Pressures of forex excess

China's enormous foreign exchange reserves are directly related to the fact that the yuan is not yet used as an international currency

China faces challenges because of its expanding foreign reserves, Huang Guobo, chief economist of the State Administration of Foreign Exchange, said during an interview with netizens on Thursday, although he emphasized that foreign reserves had helped fend off the impact of the global financial crisis, maintain economic growth, increase employment and raise people's incomes.

The rapid increase in China's foreign reserves - $3.95 trillion by the end of the first quarter - has added to the woes of macroeconomic regulation, increased the pressure of inflation, restrained the use of the monetary policy and created a bigger exchange rate risk, Huang said.

During the initial period of reform and opening-up, China's meager foreign reserves did constrain its efforts to introduce advanced foreign technologies and equipment to boost what was then its backward economy. But over the past decade, China's foreign reserves have increased at an almost unprecedented rate because of the development of an increasingly mature market economy and the booming foreign trade. In fact, China's foreign reserves are expected to exceed $4 trillion, or one-third of the world's total, by the end of the first half of this year. The figure is twice as much as that held by Japan, the world's second-largest foreign reserves holder.

China's ever-expanding foreign reserves have indeed increased the pressure on its economy. To ease this pressure, the central bank has had to increase base currency issuance for hedging, which is one of the biggest reasons for the sharp increase in China's M2 supply in the past few years and correspondingly intractable inflation pressure.

Given the "double increase" - in foreign reserves and monetary issuance - the central bank has intensified its efforts to tighten its monetary policy. This is a major reason why monetary authorities have chosen to lower the deposit reserve ratio only for some commercial banks, as opposed to all banks, amid rising calls for such a move in times of economic slowdown.

China's massive dollar-denominated foreign reserves, to a large extent, can be attributed to the settlement of a large part of its foreign trade in the US currency. This foreign reserve structure has resulted in tangible losses for China at a time when the US remains intent on using a quantitative easing policy and the dollar's devaluation to mitigate its fiscal and debt pressures.