exchange (SAFE). According to a United States Treasury Department report, until October 2009, China held $798.9 billion in US treasury bonds, $479.8 billion of long-term agency bonds, $24.5 billion of long-term corporate bonds and $100.8 billion in the US stock market, adding up to $1.4 trillion and about 60 percent of China's foreign exchange reserves.

Recently, SAFE was planning to recruit Zhu Changhong, fund manager of the world's largest bond fund, Pacific Investment Management Company, as the chief investment officer of its reserves management department, indicating that SAFE expects to turn to Wall Street elites to enhance its assets management capabilities.

The third channel is through the overseas investment of China's large enterprises. The World Investment Report, released by the United Nations Conference on Trade and Development, said China's overseas investment in 2008 topped $55.9 billion and is increasing every year. In addition to direct overseas investment, the Industrial and Commercial Bank of China, China Merchants Bank, China Minsheng Banking Corporation, Jiangxi Copper, Geely Automobile, Lenovo Group, China Steel Group, Sinopec Group and many other companies have tried overseas acquisitions.

One thing to notice is that the current management of the foreign exchange reserves is facing increasing pressure and challenges.

First, since China's entry into the World Trade Organization in 2001, China's foreign exchange reserves have been growing rapidly. The huge foreign exchange reserves mean that while China attracts large numbers of FDI, it also lends money to the US. China thus bears a huge opportunity cost by holding these reserves.

Second, US dollar assets are the main component of China's foreign exchange reserves and China is the US government's largest foreign creditor. But in the long term, with the general trend of the dollar's devaluation, China's foreign exchange reserves are at a real risk from the dollar's depreciation.

Third, foreign exchange reserves concentrating in central agencies have exacerbated the distortion of domestic asset prices. Domestic individual investors can only choose internal stock markets and real estate as their main investment targets, resulting in increasingly rising home prices and the emergence of an assets price bubble, that cast a shadow over the fragile economic recovery.

I think that in order to optimize the management of China's foreign exchange reserves, more private investment channels should be tapped.

Qualified Domestic Institutional Investor (QDII) and other forms of overseas private investment should be encouraged to allow domestic investors to choose investment objectives globally. By using foreign exchange, residents' overseas investment could not only facilitate renminbi to withdraw from circulation and ease the pressure of assets price inflation, but also reduce the size of the official foreign exchange reserves to a reasonable level.

Domestic enterprises should also be motivated to seize the current opportunity to acquire or buy shares of important overseas companies with considerable resources. Though acquiring overseas resources through a dominant share in stake is due to meet considerable political resistance, the nation could employ the joint-stock pattern to optimize the returns of resource price hikes driven by the economic recovery. Participation rather than becoming the majority shareholder is also in line with China's lack of experience in managing multinational enterprises.

There is still a certain margin for renminbi appreciation. Renminbi appreciation not only is conducive to reduce the level of foreign reserves but also could create pressure to promote the transition of export-oriented enterprises and get rid of the mindset of seeking cost competititiveness at the expense of product quality, environment, employees' basic rights and interests. Although doing so will bring inevitable toil, in the long run it could speed up the pace from "Made in China" to "Creation of China".

The author is deputy director of the CEIBS Lujiazui International Finance Research Center.