Test­ing times for China’s for­eign ex­change re­serves

China Daily (Canada) - - BUSINESS - By ZHU NING

China’s for­eign ex­change re­serves, the largest in the world, reached a record $3.82 tril­lion last year.

Since China’s re­serves started ac­cu­mu­lat­ing more than a decade ago, the in­crease has been widely re­garded as an en­cour­ag­ing and ben­e­fi­cial de­vel­op­ment. With China grad­u­ally be­com­ing the “world’s fac­tory” and post­ing an in­creas­ing trade sur­plus in the past decade, Chi­nese re­serves bal­looned. Dur­ing that pe­riod, the Chi­nese felt pos­i­tive about grow­ing re­serves. But now they are feel­ing in­creas­ingly ner­vous about the sit­u­a­tion.

With the rolling out of the three stages of quan­ti­ta­tive eas­ing, the Chi­nese re­al­ized with great dis­ap­point­ment that the real value of their re­serves had de­pre­ci­ated con­sid­er­ably due to the United States’ mon­e­tary pol­icy, which is be­yond the Chi­nese govern­ment’s con­trol.

The US govern­ment budget limit prob­lem last Oc­to­ber once again high­lighted the pos­si­bil­ity of a US de­fault, which would not only af­fect its cred­it­wor­thi­ness and the cost of US govern­ment fi­nanc­ing but also the value of China’s re­serves and the con­fi­dence of the coun­try, which is the largest in­vestor in US govern­ment se­cu­ri­ties.

Not only would China lose due to the re­duced value of its in­vest­ment in US Trea­sury notes and re­lated as­sets, but it also could be crit­i­cized for al­low­ing the US govern­ment to main­tain low in­ter­est rates and re­lease un­prece­dented amounts of liq­uid­ity into the global econ­omy.

As fi­nance text­books would preach in any in­vest­ment con­text, to di­ver­sify is prob­a­bly the most ef­fec­tive way to hedge against risks com­ing from a spe­cific coun­try or as­set. Con­se­quently, China should di­ver­sify its re­serve as­sets.

China has been try­ing to di­ver­sify those as­sets dur­ing the past few years. Ac­cord­ing to US Trea­sury sta­tis­tics, US dol­lar­de­nom­i­nated as­sets make up about 49 per­cent of Chi­nese re­serves, down from 69 per­cent about three years ago.

China’s for­eign ex­change re­serve ad­min­is­tra­tors have re­al­ized the risks as­so­ci­ated with con­cen­trated hold­ings in US dol­lar-de­nom­i­nated as­sets.

China has in­creased the pro­por­tion of Trea­sury bills in its US dol­lar-de­nom­i­nated as­sets, pri­mar­ily due to its height­ened risk of ex­po­sure in US govern­ment agency se­cu­ri­ties from the sub­prime mort­gage cri­sis.

Yet, given their rel­a­tively high cor­re­la­tion with US T-bills in the grand scheme of things, such di­ver­si­fi­ca­tion within US as­sets may not of­fer China a big enough hedge against fluc­tu­a­tions in US eco­nomic growth, the budget dilemma or a pos­si­ble de­fault.

This sit­u­a­tion is closely tied to the crux of the prob­lem sur­round­ing China’s re­serves: The coun­try in­tends to di­ver­sify its re­serves into other sov­er­eign trea­suries or as­sets, but it can find few al­ter­na­tives.

The Euro­pean sov­er­eign debt cri­sis has shaken in­vestors’ con­fi­dence in such as­sets and “Abe­nomics” has cast doubts over the sus­tain­abil­ity of Ja­pan’s govern­ment and fis­cal sit­u­a­tion.

Ig­nor­ing the eco­nomic sit­u­a­tion of these re­gions for a mo­ment, one would find the mar­kets for such se­cu­ri­ties are small com­pared with those for US T-bills and agency se­cu­ri­ties.

Given the mas­sive size of China’s re­serves, with­draw­ing from such a mar­ket would have pro­found ef­fects and would in­evitably dam­age the value of China’s re­serves.

One very im­por­tant func­tion of re­serves is to serve as “bal­last as­sets” that can be used to sta­bi­lize the value of a coun­try’s cur­rency.

As a re­sult, liq­uid­ity, im­me­di­acy and sta­bil­ity are cru­cial to re­serve in­vest­ments, and in this re­gard, US Trea­sury bills serve as a near-per­fect choice.

How­ever, many ex­perts, in­clud­ing some Chi­nese cen­tral bank of­fi­cials, be­lieve that China’s re­serves are too large and a big chunk of them could be in­vested not for sta­bil­ity but for higher re­turns. If this is true, the real ques­tion be­comes what the op­ti­mal size of China’s re­serves should be.

Al­though China has been try­ing hard to di­ver­sify into nonUS-de­nom­i­nated as­sets over the past few years, the bal­loon­ing size of its re­serves in­creases rather than de­creases China’s ex­po­sure to risk, and that seems to be the cause of Chi­nese anx­i­ety over US fis­cal prob­lems.

If this is the prob­lem, China should deepen its fi­nan­cial re­forms, let­ting mar­ket forces de­ter­mine its do­mes­tic in­ter­est rates and in­ter­na­tional ex­change rate. Once China stops its pas­sive “ster­il­iza­tion” of the in­flows of dol­lars into its re­serves, China’s re­serve in­vest­ment chal­lenges — along with many other chal­lenges, such as do­mes­tic in­fla­tion and high hous­ing prices — may be re­solved once and for all. The au­thor is deputy di­rec­tor of the Shang­hai Ad­vanced In­sti­tute of Fi­nance, Shang­hai Jiao­tong Univer­sity.

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