Too many dollars: Cost of forex excess

China's bulging foreign exchange reserves are linked to the fact that the renminbi is not yet internationalized

China faces challenges because of its expanding foreign reserves, Huang Guobo, chief economist of the State Administration of Foreign Exchange, said during a recent interview with netizens, although he emphasized that foreign reserves had helped fend off the impact of the global financial crisis, maintain economic growth, increase employment and raise people's incomes.

The rapid increase in China's foreign reserves - $3.95 trillion by the end of the first quarter - has added to the woes of macroeconomic regulation, increased the pressure of inflation, restrained the use of the monetary policy and created a bigger exchange rate risk, Huang said.

During the initial period of reform and opening-up, China's meager foreign reserves did constrain its efforts to introduce advanced foreign technologies and equipment to boost what was then its backward economy. But over the past decade, China's foreign reserves have increased at an almost unprecedented rate because of the development of an increasingly mature market economy and booming foreign trade. In fact, China's foreign reserves are expected to exceed $4 trillion, or one-third of the world's total, by the end of the first half of this year. The figure is twice as much as that held by Japan, the world's second-largest foreign reserves holder.

China's ever-expanding foreign reserves have indeed increased the pressure on its economy. To ease this pressure, the central bank has had to increase base currency issuance for hedging, which is one of the biggest reasons for the sharp increase in China's M2 money supply in the past few years and its correspondingly intractable inflation pressure.

Given the "double increase" - in foreign reserves and monetary issuance - the central bank has intensified its efforts to tighten its monetary policy. This is a major reason why monetary authorities have chosen to lower the deposit reserve ratio only for some commercial banks, as opposed to all banks, amid rising calls for such a move in times of economic slowdown.

China's massive dollar-denominated foreign reserves, to a large extent, can be attributed to the settlement of a large part of its foreign trade in the US currency. This foreign reserve structure has resulted in tangible losses for China at a time when the United States remains intent on using a quantitative easing policy and the dollar's devaluation to mitigate its fiscal and debt pressures.

China needs foreign reserves up to a certain level to have enough funds at its disposal to conduct international transactions and deal with potential risks. But its excessive foreign reserves are like an unendurable burden, which can affect its normal economic operations. Thankfully, China has realized the challenges that its massive foreign reserves pose and has taken some measures to lessen the risks. The measures include the establishment of a special outward investment company to maintain and increase the value of its reserve assets. Nevertheless, some overseas investments made by China Investment Corporation have failed to yield the expected results, and even incurred heavy losses, because of miscalculations.

China's foreign reserves have ballooned because the renminbi is still not used as an international currency. Once the renminbi is recognized as an international currency, China will not have to hold huge foreign reserves to facilitate its foreign trade. This highlights the need for China to accelerate the process of the renminbi's internationalization in order to reduce its burgeoning demand for foreign exchange to conduct foreign trade and thus ease the foreign reserve pressure.

Following the global financial crisis, China realized the negative effects of its massive foreign reserves and has taken some rudimentary steps to internationalize the renminbi. The reform of the renminbi's exchange rate regime, bilateral currency swap deals and experimental renminbi-denominated trade settlements with some countries, as well as the adoption of RQFII (renminbi qualified foreign institutional investors) have considerably increased the renminbi's influence in the international market. Thanks to China's rising economic and strategic strength and its growing status in the international community, an increasing number of countries have come to accept the renminbi as a medium of exchange, facilitating its internationalization.

The internationalization of the renminbi, however, is a long process in which grappling with the dollar, euro and the yen is unavoidable. And since the renminbi cannot be internationalized in the near future, China has to continue to depend on the dollar and other foreign currencies for its foreign trade. This means the pressure created by its growing foreign reserves on the economy will not ease in the foreseeable future.

Therefore, aside from taking strong measures for the renminbi's internationalization, China should also try to find ways to ease the foreign reserve pressure in the short run. For example, it should consider using its foreign reserves to import some resources and consumer commodities, a move that could also help reduce trade frictions with other countries because of China's rising trade surplus.

The author is a Shanghai-based economics commentator. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 06/27/2014 page12)