A Look at China's Foreign Exchange Reserves

By Lu Gonglu

In the nearly four decades since China launched its reform and opening program, it has relied on export-driven economic development. Over this period, as part of the growing levels of economic exchanges, funds have flowed on a daily basis between China, its neighboring countries and the world's major economies. As a result of the inflows of funds from abroad,China's central bank accepts and manages foreign exchange on behalf of the state. It uses these foreign exchange funds to meet the nation's total overseas obligations. At the same time, it uses some of these funds to intervene in the foreign exchange market to reduce volatility in the renminbi exchange rate and ensure that the national currency remains stable and provides a favorable environment for China's economic development.In short, from the national perspective, the main purpose of foreign exchange reserves is to meet daily needs and ensure there are sufficient funds to cover any unanticipated events. These funds should not be viewed as a cash cow that produces high returns. To do so would be like investing all of a family's wealth in the stock market in search of big profits while ignoring considerable levels of risk.

Creating Foreign Exchange Reserves

As we examine foreign exchange reserves we need to look at the demand side of the economy as measured by the gross domestic product. Some of the nation's economic output is used to meet consumer demand as well as investment needs(including from the private and public sectors),while the rest is exported abroad.

If we drill down and look at individual enterprises that export goods or services, we see that these exports are exchanged for US dollars or another foreign currency. The net exports of all these individual micro-level manufacturers are aggregated to form national macro-level exports.The US dollar income earned from all these exports will be reflected in the national balance of payments and recorded under the current account.

In addition, external funds are being brought in as foreign direct investment or securities investments under the Qualified Foreign Institutional Investors program. From a macro perspective, the sum of these funds is reflected in the national balance of payments and recorded under the capital account. As long as there are net inflows of foreign currency in these areas, the accounts will show surpluses under the foreign exchange reserve column of the nation's balance sheet.

Foreign currency funds entering the country generally are converted into renminbi for domestic use. Taking exports of domestic enterprises under the current account as an example, these funds need to be settled in renminbi in order to pay for the raw materials used in production, pay wages to workers and cover other local costs. Therefore,exporters convert foreign exchange income into renminbi, which later enters the bank accounts of these enterprises.

The exchange of foreign currency for renminbi is completed in the foreign exchange market through commercial banks. In this market, the banks act as intermediaries. As a result of these transactions,foreign currencies are concentrated in the hands of the central bank by way of the commercial banks.As we noted earlier, the renminbi funds flow into the bank accounts of the exporters. In some sense it can be said that the central bank is the ultimate market maker and ultimate liquidity provider for the market.

Foreign currencies are bought and sold on the interbank foreign exchange market where there are many market makers. As with other markets,if there are more buyers than sellers of a specific foreign currency -- such as the dollar -- the value of that currency will go up against the renminbi.Conversely, the value or price will decline if there are more sellers of the currency than buyers. As the central bank is the ultimate liquidity provider for this market, it will sell dollars to relieve upward market pressure from dollar buyers to prevent the US unit from rising beyond the permitted trading range. Conversely, the central bank will intervene to buy dollars and sell renminbi to prevent the US currency from falling below its designated range.

Regardless of the currency transaction process,current account surpluses and capital account surpluses eventually end up on the central bank's books, and these form the central bank's foreign exchange reserves. At the same time, renminbi of equal value move off the central bank's books. Without a mechanism to offset this, there will be an increase in the central bank's reserves as well as an increase in renminbi on the market if there are continued surpluses under the current and capital account.

The PBOC's Balance Sheet

Before discussing what can be done with the nation's foreign exchange reserves, let's look at the central bank's balance sheet. With reference to Western economic research, a nation's economic activity is comprised of various actors, such as consumers, producers, governments and the central bank. One of the functions of the central bank is to issue money and thereby provide the tools for other parties to complete their transactions. Here,the central bank can be understood as a maker or manufacturer of currency. This manufacturer has its own distinctive features, however, as the purpose of producing money is designed to act on behalf of the state in providing the economy with the trading instruments and national credit necessary for transactions. It is not specifically a profit-making role. However, as a manufacturer,the central bank, like other manufacturers, should have its own balance sheet that objectively records its own external liabilities and total assets.

First, let's examine the central bank's liabilities.The cash issued to the market by the central bank,along with the reserve deposits of commercial banks, constitute the monetary base, or sometimes known as reserve money. In addition to issuing bills, China's central bank issues central bank bills in the interbank bond market in order to soak up liquidity. The monetary base and the various central bank bills issued by the central bank, together with government deposits and the central bank's own funds, constitute the central bank's total liabilities.The total amount and structure of the reserve money on the liability side can be adjusted by issuing or withdrawing central bank bills and other open market operations such as changing the reserve requirement on bank deposits.

The change in the total amount of money in circulation (for example, M2 money supply) in economic operations starts from the reserve money of the central bank's liabilities, which is developed further through the commercial bank's continuous deposit-loan monetary multiplier mechanism.Therefore, the increase or decrease of the central bank's monetary base directly determines the increase or decrease of the total amount of money in the economy.

Turning to the central bank's assets, when the central bank injects funds it must complete equal exchanges with commercial banks, government departments and the like. And it is not a free gift. This is done at a price. The central bank puts the monetary base in these commercial banks in exchange for government bonds and the like which are placed on the central bank's books, forming an important part of the asset side. This is domestic credit. Another part of the central bank's assets are the foreign exchange reserves. The central bank takes the US dollars exchanged from renminbi taken on the liability side for assets listed on its books.

Regulating and stabilizing interest rates and regulating and stabilizing the exchange rate are the internal and external functions of the central bank.Interest rate adjustments can be accomplished by expanding or compressing the monetary base on the liability end, thereby affecting the total supply of money. The adjustment of the exchange rate is accomplished by expanding or reducing the foreign exchange reserves on the asset side. In conclusion, both the central bank's monetary and exchange rate policies ultimately will be achieved in the asset-liability management. Understanding this critical to understanding the role and formation mechanism of foreign exchange reserves. This helps eliminate some misunderstandings regarding the foreign exchange reserves.

Foreign Exchange Reserves and Money Supply

The central bank's asset-liability management is the source of changes in the total amount of money in the economy, such as the M2 money supply. That is, changes on both the asset side and the liability side may cause changes in the total amount of money in the economy. This means that the change in the balance sheet of the central bank causes a change in M2. Therefore, analyzing the time sequencing between the two is an impactresponse process.

For instance, a one dollar increase on the asset side under the foreign exchange reserves means a corresponding amount of seven yuan as the input of base currency (assuming one US dollar equals seven yuan) on the liability side. Taking into account the multiplier effect (assuming a multiplier of 2, reflecting the repeated deposits and loans in the commercial banking system), there will be an increase of more than 14 yuan in the economy as seen in M2. Therefore, the process of increasing foreign exchange reserves is a process of multiplying the renminbi in the economy.

However, the situation in reality is far more complicated because the central bank will undertake offsetting operations. For example, it is known that an increase of one US dollar in foreign exchange reserves corresponds to a monetary base of seven yuan on the liability side. At the same time, the central bank reverses the operation and sells seven yuan of government bonds in the open market in order to recover the equivalent seven yuan. In other words, the liability side of the central bank corresponds to two operations; one is to put seven yuan as base currency into the market while the other is to recover seven yuan. Ideally,on the balance sheet of the central bank, the two deals were offset exactly, which is called complete offsetting. In addition to the above simple offsetting operations, the central bank can resort to other types of activities, including adjusting the bank reserve deposit ratio, issuing or withdrawing central bank bills in the capital market, adopting reverse repurchases in the money market and the like. In actual operation, a variety of tools are used interchangeably in order to form a comprehensive package to rationally control the pace of issuing base currency.

In theory, with the continuous increases of foreign exchange reserves, the renminbi injections by the central bank will continue to increase.Hence there are two results. First, the central bank's balance sheet will be constantly expanding;second, the central bank's renminbi investment in the market continues to increase, which is then to expand the overall supply of money through the commercial banks' multiplier effect. As a result, more and more money accumulates in the economy.

In practice, however, the central bank needs to offset this. That is, the increase in foreign exchange reserves will lead to the recovery of the renminbi by other means. Therefore, the increase of foreign exchange reserves does not necessarily result in an increase in the base currency after a period of time. However, it depends on the extent to which the central bank implements its offsetting efforts.To take a step back, even if the central bank does not offset in a timely manner, it can later adjust the deposit reserve ratio to adjust the monetary base, so as to reduce M2 by reducing the money multiplier. Therefore, the increase of M2 resulting from foreign exchange earnings is only a potential one and not a certainty. The actual increase in M2 is in fact the result of a combination of many factors.

Role of Foreign Exchange Reserves

As we noted earlier, although foreign exchange reserves are an important part of the central bank's assets, their main purpose is not to create profits so achieving high returns is not the ultimate objective.The reason for maintaining a certain amount of foreign exchange reserves is to protect the normal settlements and sales of foreign currency and in renminbi under the current and capital accounts.Creditors believe that a country's foreign exchange reserves can stabilize bouts of panic caused by rapid outflows of hot money so as to maintain the relative stability of the local currency over a period of time. Finally, foreign exchange reserves can serve as a form of ballast. Such was the case in the crash in the securities market in China in 2015.Back then, if the central bank hadn't intervened in a timely manner, the consequences could have been disastrous. Phoenix Tree Funds, set up by State Administration of Foreign Exchange, for example, plays an important role in stabilizing market sentiment. It is believed that the future of foreign exchange reserves can provide powerful tools in dealing with local liability risks and possible systemic risk to the banking system. Therefore, for a huge economy such as China, foreign exchange reserves can perform their external functions and help authorities concentrate on major issues and avert systemic risks to the economy and financial system.

In addition to the above functions, foreign exchange reserves can help implement the national foreign exchange policy from a macro perspective,and this in turn can assist national monetary policy at home.

First, we need to examine the strategic role of coordinating the country's export development.One of the basic success stories of the reform and opening up program has been the development of an export-oriented economy. Foreign exchange earnings can add to the foreign exchange reserves and attract skilled talent from developed countries and regions in the world. Initially, China had two advantages -- cheap labor and a competitive price advantage of its exported goods. However,increasing labor costs have chipped away at that price advantage and neighboring countries now are competing effectively with China.

On the macroeconomic level, it will take some time to cultivate domestic consumption.However, excessive reliance on investment to stimulate the economy could easily create asset bubbles. Therefore, in order to promote economic development, a more effective export strategy is needed. In order to ensure a steady growth of exports, in addition to more innovation and industrial upgrading, exchange rate management is needed. A key part of this management is the allowance of a reasonable trading range for the renminbi. And in order to keep the exchange rate within this reasonable trading range, the importance of sufficient foreign exchange reserves is self-evident. The central bank needs to be able to concentrate its foreign exchange muscle, so as to formulate a reasonable national foreign exchange policy and effectively manage the exchange rate trading range.

Second, we need to look at the ability of foreign exchange to complement monetary policy. Foreign exchange reserves can help adjust exchange rate expectations and in turn manage inflation expectations. That can ease pressure on national monetary policy. For instance, in the 1980s,inflation was rampant in much of Latin America.Policymakers were unable to hold back inflation expectations. Later, under the guidance of a number of economists, a monetary stability policy was introduced with fixed foreign exchange rates.Foreign exchange reserves were used to stabilize the national currency to reduce expectations of a devaluation of the home currency against foreign currencies. Over time, inflation expectations dropped significantly. The beneficial effect of having sufficient foreign exchange reserves was obvious.

A Reasonable Scale of Foreign Exchange Reserve

So what is an appropriate amount of foreign exchange reserves for the central bank? It is hard to say. It is like asking how much of a family's income should be kept as a cash reserve. The answer is -it depends. The International Monetary Fund has studied the foreign exchange reserves of many countries in the world and concluded that there are six factors that have a significant impact on foreign exchange holdings, namely the implemented exchange rate system (fixed or floating rate systems), the effectiveness of capital controls,export volume, the amount of short-term debt, M2,and other offshore liabilities.

According to some academic research, the US$3 trillion in reserves is more than enough. Other scholars contend that if capital controls are not sufficiently tight, the current foreign exchange holdings are not enough. It should not worry too much about the calculation data obtained by scholars; after all, there is a gap between research and actual practice. However, academic research provides good perspectives on the following issues. First, foreign exchange holdings and capital regulation are two complementary variables in foreign exchange management. If controls are relaxed, then foreign exchange holdings need to increase. The size of the M2 money supply has much to do with the foreign exchange holdings.With China's currently huge M2, a worst-case scenario would be a massive public movement to convert renminbi to US dollars. Therefore,whether US$3 trillion is sufficient depends on one's perspective.

Foreign Exchange Reserves Asset Management

The role of foreign exchange reserves as ballast has been emphasized, and this is classified as corporate risk reserves. At the same time, it is undeniable that foreign exchange reserves represent the accumulation of national wealth.Proper asset management must be carried out under the premise of meeting the requirements of preventing internal and external risks, enabling daily exchange transactions and stabilizing market sentiment, in order to keep the nation's economy and financial system on a healthy course. In recent years, with the increase in foreign exchange reserves, there has been more public concern over how to protect and increase the value of those assets. Policymakers and researchers have responded to the general public on such relative concerns. How to preserve and increase the value of foreign exchange reserves is politically,technically and professionally related. Therefore,professionals will be the appropriate persons to study and answer such question. The author hereby puts forward two suggestions for consideration:

First, it is necessary to properly handle the centralized management of foreign exchange and the management of foreign exchange in public hands. The central bank should rationally formulate its foreign exchange policy, dynamically managing and adjusting the size of its foreign exchange reserves based on the needs of its macroeconomic development in serving the national economy and political objectives (the Belt and Road Initiative and the internationalization of the renminbi for example). After much study of the subject, it has been suggested that foreign reserves in excess of reasonable levels should be allowed to be held by the public at large through professional managers.That will mean a dual track system of foreign exchange reserve management - part managed by the state and part by the private sector. A large part will be placed in the central bank for implementing national foreign exchange policy and maintaining national financial stability. This is the role of ballast.The other part is keeping foreign exchange in the public will be autonomously managed by market players in a market-oriented manner, in order to maximize foreign exchange earnings.

Second, research on foreign exchange reserves within the central bank should be carried out,implementing a hierarchical, scientific and dynamic management. It is necessary to properly handle the relationship between risk and return, the relationship between liquidity and profitability, the relationship between short-term needs and longterm strategic reserves, as well as the relationship between the external management of the exchange rate and the control of internal risks.