"China's Rising Reserves Are a Growing Problem:
Beijing May Be Wasting the Fortune It So Quickly Amassed"
Mark O'Neill, China Study Group

If China were to distribute its foreign exchange reserves to its 88 million poorest citizens, each would receive the equivalent of 78 years of their annual income of 625 yuan.

That astonishing statistic illustrates both the success and failure of how China has within two short years built up the biggest reserves in the world, second only to Japan.

At the end of September, forex reserves excluding gold stood at US$ 514.5 billion, triple the US$ 165.6 billion at the end of 2000 and more than double the US$ 212.2 billion at the end of 2001. They are likely to reach US$ 700 billion by the end of next year.
For a country that had 490 million people living on less than US$ 1 a day in 1981 and chronically short of foreign currency throughout its modern history, this accumulation is a remarkable achievement.

But, like a pauper who moves overnight into a palace, China finds itself uncertain what to do with its sudden new wealth. Buy Middle East oilfields and South American copper mines? Revive the ailing stock market? Put it in a fund to pay pensions and health benefits, or build schools and hospitals?

In fact, it is doing little of these and behaving like governments in the rest of the world, placing the money into banks and bonds abroad. It keeps about two-thirds in US dollars, including US$ 174.4 billion in US treasury bonds, making China the second-biggest holder after Japan, with US$ 720.4 billion, and ahead of Britain, with US$ 134.6 billion.

Dollar holdings earn a meagre 2 per cent in interest every a year and help finance the budget deficit of its most important global competitor, the United States.

Is this the wisest use of its new found wealth? Many Chinese analysts think not.

Jiang Ruiping, director of the department of international economics at China Foreign Affairs University, argued that this dominance of dollars posed a serious financial risk, noting that the decline in the greenback had wiped out more than US$ 10 billion in value from the country's forex reserves since the summer. He said that China should switch more of the money into euros and yen, to avert the impact of a prolonged US dollar slump on the economy.

Mr Jiang said that the greenback would continue to fall because of Washington's failure to control its burgeoning budget deficit, declining foreign investment into the US, and the switch by Russia and Middle Eastern countries into the euro from the dollar.

In April, Guo Shuqing, director of the State Administration of Foreign Exchange, said that while the US dollar would remain the main currency for China's reserves, his agency had recently bought more European, including Italian, government bonds and was considering similar purchases in Asian markets.

China's reason for financing the US budget deficit is the same as that of Japan since the 1980s and Taiwan and South Korea since the 1990s - buying US treasuries keeps US interest rates low and supports consumer spending, which ensures that Americans can afford to keep buying exports.

China benefits greatly from the current arrangement - a weak US dollar translates into an undervalued yuan, making its exports competitive and attracting billions of dollars from foreign investors. These include US manufacturers, who constitute a powerful lobby in Washington to counter resistance to Chinese imports.

The US dollar also remains the safe choice. It is the world currency and the one in which most of China's trade is denominated.

Andrew Crockett, president of JP Morgan Chase International, said that, like most countries, China had chosen the dollar because it had the most-liquid and deepest market. He said China was likely to continue that way, but that it might soon make a revised judgment on currency diversification.

He also said that, like other countries with reserves much greater than their short-term needs, China would think more about longer-term investments, like agency paper which is triple A and high-grade corporate bonds.

"Some countries might even consider going into equities."

While political ethics might call for some of China's reserves to be spent at home, in practice the government is going to enormous lengths to quarantine the money.

Each dollar used at home must be converted into yuan, increasing money supply when the authorities are trying to slow growth.

So the central bank wants the reserves kept abroad and has taken measures to control the use of foreign exchange at home - where forex deposits reached US$ 151 billion at the end of June - to reduce their impact on the money supply.

On November 11, it raised the foreign exchange deposit reserve ratio for overseas and domestic financial institutions to 3 per cent, from January 15 next year, so that the banks will have less foreign exchange to lend. Currently, the ratio for domestic banks is 2 per cent. In addition, domestic financial institutions are required to keep their foreign exchange reserves in special accounts, enabling the central bank to monitor them more easily.

On November 16, the bank announced that from this month Chinese emigrants would be allowed to transfer their assets overseas.

But economists agree that the reserves will continue rising for at least the next 12 months, with a continued inflow of foreign investment, a trade surplus and the inflow of money betting on a revaluation of the yuan.

In the larger scheme of things, the government is happy to have such a high level of reserves.

It argues that they are a defence against currency speculation, enhance the government's ability to control the economy and are a necessary condition to promote the yuan as an international currency. It also says that they improve China's national image and encourage inward investment.

Not many challenge this view at home, but Kwan Chi-hung, a senior fellow at the Nomura Institute of Capital Markets Research, wrote in a research paper that the government's view was out of date.

"There is no clear-cut relationship between foreign exchange reserves and national power. China should pursue the betterment of the lives of its people, through institutional reforms and investing in domestic human capital and physical capital such as production facilities and infrastructure," he said.

"The government should stop lending the precious savings of its people to the US government at low interest and instead use it more efficiently to develop its economy.""