Op-Ed Contributors

Cocktail of assets may be the right cure

By He Zhicheng (China Daily)
Updated: 2010-03-10 07:59

Recently a debate has sparked domestically about whether it is wise for China, which has a massive amount of foreign exchange reserves, to continue purchasing United States Treasury bonds.

China's methods of preserving and increasing the value of its foreign exchange reserves not only influences the security of State reserve assets, but also bears on the stability of the international exchange market.

But with the recent debt crisis in Europe, investors globally are waiting to hear from China on the foreign exchange reserves issue.

The Chinese government faces a big dilemma: Although it's a great risk to keep buying up US Treasury bonds, it seems that China has to continue purchasing them.

Several economists have said that China should reduce its US dollar reserves and its holdings of the US Treasury bonds. A buzz is spreading that the euro and the United Kingdom's pound will collapse, causing China's foreign exchange reserves to shrink.

To guarantee the security of China's foreign exchange assets, in the long run it's important to drastically reduce trade surplus and a dependency on exports to developed countries, such as the US. China should also improve its industries, and tap into the increase on domestic demand to offset the decline in foreign demand. But this will be a long process.

In the short run, keeping the renminbi strong and stable is key for China to increase its US dollar reserves. Experience has shown that as long as China's economy doesn't slide into a recession, the RMB will not depreciate. In that case China won't have to drastically reduce its US dollar reserves and the monies around the world will be stable and the US dollar will not sharply drop in value.

Meanwhile, China's huge amount of foreign exchange assets could guarantee that the RMB will be more accepted worldwide. The security of China's foreign exchange assets will ensure the stability of the RMB's domestic purchasing power. How China manages its foreign exchange assets is very important.

If China can't reduce its foreign exchange reserves, it has to manage it better.

I recommend the theory of "cocktail-style" foreign exchange reserves. A country's foreign exchange reserves should consist of a variety of currencies in flexible proportions. Only when China's foreign exchange reserve is highly liquid can it resist drastic fluctuations in the international foreign exchange market. It is the premise to increase the overall value of China's foreign exchange reserves.

The cocktail-style method is different from the diversification of foreign exchange reserves that has been suggested by some experts, largely because the diversification theory is based on a considerable decrease in US dollar reserves.

The cocktail-style theory believes that there's no conflict between the diversification of foreign exchange reserves and purchasing foreign assets. For example, China can purchase more foreign equity holdings and mining concessions. This theory also implies that the diversification of State and private foreign exchange reserves are compatible. The reserves of assets and currencies should go together with the reserves of advanced technologies, intellectual property rights and creative talent.

The main ingredient of the cocktail-style theory should be the US dollar, which should be above 60 percent of China's overall foreign exchange reserves. The theory also emphasizes liquidity, which means the country should flexibly adjust the proportions of its main currencies according to market changes. When there is a downtrend of US dollars, we should reduce the holdings of US dollar modestly, as well as the euro and other currencies. The proportion of main currencies in the package of foreign exchange reserves should not stay static.

Considering China's large amount of foreign exchange reserves, which make up one-third of the total foreign exchange reserves of all the governments in the world, it will be difficult to frequently adjust China's foreign exchange reserves without giving rise to violent fluctuations in the foreign exchange market. Therefore, the cocktail theory also focuses on the invisibility of adjustments. The adjustment of foreign exchange reserves should be done in a subtle way.

Currently, China's foreign exchange management system, centered on the State Administration of Foreign Exchange (SAFE), can hardly accomplish this. To achieve this goal, we can decentralize the management rights of State foreign exchange reserves and entrust financial institutions, especially overseas ones, to operate them.

Experience has shown that the cocktail-style method can stave off and prevent violent fluctuations in the international forex market.

The author is a senior economist at the Agricultural Bank of China.

(China Daily 03/10/2010 page9)