Foreign exchange reserves and overseas investments have played an important role in China’s economic growth miracle. The Chinese reserves are already the world’s largest. At the end of March 2011, foreign exchange reserves soared by 24.4 per cent to become US$ 3.04 trillion. The following table shows the growth of foreign exchange reserves in the country, since 1992 when the country undertook additional reforms:
Table 1: China’s Foreign Exchange Reserves
Source: State Administration of Foreign Exchange, Beijing Review, The Hindu Businessline
However, excess reserves lead to excess liquidity. Zhao Xiaochun, Governor of the People’s Bank of China (PBOC) said, “Foreign exchange reserves have exceeded the country’s rational demand and too much accumulation has caused excessive liquidity in markets, adding to the pressures of the central bank’s sterlisation”. Xia Bin, an advisor to the Central Bank’s monetary policy committee, said that the reserves of US$ 1 trillion were adequate and the balance should be diversified into investments. The country’s external liabilities rose 20 per cent year-on-year to US$ 2.34 trillion, while net external financial assets increased 19 per cent to US$ 1.79 trillion in 2010.
According to analysts, as the value of the Yuan rises, a reduction in trade surplus — an important component of foreign exchange reserves and lower inflows of speculative capital from overseas, would help ease the problems caused by excess liquidity ranging from inflation to asset bubbles. The Chinese economy grew by 9.7 per cent in March 2011, while the Consumer Price Index (CPI), an important gauge of inflation, jumped 5.4 per cent in March 2011. This has been the sharpest increase in three years. The full year CPI for 2011 has been targeted at four per cent. But, as warned by the Chinese Academy of Social Sciences (CASS), if additional steps are not taken, the CPI would exceed the set target.
Keeping the prevailing levels of inflation in mind, it is essential that a closer look is taken at the issue of skyrocketing foreign exchange reserves in the country. The PBOC has raised interest rates four times since October 2010 to cool down the searing price index. Nevertheless, foreign exchange reserves continue to add to liquidity in the market. The M2, a broad measure of money supply which includes all types of cash and deposits, rose 19.7 per cent from a year earlier, in June 2011.
Li Yining, member of the National Committee of the Chinese People’s Political Consultative Conference, had stated in March this year that there is a need to adjust the portfolio of China’s foreign exchange in line with changing conditions. He also stressed the need to moderately increase the size of gold in its foreign exchange reserves. He added that China’s foreign reserves are largely held by the government, and it would be safe to let residents hold more to diversify risks”.
Diversified assets are urgently required because most of China’s foreign exchange reserves are in U.S. dollars. The exact figures are not made public, but estimates are that almost 70 per cent of China’s reserves are in US dollars, 10 per cent in Yen and 20 per cent in British pounds. Despite the large holdings of US treasury bonds, substantial reductions in these holdings can lead to turbulences in the global financial market .
A transfer of US dollar assets into assets denominated with other currencies will be conducive to increasing the safety and profitability of China’s reserve assets. An economic restructuring is required since the high level of foreign exchange reserves are rooted in the economic and trade structure of the country. To avoid reserve asset losses, China needs to undertake an urgent restructuring.
(The author is a Junior Fellow at Observer Research Foundation, New Delhi)