By Xia Bin & Chen Daofu

Research Report No 108, 2006

I. The Growth of Foreign Exchange Reserve Is of a Long-Term Nature but Revaluation Expectation Increases the Short-Term Pressure upon Foreign Exchange Growth

The current trade imbalance between China and the United States is one of the embodiments of the imbalance of the world economic structure. Since the end of the post-Cold War in the 1990's, industrial capital in the United States began to move to the developing countries that had vast markets and abundant and cheap labor forces. As the United States has long been plagued by the "double deficits" and as China has become one of the fastest-growing economies in the world noted for its sound investment environment and cheap labor force, trade surplus in favor of China naturally has been growing rapidly. As a result, the United States as a developed country has become a debtor country and has been borrowing from China and other poor countries to sustain its economic growth. As long as the U.S. economic growth does not slow down and as long as that country still pursues the current high rate of economic growth, this pattern is unlikely to undergo fundamental changes in the short run. Even if China drastically raises its exchange rate, what can be changed is that the trade imbalance between China and the United States is replaced by the trade imbalance between other Southeast Asian countries and the United States. Accordingly, it is safe to say that so long as China continues to maintain its sound policy environment, its trade imbalance with the United States will continue to exist for a considerable time to come. Therefore, the growth of China's foreign exchange reserve is of a long-term nature.

But it should also be noted that an analysis of the data from various sources has indicated that the sharp growth of China's foreign exchange reserve in the past two years or so has been closely related to the Renminbi revaluation expectation. Under the influence of the policy carried out for 18 years by the AmericanFederal Reserve when it was led by its former chairman Alan Greenspan, the world abounds in hot money. In addition,most international investors areoptimistic about the prospect of the Chinese economy. As a result, the amount of China's surplus of foreign exchange sales and purchases has been much larger than that of its trade surplus. Transfer revenue has risenconsiderably and erroneous and omitted items have changed from outflow into inflow, which shows a distinct change in the structure of China's foreign exchange reserve.The contribution of the capital account surplus to the increment of foreign exchange reserve has risen and that of the current account surplus has declined. We believe that about 22 percent of the newly increased foreign exchange reserve in 2005 arose from the Renminbi revaluation expectation. The influx of short-term speculative capital has also increased the pressure on exchange rate management.

II. The Negative Impacts Arising from Continuous Growth of Foreign Exchange Reserve

In essence, foreign exchange reserve is a type of liquid asset that is owned by the government and can be freely converted in the world. The fact that a country possesses a considerable amount of foreign exchange reserve is unlikely to bring direct insecure factors to its economy. In this sense, excess fears over large amount of foreign exchange reserves are unnecessary. But China's foreign exchange reserve has been continuously rising to the current level of more than 850 billion dollars, the highest in the world. This could produce negative impacts in four aspects.

First, it is unfavorable for China to maintain its independent monetary policy. Large amount of foreign exchanges can passively increase money supply after being converted into local currency. Although the central bank can adopt hedge operation to withdraw redundant money, insufficient hedging can cause domestic inflation under certain conditions. At present, the direct pressure comes from the rising prices of the real estate assets. If there is a sharp increase in hedging, it will boost the interest cost of the government and push up the interest rate of the market. The rapid inflow under revaluation expectation can offset the hedging effect. If the mandatory bank deposit rate is set at an excessively high level, it may undercut the profits of commercial banks and impede the process of the banking reform.

Second, it is unfavorable for China to improve the overall efficiency of its economic activities. A huge amount of foreign exchange reserve means that the corresponding national savings have settled in the course of economic activities and failed to participate in the operation of the national economy. On the other hand, money is urgently needed to solve many difficult historical problems left over in the course of reforms such as the issue of agriculture, rural areas and farmers, the development of small and medium-sized enterprises, the huge amount of nonperforming loans of financial institutions and the funding shortage of the social security system. To a country whose economy is enjoying rapid growth, lending money to foreign governments at relatively low interest rates is tantamount to a waste in the sense of overall economic efficiency.

Third, it puts China under the risk of U.S. dollar devaluation. Most of China's foreign exchange reserve is in the form of U.S. dollars. It is safe to say that the status of "dollar hegemony" is unlikely to change in the next two or three decades or even longer. History indicates that the empire with the "dollar hegemony" usually ignored the interests of other countries and always used dollar revaluations and devaluations alternately to solve its domestic economic problems. If China maintains a huge amount of dollar reserve for a long time, dollar devaluations could cause considerable losses to the country.

Fourth, it may bring intensive international pressure to China. Prolonged trade wars, interest rate wars and even other sanctions imposed by a few countries are detrimental to the formation of an international economic environment that is necessary for China's peaceful rise.

In the long run, therefore, maintaining a proper amount of foreign exchange reserve and improving its usage efficiency of foreign exchange reserve will help raise the growth rate of the national economy, lessen the unevenness of the economic structure, fundamentally reduce the possibility of balance of payments imbalances, and eventually enhance the stability of the country's economic operation. In the short run, a country only needs an amount of foreign exchange reserve that is enough to meet the exchange demand arising from the balance of payments imbalance. Better usage should be explored for the excess part of foreign exchange reserve.

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