1. science
2. mathematics
3. statistics

Author: Ke Liu
Advisor: Erik Strøjer Madsen
How to Manage China’s Foreign
Exchange Reserves?
Aarhus School of Business
MSc in Finance and International Business
November 2007
Abstract
Financial crisis is not a new term to the world and has been through the financial
globalization in the past decades. Many developing countries choose to stockpile a
large amount of foreign exchange reserves to protect their economy from external
shocks. However, given the declining value of the US dollar, the rapid built-up of
reserves also creates a new debate on what amount and which form to hold for
emerging economies. This paper attempts to address the two questions for China, the
largest reserve holder since 2006. By performing an empirical analysis of 42
developing countries, a series of conclusions are drawn, including a major
confirmation that China’s holding of reserves exceeds the estimated adequate level.
With a combination of telling evidence and theoretical interpretation, this paper
provides a package of solutions to the issue of how to manage China’s foreign
exchange reserves in the long-term and short-term scenarios. To fundamentally
slowdown the growth rate of reserves and reduce the aggregate amount, a shift in
economic policies is desired. Meanwhile, taking into account the opportunity cost of
holding, a course of proactive reserve management would be advisable.
JEL codes:
E58, F31, F33
Keywords:
foreign exchange, reserves, China, reserve management
Scholium
“It is one thing to save for a rainy day, but one trillion dollars in reserve
accumulation is more like building Noah’s Ark.”
By Ken Rogoff, former chief economist at IMF
Contents
Part I
Introduction ............................................................................................................. 1
Part II
Literature Review .................................................................................................. 5
2.1
Ratio Analysis ................................................................................................................ 5
2.2
Regression Analysis ...................................................................................................... 8
Part III
Quantitative Analysis ......................................................................................... 11
3.1
Formulation of Model ................................................................................................. 11

Scatter Plots ................................................................................................................... 12

Cross-Section Analysis .................................................................................................. 15

Pooled Analysis for Each Variable .............................................................................. 16

Curvilinear Trend Test ................................................................................................. 17

Structural Change Test ................................................................................................. 19
3.2
Model Correction ........................................................................................................ 24
3.3
Final Conclusion From the Quantitative Analysis ...................................................... 25
Part IV
Analysis of Economic and Policy Dynamics ..................................................... 27
4.1
Balance of Payments Analysis .................................................................................... 27
4.2
Foreign Exchange Policy Analysis ............................................................................... 33
4.3
Capital Control ............................................................................................................ 36
4.4
Shift in policy............................................................................................................... 40

Negative Influence of Foreign Reserve Surplus .......................................................... 42

Influence of Reserve Growth on Money Supply ......................................................... 43

Influence of Reserve Growth on National Economy .................................................. 45

Solutions ......................................................................................................................... 45
Management of Reserves ..................................................................................... 49
Part V
5.1
Diversification: From a Dollar Dominated Reserve to a Diversified One.................. 49
5.2
Trend in Composition of Instruments ........................................................................ 52
5.3
Different Foreign Reserve Management Frameworks .............................................. 56
5.4
Which way should China follow? ............................................................................... 58
Part VI
Concluding Comments ....................................................................................... 60
Reference ................................................................................................................................ 63
Appendix A: Stylized Facts about China ............................................................................ 67
Appendix B: Selected Data ................................................................................................... 70
Appendix C: Curvilinear trend test ..................................................................................... 71
Appendix D: Structure Test with Quadratic Variables ..................................................... 72
Appendix E: Regression Output .......................................................................................... 73
Part I
F
Introduction
oreign exchange reserves, also refer to international reserves, are
indispensable financial resources of an economic entity. To every open
economic region, the amount of reserves held by monetary authority varies
dramatically based on an array of vested policies and objectives. The International
Monetary Fund (IMF) identified an economy’s international reserves as “those
external assets that are readily available to and controlled by monetary authorities for
direct financing of payments imbalances through intervention in exchange markets to
affect the currency exchange, and/or for other purposes.1” The commonly used form
consists of convertible foreign exchange held by monetary authorities in the form of
currency, deposits, securities or financial derivatives, monetary gold, special drawing
rights (SDRs), and unconditional drawing rights with the IMF.
Individual countries, especially those who have a large volume of international trade,
experience a high risk of random shocks to their external balances, resulting from
temporary or continuous sudden drops of their foreign exchange earnings. Therefore,
international reserves serve to absorb such undesired crises through financing the
payment deficits, which in turn avoid the costs of macroeconomic adjustment2. In
addition, foreign exchange reserves can be used to serve external debt or act as the
collateral for international borrowing. For those economic entities who undertake a
fixed exchange rate policy, international reserves also play an important role in
backing up their currencies and enhancing the countries’ credibility.
As the international trade flow increases and global financial integration evolves, the
demand for international reserves has grown as well. In 1990, the world aggregate
holding of reserves amounts to $919 billion and China’s share merely equals 3.3
percent at that time. Sixteen years later, however, the world’s total holding grows up
to $5,038 billion, more than one fifth of which is contributed by China.
1
2
See the latest Balance of Payments Manual (1993) published by IMF.
See Clark 1970.
1
1200
Billion $
1000
25
Percent
20
800
15
600
10
400
5
0
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
200
Total foreign exchange reserves of China (left axis)
China's holding as of world aggregate (right axis)
Figure 1: China’s recent built-up of reserves
During the past decade, China has accumulated a huge lump sum of foreign exchange
reserves due to its prominent economic development. In late February 2006, China
surpassed Japan to become the world’s largest holder of foreign exchange reserves,
and at the end of March 2007, this number reaches 1.2 trillion U.S. dollars. The
reserve to GDP ratio is approximately 40 percent at the end of 2006, while the world
average level was around 10 percent. One view is that reserves have been
accumulated as insurance against the risk of balance of payments crises, which came
to be perceived as higher after the 1997-98 Southeast Asian crisis.
Although the strongly export-oriented economic development accounts for part of the
upward trend, FDI inflows have been assumed to be responsible for a big portion of
the reserves. Despite of capital controls, evidence also indicates that speculative
capital flows into this country through various channels, betting on the appreciation of
RMB.
As a large transitional economy, China is in a stage of rapid economic development
and restructuring. Large foreign exchange reserves help to maintain the credibility of
both the country and its currency, to expand international trade, to attract overseas
investment, to lower the cost of financing its institutions in their efforts to enter the
international market, to enhance overseas financing capacity and to uphold steady
growth as the country develops.
2
However, some economists argue that the recent heavy foreign exchange
accumulation, including rapidly increased speculative capital flows, has augmented
risks to the country’s financial system, exacerbated inflationary pressure, created huge
opportunity costs that resulted in large wealth losses with the weakening dollar,
intensified pressure for the RMB appreciation and finally increased the complexity of
macroeconomic adjustment and foreign exchange reserve management.
The recent large increase in international reserves has generated a debate on the
optimal level of reserves for emerging countries. However, quantitative literature on
reserves has lagged somewhat behind the policy questions raised by the international
financial crisis of the 1990s. The heyday of the reserve adequacy study dates back to
the 1960s and the 1970s with a major pitfall of difficulties in quantifying determinants.
Policy makers have often used rules of thumb, such as maintaining reserves
equivalent to quarterly imports or the “Greenspan-Guidotti rule” of full coverage of
total short-term external debt. But this is not the case for Far East countries with more
financial assets and liabilities under financial globalization.
Dooley and others (2004) assert that reserves buildup in Asia is the unintended
consequence of policies that maintain large current account surpluses. Li (2006)
refutes that China’s foreign exchange reserves are not excessive because it needs
sufficient reserves to maintain the stability of its currency and to maintain the
confidence of international investors. He also argues that China’s foreign exchange
reserves have been rewarded by sufficient returns. Frankel (2004) emphasizes the
opportunity cost of huge foreign exchange reserves and concludes that China has been
presumably paying foreign investors on their inward investment a higher return than
the earning made from its foreign exchange reserves. Xia (2006) estimates that $700
billion in foreign exchange reserves should be sufficient.
Therefore, the issue about what is the optimal size, or in other term, the adequate level
of China’s foreign exchange reserves needs to be addressed. Currently, most relevant
research either focuses on general discussions of determinants of the demand for
foreign exchange reserves or empirically analyzes countries’ holding compositions.
However, little work pays attention to a thorough analysis of foreign exchange
reserves management with a Chinese feature. Furthermore, as the US dollar is
expected to depreciate in the long-run due to its large current account deficit, both
3
evidence and theories suggest a diversification of foreign exchange reserves away
from a single US dollar structure. Hence, how to allocate China’s foreign assets is the
second question to be answered.
This paper examines the claim that the foreign exchange reserves of China are not
only sufficient but also exceed its demand for liquidity and other major economic
considerations. With this confirmation, the latter phase centers on how to adjust the
current level to the adequate level estimated.
The layout of the paper is organized in a logically flashback manner. Section 2 digs
into previous relevant research in order to summarize and compare the pros and cons
of each measure of the optimality of foreign exchange reserves. Section 3 empirically
tests the hypothesis that China is holding an excessive level of reserves. Given the
affirmative conclusion drawn afterward, section 4 provides the whole picture of
China’s balance of payments structure, economic and political environment, and the
funding of its foreign reserves. Based on this analysis, a shift in a series of
corresponding policies is suggested with a long-run perspective. Section 5 shows the
trend of style changes in foreign reserves management and generates several channels
of allocating the excessive amount in the short-run scenario. And also, suggestion for
future research on this topic is given at the end of the thesis.
4
Part II
Literature Review
Most quantitative literature on international reserve holdings is based on theories
developed in the 1960s, when the world adhered to the Bretton Woods System and the
global capital flows were relatively small. The framework of analysis on reserve
adequacy and optimality could be classified by the methodologies used into two
categorizes: ratios as tools of analysis and regression analysis. The following gives a
chronological retrospect of previous study.
2.1 Ratio Analysis
 Reserve to import ratio
The most widely used ratio method was the ratio of reserve to import first generalized
by Triffin (1947, 1960). It is argued that the demand for reserves should move in line
with the trend in international trade since receipts and payments were observed to be
volatile. He concludes that major countries should maintain a constant reserve to
import ratio ranging from 20 percent as a minimum to 40 percent maximally.
However, this method was born with almost equal number of critics and advocators.
Machlup (1966) discredits the theoretical basis for the assumed rigid reserve-import
ratio as it lacks of evidence and theory on why such ratio should remain constant
across countries or through time. As his defense, three other ratios, including reserve
to largest annual reserve losses, reserve to domestic money and quasi money, reserve
to liabilities of central banks, were used to explain the behaviors of 14 industrial
countries from 1949 to 1965. He stated that “on purely economic grounds, reserves
are held only for the purpose of being eventually used.” However, this ex parte
assumption also neglects a precautionary nature of reserves, especially under fixed
exchange rate regime. Similarly, Olivera (1969) theoretically argues that
precautionary demand for reserves should reflect variance of changes in annual
imports, implying that a constant reserve-import ratio leads to a significant
overestimation of present and future demands.
5
The IMF started to measure the adequacy of reserves in the 1950s by the ratio of
reserve to import. European Central Bank (2006) regards four months’ import
coverage as the “rule of thumb”. Since the major function of foreign exchange
reserves is protecting a country from the uncertainty of international trade, the ratio of
reserve to import has almost been included in all analysis on this subject.
 Reserve to domestic money supply
Because enough stockpiles of international reserves would substantially improve the
credibility of a country’s currency, the ratio of reserve to domestic money indicates
the potential of capital flight from domestic currency. Machlup (1966) was the first
one who managed to use this ratio, although he finally obtained a contradictory
conclusion that the demand for reserves is independent of any identifiable variable.
The procedure of the functioning of reserve holding is nevertheless sound while ratios
act unstable through time. This evidence is proved by Frenkel (1971), who performed
a regression equation on 55 countries, and the coefficient of domestic money supply
was statistically significant, especially for less developed countries.
Furthermore, Frenkel and Johnson (1976) expatiate that international reserves will
increase if the demand for money exceed supply and vice versa. In that sense,
international reserves are a residual. Based on this view, Frenkel (1978) suggests
combine the demand for international reserves theory and the monetary approach to
the balance of payments, followed by an attempted analysis by Lau (1980).
Interestingly, Edwards (1984) empirically explores the relationship between reserve
flows and domestic credit creation by using 23 fixed exchange rate developing
countries and concludes that domestic credit cannot be considered completely
exogenous but partial evidence.
 Reserve to short-term debt ratio
Brown (1964) gives an analysis of the reserve to net external balance ratio on the
ground that reserves function as a cushion against future balance of payments deficits.
It is assumed that this ratio reflects an economy’s financial ability to serve its existing
6
short-term external debts3, especially in times of a sudden stop in short-term external
debt flows. Greenspan and Guidotti4 (1990) suggest that developing countries, with
limited access to international capital market, should at least cover all their short-term
debts.
 Opportunity Cost of Capital
The opportunity cost of holding international reserves plays a central role in models
of optimal demand for foreign exchange reserves. Heller (1966) first introduces a
cost-benefit perspective to solve the issue of adequacy of international reserves by
means of econometric analysis. The theoretical definition of cost refers to the
opportunity cost of holding reserves and the benefit derives from the avoidance of
macro-adjustments for external deficits.
The opportunity cost of holdings, practically proxied by government bond yield5, the
domestic discount rate6, or the yield on domestic securities7, reduces a country’s
national income which can be used for domestic consumption and investment.
Therefore, it is expected to be negatively related to reserve demand. However, these
farfetched proxies have failed to indicate a significant cost effect since none of them
is accurately consistent with the theoretical definition. In addition, because foreign
exchange reserves are to be invested abroad, domestic discount rate or yield on
domestic securities are unsatisfactory in explaining the cost-benefit criteria. Nominal
rate of return does not represent the real return because inflation varies dramatically,
especially in developing countries.
Macroeconomic adjustments, such as contractionary fiscal/monetary policy and
exchange rate depreciation, result in costs in terms of aggregate income and welfare
loss. Therefore, reserves serve as an alternative to absorb the balance of payments
shocks facing the authorities. The reserve-yielded returns, though comparatively small
due to policies and restrictions, are more often than not ignored in empirical studies.
Heller’s model can be used to analyze the effects of adjustment to an external
3
4
5
6
7
Referring to foreign debts with a maturity of less than one year
The Greenspan-Guidotti rule was justified by Jeane and Ranciere, 2006
Courchene and Youssef, 1967
Iyoha, 1976
Frenkel and Jovanovic, 1981
7
disequilibrium in a precise way. However, the model is far from perfect once it deals
with the realistic world. First of all, evidence shows that the difference of demand for
reserves between developed countries and developing countries are against the
assumption made by Heller (1966) and Hamada and Ueda (1977) that the opportunity
cost is constant over time and across countries. In addition, it fails to take into account
the return on reserves, even though the amount is normally smaller than the cost. The
assumption that the possibility of disequilibrium of international trade was stochastic
is apparently no true because there might be a significant bias if applied to a specific
country.
Agarwal (1970s) modifies Heller’s model on the ground that the opportunity cost of
reserve holdings is the value created by the foreign currency held by the monetary
authority instead of the imported productive goods. Specifically, central banks are
accumulating foreign exchange reserves at the expense of investment and current
consumption. However, this model is not without pitfalls, either. It neglected the
function of foreign exchange reserves as a source of international trade and foreign
debt payments, as well as the options of different economic policies.
2.2 Regression Analysis
The use of regressions as a technique to analyze reserve demand function also
initiated back from the 1960s. The theoretical assumption of using regression equation
to construct the relationship specified follows the empirical study on various
individual determinants. The observed levels of reserve holdings reflect the behaviors
of different countries as demanders of reserves, although not all countries are
expected to fit the “long-term” demand function at each spot of time.
Studies on the demand for international reserves under pegged exchange rate suggest
that the variability of current account and the relative size of foreign trade are among
the main explanatory variables 8 . Serving as a buffer stock accommodating
fluctuations in external transactions, the desired amount of reserves is expected to be
positively proportional to the variability of external net receipts9.
8
9
See Heller 1966; Kelly 1970; Clark 1970; Flanders 1971.
This variable is emphasized by Kenen and Yudin 1965, Archibald and Richmond 1971.
8
Courchene and Youssef (1967) make use of three traditional variables: imports,
money supply levels, and long-term interest rates to estimate the reserve holdings of 9
countries. Notably, the variable of money supply was proposed by Johnson (1958),
whose major contribution was the theoretical foundation of the relationship between
the domestic money supply and foreign payments imbalances. This theory of
monetary approach to the balance of payments indicates that, given domestic credit,
international reserves increase with an excess demand for money and decrease with an
excess supply of money 10 . The long-term interest rate is used as proxy of the
opportunity cost of holding.
In the 1970s, a distinction had been made between developed and less developed
countries and a separate analysis was suggested. Frenkel (1974) estimates separated
demand functions for international reserves by developed and less-developed
countries, showing that behavioral parameters of the two groups are significantly
different. He finally gives an estimate of the function of demand for reserves
explained by three related factors, including average propensity to import, the
variability measure of the level of imports, and a inversely related input, the
opportunity cost of reserves, despite of the overall poor predictive power of this
variable due to the measurement problem.
Edwards (1983) conducts an empirical research by taking into account the element of
exchange rate adjustment. His report indicates that not all less-developed countries
behave in the same way with respect to their demand for international reserves. In
particular, the demands are higher by countries that have maintained a fixed exchange
rate for a long period than those who occasionally devalued their currencies to correct
payments imbalances. He suggests that the reserve holding decisions and exchange
rate adjustments should be viewed as jointly determined simultaneously.
Ford and Huang (1993) investigate the demand for foreign exchange reserves of a
typical planned economy, China, using an error correction model. With the series of
data from 1956 to 1989, they conclude that China had maintained the amount of
reserve on the long-run level due to its prudential foreign reserve policy and monetary
disequilibrium had significant short-run influence on reserve holdings, reflecting the
10
Empirically analyzed by Edwards, 1984
9
country’s special economic structure.
While Asian central banks after the financial crisis of 1997-98 became more
forethoughtful of their reserve holdings, many works found evidence of a change in
the behavior of parameters. Gosselin and Parent (2005) claim a positive structural
break in the demand for international reserves, indicating that the actual level of
reserves accumulated in the post-crisis period was in excess relative to their estimated
optimal level. They also predict a slowdown in the rate of accumulation because of
the risk of depreciation of the U.S. dollar has put on their holdings. However,
Papaioannou, Rortes, and Siourounis (2006) witness that the introduction of the euro
in countries’ portfolio of reserve holdings allowed emerging economies to diversify
away from the U.S. dollar while keeping their total liquidity unaffected.
Following Grubel (1971), taste preferences and large numbers of structural
characteristics of economies which determine the demand for reserves of individual
countries cannot be measured adequately and incorporated in cross-section studies. In
time series analysis involving one country alone, it is reasonable to assume that tastes
and structural characteristics change only slow through time so that observed
statistical relationships among variables are persistent and reflect rational economic
behavior.
10
Part III
Quantitative Analysis
3.1 Formulation of Model
In this paper, the conventional theory of reserve-holding based on the notion of
welfare or opportunity cost is abandoned due to the following two reasons. Firstly, the
costs are the consequence of excessive reserves rather than the cause. From the
economic perspective, these costs are endogenous. The management of costs matters
only when the actual holdings are perceived to be excessive. In other words, the costs
incurred should be considered to be reduced only if the liquidity needs and other
requirements have been fulfilled. Besides, Proxies for these costs do not have
explanatory power unless they possess predictive or forward-looking component.
Therefore, it is more reasonable to have the welfare and economic policy issues
analyzed within an equilibrium framework.
Since some researchers have claimed a structural change in the demand for
international reserves after the 1997 Asian financial crisis, it is necessary to examine
the existence of this change in case of drawing a biased conclusion. Therefore,
following Frenkel’s approach (1974), we formulate a regression model to test the
crisis effect on the parameters of the function. If the determinants of the model behave
differently before and after the year of 1997, the structural change exists and then we
can only incorporate data after 1997 to run the estimation. Otherwise, the boundary
fails to have a major effect on the independent variables, leading to employing a
longer period, covering years both prior and after 1997, to obtain a better long-run
estimate.
The objective of this quantitative analysis is to draw a conclusion on whether China’s
holding of foreign exchange reserves is larger than the desired amount. It is important
to mention that this model explores the adequate level of holding rather than an
optimal level. By adequacy, the model strives to define a sufficient level of holding to
meet the general liquidity and security needs; optimality, on the contrary, takes into
11
account the risk/reward characteristics, which are not included within this section.
The model is initially formulated as follows:
ln( R)    1 ln(m)   2 ln(
m
)  3 ln(var)   4 ln(d )  
GDP
where R is international reserves; m denotes annual imports; the ratio of import to
GDP stands for the propensity of openness of the sample countries; var is the variance
of current account balance; d is total external debt used as a proxy for international
debt. All these variables in this equation are in log form.
The sample set covers 42 less-developed countries (LDCs) from East Asia and Pacific,
Europe and Central Asia, Latin America and Caribbean, and Middle East and North
Africa. Some of the African developing economies which have too much risk of
political uncertainty are excluded from the pool.
In addition, the entire sample period contains 16 years, from 1990 to 2005. To
demonstrate the existence of the structural change in the demand function,
observations could be segmented into two groups in accordance with the two
sub-periods, 1990-1996 and 1998-2005.
 Scatter Plots
Before any test is performed, we use the scatter plot charts to visually explore the
relationships between reserve holding and each of the four predictors.
12
Fitted Line Plot
ln(R) = - 4.620 + 1.154 ln(m)
28
S
R-Sq
R-Sq(adj)
0.587668
88.7%
88.6%
S
R-Sq
R-Sq(adj)
0.782258
79.9%
79.8%
26
ln(R)
24
22
20
18
20
21
22
23
24
ln(m)
25
26
27
28
Figure 2 Scatter Plots: ln(R) vs. ln(m)
Fitted Line Plot
ln(R) = 2.127 + 0.4887 ln(var)
28
26
ln(R)
24
22
20
18
35.0
37.5
40.0
42.5
ln(var)
45.0
47.5
50.0
Figure 3 Scatter Plots: ln(R) vs. ln(var)
13
Fitted Line Plot
ln(R) = - 1.624 + 1.016 ln(d)
28
S
R-Sq
R-Sq(adj)
0.745859
81.7%
81.7%
26
ln(R)
24
22
20
18
19
20
21
22
23
ln(d)
24
25
26
27
Figure 4 Scatter Plots: ln(R) vs. ln(d)
Fitted Line Plot
ln(R) = 25.67 - 1.105 ln(m/GDP)
S
R-Sq
R-Sq(adj)
27.5
1.74953
10.3%
10.2%
25.0
ln(R)
22.5
20.0
17.5
15.0
1.5
2.0
2.5
3.0
3.5
ln(m/GDP)
4.0
4.5
5.0
Figure 5 Scatter Plots: ln(R) vs. ln(m/GDP)
Just as expected, import, the variance of current account, and foreign debt are
positively proportional to reserves. However, although the plots of openness with
respect to reserves on the last chart are distributed stochastically, it shows a negative
effect on reserves. This is contradictory to the theoretical hypothesis that countries
14
that have a higher degree of openness appeal to stock more reserves.
 Cross-Section Analysis
The purpose of performing a cross-section analysis is to detect the changes of
parameters over time. With a large sample number of more than 30 countries in each
year, the output is supposed to be statistically significant.
Table 1: Cross-Section Analysis
Constant
ln(m)
ln(m/GDP)
ln(var)
ln(d)
1990
-9.0099
0.14734
0.46724
0.50023 0.20107
1991
-5.1221
0.77023
-0.05264
0.24686
-0.0405
1992
-5.594
1.17665
-0.29256
-0.011
0.07004
1993
-4.6022
1.24758
-0.39126
0.05301
-0.1384
1994
-3.2036
0.97223
-0.34007
0.03788 0.09484
1995
-2.9343
1.00109
-0.3822
0.05848 0.02489
1996
-2.0711
0.9313
-0.46135
0.08516 0.02357
1997
-0.5985
0.721453
-0.46552
0.12743 0.09895
1998
-2.5943
0.90821
-0.39056
0.0581
0.10947
1999
-2.3095
0.75612
-0.30189
0.0653
0.22511
2000
-1.861
0.77075
-0.25613
0.05591 0.19972
2001
-1.3622
0.91136
-0.30855
0.05298 0.05652
2002
-3.1817
0.84717
-0.18699
0.13202 0.04108
2003
-1.9999
0.92546
-0.47194
0.1065
0.004
2004
-1.2319
1.03786
-0.41613
0.06626
-0.0777
2005
-1.5222
0.85814
-0.21869
0.1257
-0.0209
Shaded cells: 5% level of significance
As shown above, the yearly data is unstable. Import performs relatively smooth, with
the lowest point in 1997. And also, only in 1997, most of the tested determinants,
including m, m/GDP, and var, are significant at the same time. This means that the
Asian financial crisis has a significant influence on the convergence of the countries’
behaviors and their demand for foreign exchange reserves.
Despite insignificant, it is roughly observed that constant is getting higher, indicating
that the total demand is moving upward, with the peak in 1997. Most noticeably, the
openness has a negative effect on the demand of reserves.
15
 Pooled Analysis for Each Variable
Table 2: Single Variable Analysis
constant
p-value
std
ln(m)
p-value
std
ln(m/GDP)
p-value
std
ln(var)
p-value
std
90-05
-5.773
0
0.41
1.199
0
0.018
90-05
25.672
0
0.453
90-05
0.164
0.732
0.48
90-05
-2.562
0
0.534
-1.105
0
0.127
0.53
0
0.012
1.044
0
p-value
0.023
std
87.40% 10.30% 75.80% 76.20%
R-Sq
87.40% 10.20% 75.70% 76.20%
R-Sq(adj)
655
655
655
655
No. obs
ln(d)
The output indicates that all of the four factors are individually significant in the
regression with the sample period of 1990 to 2005. But comparing with other
variables, m/GDP is relatively of low explanatory power with an adjusted R-square of
10.2 percent.
The elasticity of external debt is around one when tested alone, where as the
coefficient of variance is only half of import and debt, indicating that central banks
weight much more on debt risks but less on the volatility of current account balance.
In addition, even though the elasticity of import, 1.199, is greater than one, it does not
mean that countries with larger import volumes tend to have more reserves at hand.
The high correlation coefficient between import and debt, which is 0.916, shows that
the coefficient of import has taken significant debt influence. Hence, we can not
conclude that the large importers are expected to hold more reserves with the single
variable analysis.
Only m/GDP is against our expectation, which is that a country with a higher degree
16
of openness should have more foreign cash readily available in case of global turmoil.
 Curvilinear Trend Test
According to Baumol-Torbin's inventory theory, one would expect a testable decrease
in the demand for money relative to the scale variables as wealth increases. Applying
to the reserve demand function, the linear relationship between reserves the four
determinants is dubious and should be considered to be replaced with a curvilinear
one.
After testing, however, the curve trend is only significant for the variable of openness
and foreign debt, which is not the same as our expectation11.
Panel a. Openness- Range of x: (1.53, 4.65)
Panel b. External Debt- Range of x: (19.7, 26.4)
Figure 6: Curvilinearity Test
The left-handed panel shows that the relationship between reserves and openness is
not strictly linear, indicating a slight economic scale effect of openness on the level of
holding. What’s more, the curve is moving to the left, becoming steeper and less
curvilinear after 1997 than before. This means that countries become a bit more
closed and accumulate more foreign reserves in the post-crisis period.
Panel b also indicates that the debt curve is positively related to demand, but not in
perfect linear way. As countries borrow more from overseas, they are willing to have
11
The test output is attached in the Appendix C.
17
more reserves in hand, although the scale effect is tiny. We could again speculate this
effect with the high correlation between import and external debt as argued earlier,
because countries with much debt usually would have a high import volume and
thereby hold more reserves. In addition, the curve of the post-crisis period is more
rightward positioned, steeper and less curvilinear comparing to the prior-crisis period.
Hence, such change can be explained that countries are getting more conscious about
the debt problem due to the scarring financial disaster of 1997.
The reason why the curve trend for debt decreases a little can be interpreted from two
perspectives. One is that countries after 1997 prefer taking more reference from others
when making reserve decisions. In other words, central banks might tend to have
synchronized moves. This is somewhat consistent with our previous finding from
cross-section analysis that the convergence of countries’ reserve-related behavior
exists. Another speculative statement is that, this phenomenon is probably due to
chance since the post-crisis sub-period only consists of 8 years for each country. For
this reason, to make a convincing conclusion, a longer period is required.
However, adding the quadratic variables in the multivariable regression makes
m/GDP and/or debt statistically insignificant. Moreover, although the quadratic
feature for openness and debt is significant, the adjusted R-square only increases by
1.5 percent (from 10.2 to 11.7 percent) and 0.6 percent (from 76.2 to 76.8 percent)
respectively. The benefit of plugging an extra quadric independent variable is limited
while making other variables of high explanatory power become insignificant.
Therefore, the curve trend could be skipped when performing the regression analysis
in order to simplify the process.
18
 Structural Change Test
Table 3: Test of structural changes in demand for reserves, including openness
Structure Test-With Openness
1990-2005 (655 obs)
1990-1996 (287 obs)
1998-2005 (325 obs)
Coefficient
P-Value
Coefficient
P-Value
Coefficient
P-Value
Constant
ln(m)
-5.2474
0.9435
0.000
0.000
-5.0319
1.0104
0.000
0.000
-2.3753
0.8983
0.000
0.000
ln(m/GDP)
-0.0668
0.001
-0.2262
0.012
-0.3093
0.000
ln(var)
0.0916
0.000
0.0945
0.004
0.0798
0.001
ln(d)
0.0779
0.058
0.0149
0.830
0.0654
0.290
Table 4: Test of structural changes in demand for reserves, excluding openness
Structure Test-Without Openness
1990-2005 (655 obs)
1990-1996 (287 obs)
Constant
ln(m)
ln(m/GDP)
ln(var)
ln(d)
1998-2005 (325 obs)
Coefficient
-5.6583
0.9194
P-Value
0.000
0.000
Coefficient
-6.5333
0.9291
P-Value
0.000
0.000
Coefficient
-4.1002
0.7596
P-Value
0.000
0.000
0.0959
0.1025
0.000
0.000
0.1124
0.0946
0.001
0.130
0.1001
0.1933
0.000
0.000
By comparing table3 and table4, we conclude that it is essential to drop the variable of
propensity to openness and preserve the rest factors to perform the regression based
on the following reasons:
1. Although the import to GDP ratio was initially used to proxy the degree of
openness in the regression, it is also a derivative of import taking into account the
economic scale of each country. As expected, picking out the import to GDP ratio,
which eliminates the overlapped influence on demand for reserves by import,
makes the elasticity of import become smaller (from 0.9435 to 0.9194) and lead to
larger contribution from variance and debt.
2. Import was tested to have a positive linear relationship with reserves; therefore,
there is no need to consider the non-existed effect of economic size with respect to
import on reserves.
3. Either mixing import to GDP ratio or debt with import and variance to formulate
the regression equation makes limited difference in the explanatory power (with
an adjusted R-square of 88.5% and 88.2% respectively).
19
Another major finding from the above two tables is that there is a structural change in
the demand for foreign exchange reserves after the 1997 Asian financial crisis.
First of all, the dramatically increased intercept (from -6.5 to -4.1) after 1997 shows
that the general demanding for reserves by sample countries is higher than that of the
prior-crisis period. The change of average reserve holding is visually shown in below.
Average Ratio of Reserves to GDP
Percent
60
50
40
30
20
10
Other 33 LDCs
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
All 42 LDCs
Figure 7: Increase in average holding of reserves
Theoretically, high level of reserves relative to economic scale provides better
protection of a country’s financial stability. This impact is particularly true for
countries that have experience any financial crisis in history. As shown in the above
chart, the average ratio of reserve to GDP is much lower for all 42 sample counties
than that of countries which never had any financial crisis recently. To distinguish
each of the crisis surviving countries from other 33 non-crisis LDCs, a separated
analysis is given in the following.
20
Ratio of Reserve to GDP
Percent
60
50
40
India
30
Indonesia
Malaysia
20
Philippines
10
Thailand
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
Figure 8: Change in reserve holding (5 Asian countries)
Asian victims from 1997 become conscious of the inadequacy of their stock of
foreign reserves and begin to increase the level of holding immediately after that time.
Interestingly, other suffering samples other than the five Asian countries behave
nearly the same way. The only difference between the ratios of the two sub-groups is
that the five Asian nations have been keeping a higher level of reserves than the other
four countries.
Percent
16
Ratio of Reserves to GDP
14
12
10
Mexico 1995
8
Turkey 1994 2001
6
Brazil 1999
4
Argentina 2002
2
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
0
Figure 9: Change in reserve holding (4 crisis sufferers)
21
Secondly, the fitted line for import is flatter after 1997, whereas the curve of m/GDP
appears steeper. This demonstrate the fact that the weighted influence of import on
reserves has been weakening over time and the function of serving trade payments is
impaired regardless of economic size, which alternatively lead to an increased stress
on other determinants.
Indeed, despite of tiny impact of variance on the structural change, the decreasing
influence of import is absorbed by the increasingly strengthened role of external debt
in determining the demand for reserves. Even though the elasticity of debt is still
much lower than that of import, the trend is significant and gives new clue about how
financial globalization affects each member’s behavior. Apparently, countries are
becoming more aware of the debt related problems as gaining wilder access to the
international capital market.
Ratio of External Debt to GDP
India
Indonesia
Malaysia
Philippines
Thailand
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Percent
180
160
140
120
100
80
60
40
20
0
Figure 10: Change in debt holding (5 Asian countries)
The five crisis-affected Asian countries simultaneously choose to lower their default
risks after 1997 by decreasing their borrowings from overseas but at different
velocities.
22
Ratio of External Debt to GDP
Percent
160
140
120
100
Mexico in 1995
80
Turkey 1994 2001
60
Brazil 1999
40
Argentina 2002
20
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
0
Figure 11: Change in debt holding (4 crisis sufferers)
And likewise, the other four suffering countries from the pool have similar behaviors.
It should be pointed out, however, that the relatively smaller emphasis on foreign debt
is not without reasons. The debt to GDP ratio for most of the surviving countries,
excluding Indonesia and Argentina, ranges approximately from 20 to 80 percent,
while other 33 LDCs borrowed much more with an average of 200 to 300 percent
before 1997. Therefore, we can conclude that even though external debt is part of
their consideration, the major concern still remains on trade payment.
Average ratio of External Debt to GDP
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
Percent
350
300
250
200
150
100
50
0
Other 33 LDCs
Figure 12: Change in debt holding (non-crisis countries)
23
3.2 Model Correction
Thus far, we have found sufficient evidence on the structural change in countries’
demand for foreign exchange reserves and the dynamics of other parameters. From
the unusual observations (outliers), we find that there are 9 countries having a high
deviation from the estimated line. After adding a dummy variable for each of the
abnormal countries, 7 of the coefficients of the dummies are significantly different
from zero. Therefore, the updated model becomes:
ln( R)    1 ln(m)  2 ln(var)  3 ln(d )  4 Di  
where i stands for China, Dominican Republic, Mongolia, Pakistan, Panama, Ecuador,
and Haiti.
ln( R)  2.11  0.686ln(m)  0.0942ln(var)  0.196ln(d )
0.761DChina  1.47 DDo min ican  0.511DMongolia  0.625DPakis tan
1.13DPanama  1.12 DEcuador  0.953DHaiti
China, among the seven outliers, is the only one above the regression line. To
eliminate the effects of on the coefficient of China by other country dummies, all
country dummies other than China was dropped and the China effect becomes slightly
smaller as the dumped variables have opposite influence on the samples’ average
level.
ln( R)  3.45  0.696ln(m)  0.0973ln(var)  0.233ln(d )  0.756DChina
When computing the residuals for China with the model estimation given above, we
have the following chart:
24
Residuals of China's Reserves
billion $
200
150
100
50
0
1998
1999
2000
2001
2002
2003
2004
2005
-50
-100
Figure 13: Excessiveness of China’s reserve holding
Thus far, we could conclude that the actual level of international reserves held by
China is far more than the adequate level estimated by our regression. It is also
noticeable that the deviation of China’s foreign exchange reserves from an
international average level began from the year of 2001. Therefore, the dummy
variable for China was replaced with another two dummies for the two different
sub-periods for the period of 1998 to 2005 to prove the upward trend of the residual
growing.
ln( R)  3.42  0.692ln(m)  0.0979ln(var)  0.235ln( d )  0.607 DChina9801  0.916DChina 0205
In line with expectation, the increased dummy coefficient for the second sub-period
indicates the acceleration of China’s accumulation of foreign exchange reserves. By
the end of 2005, the excessive liquidity under China’s foreign exchange reserve
account reaches nearly $200 billions.
3.3 Final Conclusion From the Quantitative Analysis
The recent increased accumulation of international reserves has triggered intensive
argument on optimality and adequacy of reserve holding. To quantitatively address the
question whether China is holding an excessive amount of foreign exchange reserves,
we performed the above series of regressions and come out with the answer to it and
several by-products.
25
1. The hypothesized structural change in demand for foreign exchange reserves
exists. Hence, the demand for reserves should be treated differently before and
after 1997, indicating that only the post crisis observations should be considered
when quantitatively solving for reserve issues.
2. Trade payment is still the primary concern of developing countries while its
influence on demand for reserves is on a decline. Central banks have given more
emphasis on the debt problem after the Asian financial crisis.
3. There is a proved convergence on the behavior of monetary authorities when
making reserve-related decisions.
4. The relationship between reserves and openness, and that of reserves and debt, are
not perfectly linear but quadratic. Yet, such curve feature is only of statistically
significant, having little additional implications.
5. Victim countries have been borrowing less from overseas, and thus holding less
foreign reserves at hand than other countries that never had the suffering
experienced before.
6. Surprisingly, propensity to openness, proxied by the ratio of import to GDP, is
negatively related to the demand for foreign cash. According to the Baumol-Tobin
inventory theory of the demand for money, one would expect a testable decrease
in the demand for money relative to the scale variables as wealth increases, which
is totally contrasted with our quantitative finding.
7. The importance of variance of current account balance almost remains unchanged
after the Asian financial crisis.
8. China’s holding of foreign exchange reserves has been exceeding the adequate
level defined by the world average behavior and the existence of over-liquidity
started from the year of 2002.
26
Part IV
Analysis of Economic
and Policy Dynamics
This section provides an all-too-rare analysis of the interactions between the foreign
exchange reserves of China and its major macroeconomic variables over time. The
effects of reserves on balance of payments are discussed first, followed by a glimpse
at the foreign exchange policy of the state. With such findings, we draw a conclusion
partly consistent with our regression that China’s reserves are not only fully adequate
in the light of precautionary and mercantilist views, but also generate a series of side
effects by holding too much.
4.1 Balance of Payments Analysis
The boom of China's economy initiated from early 1990s as it furthers economic
revolution. The average rate of GDP growth was 10.21 from 1992 to 2005. Both the
levels of export and import increase by more than 10 times during the period of 1990
to 2005, whereas the level of total reserves was 19.2 times higher in the same period.
China's international reserves consist of four parts, including monetary gold, special
drawing rights, reserve position in the fund, and foreign exchange reserves. The
values of the first three components are relatively small and constant over time
compared to foreign exchange reserves. Therefore, the first three parts are ignored in
the following analysis and the focus will be net changes in foreign exchange reserves.
27
150
Percent
growth rate of export (%)
900
Billion $
growth rate of import (%)
800
growth rate of reserves (%)
100
Total reserves(in billion $)
700
Exports (in billion $)
Imports (in billion $)
600
50
500
400
0
300
200
-50
100
-100
0
Figure 14: Growth of China’s trading activities and reserves
The total process of China's accumulation of international reserves could be divided
into three phases. The first period was from 1990 to 1993, when the value of holding
was quite small relative to its economic scale. The average ratio of reserve to GDP in
the first phase was 7.5 percent. Since 1994, China's reserve level started soaring at a
moderate speed till the year of 2000. The average growth rate of reserves in the
second period is 38.7 percent and the mean of reserve to GDP ratios grew up to 12.9
percent. A steep incline began from 2001 and the level of holding reached 821.5
billion US dollars at the end of 2005. The ever large scale of foreign exchange
reserves amounted to more than 40 percent of the country’s national income as of
present.
Referring to Triffin’s method, the ratio of import to reserve of China appeared a
deviation from the rule of thumb, which is 3 to 4 months coverage, from the year of
1994 as well as its reserve to GDP ratio. With few exceptions, the ratio of broad
money to total reserves experienced a similar structural change affected by the
28
tremendous increase in reserves. Therefore, it is obvious that the economic effects
imposed on major economic variables are straight, direct, and intense.
Because of the high volatilities of different ratios, indices and proxies during the
period of 1990-2000, and the distinctive trend thereafter till 2005, a better method that
calculates the averages among the years through the first period and combines with
the data in latter periods is used to obtain a clearer result.
Table 5: Major reserve-related economic indicators
Order
1
2
3
4
5
6
7
8
9
Index
R/Debt (%)
Total reserves in months of imports
△Debt/△R (%)
△FDI/△R (%)
△trade/△R
△Current Account/△R (%)
△Capital Account/△R
Annual Growth rate of reserves (%)
Current Account/GDP (%)
91 - 93
42.34
5.68
68.91
327.78
-270.95
-291.93
464.88
1.13
0.81
94 - 00
88.53
8.00
28.70
275.33
225.54
156.50
62.95
38.73
1.85
01 - 05
201.73
10.97
27.73
47.99
44.79
46.80
49.10
37.52
3.45
Data Source: WDI database
Since financing the payment imbalances resulted from international trade is the most
important function of foreign exchange reserves, it is reasonable to assume that the
value of reserves would be higher than before as China furthers its so-called “Reform
and Opening Up” with an export-led development strategy. However, the growth rate
of reserves compared with the nation’s current account balance should be maintained
within a certain range. As recommended by international references, this index should
fall between -50 and 0, indicating that countries that following an export-led policy,
e.g. most Asian developing economies, should reduce their reserve holdings by
purchasing foreign highly productive resources. Indicator 6 illustrates that, in the past
two decades, China had been accumulating foreign exchange reserves while exporting
economic resources in return for foreign currencies.
Concerning on external debt, China’s borrowing booms from $55.3 billion in 1990 up
to $281.6 billion at the end of 2005. Yet the 5 times increase of foreign debt is
accompanied with a 27.8 times increase of foreign exchange reserves, which
exceeded the total external debt for the first time in 1998 and never fall below that
level thereafter. Based on Greenspan’s assumption, the value of a country’s
29
international reserves should never be less than its short-term foreign debt, which is
normally less than half of a country’s total borrowing. Besides, international
benchmark suggests that index 1 ought to sit between 30 percent and 50 percent.
From the ratio of annual change in foreign debt to annual change in international
reserves, it is shown that reserves had been accumulating at a faster speed than that of
debt. This yearly measure is on a clear downtrend and never exceeds 100 percent. The
large size of the foreign exchange reserves of China, therefore, is too much than what
is needed to prevent from financial crises from a debt repayment perspective.
As a main character of the Chinese economic prosperity, foreign direct investment
(FDI) had been serving as the underpinning through the entire transition of its
economic structure. It is not just that money is what is brought to the land, but also
knowledge, such as technology, management skills, corporate culture, etc. With the
help of FDI, China realized an average annual growth rate of GDP of more than 10
percent in the past decade, which is viewed as the engine of world economic
development. According to a report from National Economic Research Institute
(China), ever since 1994, FDI contributes the biggest part of China’s accumulation of
reserves, while trade surplus being the second and foreign debt the third. In addition,
the FDI effect on the expanded scale of reserves is larger than the sum of the two later
factors. However, this fact only stays true before 1997. The value of net FDI inflow
has been growing more than 25 times since 1990, when the economic opening-up was
just initiated. The increase of FDI also experienced a similar three-phase process with
a shape alike. During the first period, the average of net FDI is merely around $11.2
billion, whereas the value goes up to $37.3 billion and $50.5 billion in later time
respectively. On the one hand, even though the increase in net FDI inflow is
substantial, its influence on the accumulation of foreign exchange reserves is
decreasing as other factors are contributing more to China’s holding through time. On
the other hand, although the value of indicator 4 is decreasing, FDI would continue to
facilitate lift up the level of international reserves as long as the indicator remains
positive.
30
Table 6: Major reserve-related economic indicators
Order
1
2
3
4
5
6
7
8
Index
R/Debt (%)
Reserves in months of imports
△Debt/△R (%)
△FDI/△R (%)
△trade/△R
△CA/△R(%)
△Capital Account/△R
Growth rate of reserves (%)
91-2000
74.7
7.3
40.7
291.1
76.6
22.0
183.5
27.5
2001
116.7
8.8
82.4
78.7
59.2
36.7
73.3
28.1
2002
156.4
10.2
1.7
62.2
49.7
47.1
42.9
35.0
2003
195.8
10.6
19.1
40.5
30.9
39.3
45.2
40.2
2004
248.1
11.9
19.0
25.8
23.9
33.3
53.7
50.6
2005
291.7
13.5
16.4
32.7
60.2
77.6
30.4
33.7
Reference
30～50
2.4～5.0
0～50
≥0
-100～0
-50～0
≥0
-20～20
Data Source: WDI database
Note: Reference denotes an internationally recognized benchmark.
With respect to the astonishing speed of stockpiling of foreign exchange reserves after
2001, what we can learn from the regression result mentioned earlier is how much the
average holding of sample countries is affected by China. Table 6 illustrates the entire
process of interactions between reserves and each of their sources through the period
between 2001 and 2005. It is obvious that almost the magnitude of every single
indicator is moving toward an opposite direction of the safe zone.
The current account balance started rocketing from the year of 1994, when China
initiated an “export-led” policy with continuous export award and import limit.
Meanwhile, surplus in the capital account was caused by a dramatic increase in FDI
and foreign debt. This “Dual-Surplus” indicates that China did not use the borrowed
money from abroad to purchase real resource needed for development. Quite the
contrary, it transferred resources, such as labor force and natural resources, in
exchange for stockpiling foreign currencies. Traditional development economics
suggests that developing economies should bring in foreign capital to buy real
productive resources needed for economic development at the initial stage due to the
fact that their domestic saving used to be lower than investment. The “Dual-Surplus”
has and would continue to overdraft China’s economic potential, although it had been
proved that such policy could stimulate a conspicuous economic development at
present.
From an economic view, the quality of a country’s international reserves has little to
do with the proportion of each foreign currency held but most determined by the
source of its funding. Based on the analysis of China’s balance of payment, the
31
country would have to spend a large portion of its reserves on interests and return on
FDI since the difference between current account balance and capital account balance
does not appear significant relative to its economic size during the underlying period.
FDI and foreign debt are substitutable from a capital stand of point, but FDI is less
risky than debt and helps much more in promoting the receiver’s technological
evolution and industrial development. However, it is not a panacea since in the long
run FDI could threaten the nationalization of a country’s major industries. Therefore,
only a sustainable trade surplus could represent the high competence of a country’s
product and economic development, leading to a healthy structure of international
reserves.
It is controversial what motives are behind China’s economic policy and behaviors to
save a high amount of foreign exchange reserves, yet the obvious conclusion is that
the country is not as strong as it looks. To some extent, it is hollow. Hence, on the
management issue, whether China is running with a long-run interest should be taken
with suspicion and a shift of the source of funding of its reserves deserves more
attention. Such shift would lower the economy’s financial risk; and hence lower the
need for cash, although it might be accompanied with a dramatic decrease in the
absolute value of the reserves.
250
billion $
200
Current Account
Capital Account
Net change in R
150
100
50
0
-50
Figure 15: Interactions between current account, capital account and the yearly incremental of
reserves over time
The current and capital account alternatively plays as the largest contributor to the net
32
increase in foreign exchange reserves. The current and capital account surpluses in
2005 reached at $160.8 billion (7.2 percent of GDP) and $63 billion (2.8 percent),
respectively. Since the errors and omissions, $16.8 billion in 2005, are relatively small
and negligible, we can conclude that current account, 134 percent higher than the
level of the previous year, surpasses the capital account, which is 43 percent less than
the 2004 level, as the greatest factor behind the increase of reserves. The de facto
external imbalance itself refutes the argument given by the Chinese government that
the upward pressure on RMB is the result of speculative capital flows rather than
actual demand based on current transactions.
4.2 Foreign Exchange Policy Analysis
In addition to the precautionary perspective, which is to serve foreign debts and
international payment imbalances as the reason to accumulate foreign currencies,
China has a second consideration—the mercantilist motive. Under a fixed exchange
rate regime, the country needs sufficient money to support its pegging target, which in
turn facilitates gain a cost advantage in international trades by keeping the RMB
undervalued. To illustrate the motivation of China’s policy, a brief history of the
Chinese foreign exchange policy is given below.
China's present foreign exchange policy is the consequence of a series of reforms
upon its national foreign exchange control system. Before the “Reform and Opening
Up”, all foreign incomes and expenditures are settled centrally and distributed
according to the plan of its economy. This unenlightened system ended up since 1979,
when the settlement of foreign currencies of the nation updates to a “Quota” one,
requiring companies that have business with foreign entities to turn in their foreign
incomes in exchange for RMB while attaining the right to use part of them under
regulations. In 1994, China enacted a new set of foreign exchange administration
rules, including establishing a unified nation-wide inter-bank foreign exchange market,
employing a market based managed floating exchange rate system, abandoning the
examining and approval of foreign exchange spending, and realizing the conditional
convertibility of the RMB. Beginning on July 21, 2005, China announced to reform
the exchange rate regime again by moving to a managed floating exchange rate
regime based on market supply and demand with reference to a basket of currencies.
33
The value of RMB appreciates by 2.1 percent immediately after the announcement.
Currently, the framework of foreign exchange control system enables free exchange
for transactions under the current account, but the capital account items are still under
restrict control. As proclaimed by the Chinese government, the ultimate objective of
free convertibility of RMB takes a long time and several prerequisites: (i)
improvement of the country’s risk resistance, (ii) stable increase of its economy, (iii) a
healthy internal financial system, and (iv) high efficiency of macroeconomic policy.
However, the international society, particularly the US, is not satisfied with the slow
speed and the degree of the reform on China’s foreign exchange policy. It has been
argued that, from 1994 to 2001, the real effective exchange rate of RMB raised by
37.2 percent, whereas its current account surplus improved by 152 percent within the
same period. Hence, China should pay a significant down payment12 to ease the trade
imbalance between China and the US, and thereby influence on the trading
relationship between the US with other Asian developing countries.
120
180
160
140
120
100
80
60
40
20
0
-20
-40
100
80
60
40
20
0
Real Effective Exchange Rate Index (2000 = 100, left axis)
Current Account Balance (in billion $, right axis)
Figure 16: Interaction between exchange rate and current account balance
More often than not, China explains the motives behind its sterilization operation as
concerns on its protection from harm to state-owned enterprises, unemployment, and
domestic agriculture. Nevertheless, the country’s effort appears to have little effect on
the improvement of its macroeconomic stability and the protection of inefficient
12
As of Sep, 2007, the exchange rate of RMB to USD raised by 9.2% since Jul, 2005. Yet Morris Goldstein,
suggests an immediate change of at least 15% to 20%.
34
companies and industries. To achieve the two goals, based on Tinbergen and
Mundell’s rules13, maintaining the RMB at a comparatively low level alone will not
be sufficient. In detail, foreign exchange policy only works on macroeconomic
stability, whereas internal institutional reforms are required to resolve structural
problems. The “excuses”, such as increased unemployment, agriculture, and
state-owned economies, all of them are structural in nature. Besides the redundant
labor force in rural areas, the unemployment in the urban area is worsening resulting
from the restructuring of state-owned companies. Also, large amount of productive
resources taken by agriculture, and state-owned entities, including labor, land, capital,
and so forth, are used in an inefficient manner. To improve the overall efficiency of
the economy, these resources should be transferred to sectors of high productivity,
rather than merely count on keep the RMB cheap.
It is the market intervention by the Chinese monetary authorities to suppress its
currency from appreciation that fundamentally causes the surge of external surplus.
Theoretically, no external account imbalances would exist if a floating exchange
regime was adopted. Since US is the largest trading partner of China and because of
its large current account deficit, RMB is expected to appreciate against dollar and
other major currencies in parallel. Despite rising upward pressure on the RMB, the
central bank of China remains prudential about revaluation and continues to intervene
in the foreign exchange market in massive amounts with part of its international
reserves set aside14. It is also noticeable that, even now the Chinese authorities have
been hesitating to revalue its currency; they are not completely ignorant about the
negative effects of the economic disequilibrium, including increased trade friction
with major trading partners and excess liquidity of reserve holdings. Specifically, on
the current transaction side, they imposed export restraints on such goods as steel and
wood products that require large amount of inputs and lead to pollutions, and on
certain textile products, which is the focus of trade negotiations with the United States
and European Union. To release the pressure of the White House from the American
corporate society, the Chinese government made a nice gesture by confirming a large
13
Tinbergen’s rule: Achieving a multiple number of independent policy targets requires an equal number of policy
instruments. Mundell’s rule: Each policy instrument should be assigned to the policy target on which it has greatest
relative effect.
14
According to a report from Peterson Institute for International Economics, the heavy foreign exchange
intervention by Chinese authorities was $20 billion a month in 2006, $45 billion a month in the first quarter of
2007 and had amounted to 10 percent of its GDP in each of the years from 2004 to 2007.
35
sum of orders 15 . In addition, the government introduced a “Qualified Domestic
Institutional Investor” (QDII) mechanism to channel domestic capital off to overseas
markets. These moves, however, have performed limited effects on China’s external
imbalance and cannot ultimately solve the problem.
4.3 Capital Control
Another medium-term objective announced by the Chinese monetary authorities,
besides the exchange rate flexibility, is the capital account convertibility. The present
mechanism of China’s capital controls is comprised of three functional components:
controls over foreign debts, international portfolio investment and foreign direct
investment.
International borrowings subject to permission and registration contain foreign loans,
project financing, external collateral, and risk control. The control involves
government’s liability to such foreign entities as foreign governments, international
organizations, international banks and companies. The management of debt operation
covers the size, structure, maturity and repayment plan.
2005
2004
2003
0
2002
0.00
2001
10
2000
50.00
1999
20
1998
100.00
1997
30
1996
150.00
1995
40
1994
200.00
1993
50
1992
250.00
1991
60
1990
300.00
External debt, total (current US$, in billion, left axis)
Short-term debt (% of total external debt, right axis)
Total External Debt to GDP (%, right axis)
Figure 17: Change in composition of capital inflow
15
Wu Yi, the Vice Premier of China, led a huge business delegation to the US and signed purchasing contracts
worth some $16 billion with US firms, including a deal with major aircraft manufacturer Boeing to buy eighty 737
passenger jets (worth $ 4.6 billion).
36
China has been cautious about taking on foreign debt in the past decade. The total
external debt to GDP ratio has remained stable around 15 percent, indicating a
relatively effective control on discouraging companies from borrowing from overseas
capital market as a consequent of certain policy. Meanwhile, in despite of dramatic
increase in the total absolute value of external debt, the proportion of short-term
borrowing maintained moderate with an average of 16.4 percent until 2001. In general,
countries with a high level of short-term debt tend to be more susceptible to external
shocks and crises. In this view, the sharp flying of the ratio of short-term debt as
percent of total foreign debt (9 percent in 2000 and 53 percent in 2005) elicits a high
risk potential. However, a considerable part of the raising short-term debt is
contributed by the surge in trade credits, which accounts for 13 percent of total
external debt in 2001 and 19 percent in 2003 16. Notwithstanding short maturity
feature, trade credits impose less risk on China’s external balance as they are
perceived to be closely linked to subsequent export receipts.
Concerning on investment activities, as the country imposes restrictions on the
residences’ ability of purchasing foreign securities, the primary guidelines deal with
controlling upon international bonds backed by foreign governments, share listing of
Chinese companies in overseas stock exchanges (including the Hong Kong Stock
Exchange), and the issuance of B-share, which is a special form of Chinese shares
dominated in non-local currency and designed for residents outside China mainland.
As argued earlier, non-FDI have been playing a dominate role in building up the
recently fast-paced accumulation of reserves. The noteworthy evidence on China’s
management of FDI is the switching of the major policy focus from inward FDI to
outward FDI generated by Chinese corporations. Driven by the distinguished
attractiveness of investment environment, the traditional focus used to be the capital
inflows, including paid-in capital, receipts in foreign currencies under capital account,
and FDI firms and projects related external debt.
In principal, the capital controls were initially applied to ensure the matching of
imports and exports in financial terms in pursuing an external balance. A crucial
consideration for less-developed economies is that such controls, in someway, impose
16
See Prasad and Wei, 2005
37
disciplines on macroeconomic policies. Empirical evidence suggests that countries,
particularly those with underdeveloped financial intermediaries and limited access to
international capital market, favor adopting rigid exchange rate regimes receive
benefits in the form of macroeconomic stability17. For historical reasons in China, the
designed financial mechanism worked well in serving the functions of preventing
disruptive capital movements and mobilizing the scarce resource of foreign exchange
within the country. However, these controls have become less effective and the
benefits tend to erode over time. When countries become integrated with global
markets and economies boom and mature, a flexible exchange rate regime appears
more valuable. And also, since China is now having a big foreign exchange reserves
surplus, it is neither necessary nor beneficial to maintain the rigid system.
The domestic financial system in China is heavily dependent on the banking sector,
which is dominated by state-owned commercial banks and lacks of competition.
There will be considerable financial risks associated with capital flows in the absence
of efficiently managed institutions. However, the porous banking industry may not
experience substantial pressure resulting from the greater exchange rate volatility with
the existing capital controls in place. As the overwhelming portion of foreign
exchange is held in the hand of central government, banks do not have sufficient
exposure to currency risk, and thereby will be short of incentives and channels to
develop its foreign exchange market for currency risk management.
If the national wealth dominated in foreign currencies can be distributed into the
domestic banking system in a fairly comprehensive manner, the market will be
expected to harness hedging instruments, e.g. financial derivatives, to manage the risk
facing. In this wise, the introduction of exchange rate flexibility will not only expedite
the process of capital account liberalization to cope with the influence of increasing
capital flows, but also spread the excessive hoarding of foreign exchange reserves
under the balance sheet of the people’s bank of China.
Financial crises occurred in many developing countries illustrate that opening the
capital account while maintaining the exchange rate regime inflexible provides a
fertile ground for high potential of risks, especially for those nations that are not
17
See Rogoff, 2004
38
systematically ready for the requirement of opening. However, it has long been
widely accepted that financial integration encourages a more efficient global
allocation of capital. Developing countries equipped with lower capital entry barriers
could be expected to be pushed to a high growth path. By sharing income risks across
boarders, moreover, the capital-demanding developing economies that subscribed to
this belief and liberalized their capital accounts would acquire more channels to
investors and enhanced possibilities for consumption smoothing.
The two-edged capital account liberalization delivers a mixed signal: more access to
the international capital market but higher financial risks. Theoretically, capital
inflows can help a developing country to spur economic growth in a number of ways,
such as augmentation of domestic savings, lower cost of capital, and development of
the domestic financial sector, all of which indirectly induce policy adjustments. A
large literature shows that, it is the composition of capital flows, rather than the
degree of financial openness, that determine the risks facing the developing
countries18. FDI inflows are not as volatile as other capital flows and are of few
possibilities of becoming reversed. Foreign debt, especially a high proportion of
short-term debt, on the other hand, would lead to capital account vulnerability with
financial integration.
A crucial problem for most developing countries, so does China, is that they have
little freedom in choosing the composition of capital flows as well as the
accumulation of foreign exchange reserves. The semi-control power is mostly due to
the weak domestic macroeconomic fundamentals, pushing the countries to rely
heavily on external debt with a high share of short-maturity ones as they move further
on the path toward financial openness. While having enhanced access to world capital
markets, the actual borrowing probably would exceed the desired amount given the
inefficient government expenditure, leading to increased debt exposure. In addition,
transparency and corruption problems also threat the confidence of investors, inviting
speculative behaviors and contagion effects.
These negative influences of financial integration would inevitably float above
surface if the threshold effects were not conquered. Only nations with efficient
18
See Prasad, Rogoff, Wei, and Kose, 2003
39
domestic institutions and sound economic policies are capable of gaining the full
benefits of financial openness at a relatively lower risk associated in the initial phase.
China has been enjoying the benefits from a pattern of capital composition heavily
titled with FDI for a long time. In addition to the sufficient fund provided by FDI
inflows, the country has also received a great deal of advanced technologies and
managerial know-how through the cooperation with foreign institutions. However,
although the financial system of China is centered on its banking sector, as shown by
experience of the Asian crisis countries, foreign fund would flow into the domestic
market through various channels and create serious imbalances.
The declining proportion of FDI in China’s total capital inflows shows that the
potential risks of financial globalization is increasing, implying that the country will
be facing difficulties in having effective controls over those risks if a cautious
approach to capital account liberalization was not to be taken.
4.4 Shift in policy
Thus far, we have discussed the two major motives behind the accelerated
accumulation of China’s foreign exchange reserves. In principal, having met the
liquidity need, the remaining amount of holding is perceived to be excessive and
operated at low efficiency. To fundamentally solve the problem of over holding,
China should follow a “two-step” approach. The first step intends to slow down the
growth rate of reserves via a series of policy changes, and the subsequent move is to
allocate the economic resource in an efficient way to reduce the whole stockpile to an
adequate level.
Based on neoclassic economic theory, the pattern of capital import for a developing
country will experience a four phases. Since the investment used to be higher than
savings in emerging markets, they tend to borrow money from abroad to keep the
domestic growth rate at a high level, and thus, a trade deficit exists which is the main
feature of phase one. The gap between investment and saving illustrates the net inflow
of capital, which is larger than the trade deficit because the capital importer needs to
pay interests to the lenders. The persistence of such deficit would cause foreign debts
to increase. As the national income grows and the saving increases, the gap between
40
investment and saving would shrink and subsequently reduce the trade deficit.
However, because the interest on borrowing is increasing as well, the speed of
changes in net inflows will be slower than that of the reduction of deficit. And also,
the total amount of foreign borrowing would not stop growing but at a slower rate.
When the domestic saving is sufficient to support its investment, the trade deficit
would disappear and the capital importing phase calls to the end. The country goes to
the second phase when the trade balance turns positive and becomes a capital exporter.
But this is only an early exporting stage because it still has to pay foreign debtors the
interests and returns, which are larger than the trade surplus. And correspondingly, the
debt is climbing as usual. When the capital outflows exceed the inflows, foreign debts
start to decrease until the country become a net capital exporter. At this time, both
current account and trade balances are positive, symbolizing the medium capital
exporting phase. The last phase defines the turning point when the country evolves to
a developed economy and becomes a creditor nation.
In practice, it takes a fairly long time for those developing countries that emphasize
using foreign capital as a complement of the insufficient saving to promote to a trade
surplus nation. China, as a low-income economy, is supposed to be a resource
importer. In other words, the persisting trade surplus of China is a result of
inappropriate economic policy.
Theoretically, unlike a closed economy, an open economy is capable of raise
investment and foreign borrowing without changing its savings. The current account
may be the result of either high savings or low investment level. China is well known
for its tremendous investment opportunities, but its savings are even much higher.
Since 1990, the gross saving hovered around 40 percent as of GDP and reached the
peak of 50.4 percent in 2005. Such high savings are built up by acquiring foreign
wealth, rather than raising its own capital stock. Since a country’s current account
surplus is also referred to as its net foreign investment, evidence shows that China is
both a capital importer and a capital exporter.
41
60
50
40
Current account
balance (% of GDP)
30
Gross savings (% of
GDP)
20
Investment (% of GDP)
10
0
1990 1992 1994 1996 1998 2000 2002 2004
-10
Figure 18: China’s saving dilemma
In general, the purpose of importing capital is to support the desire for investment and
release the shortage of domestic funding. Therefore, there is usually an interactive
relationship between current account and capital account: current account is normally
accompanied by capital account deficit, and capital account surplus often goes with
current account deficit. However, such relationship stopped appearing from 1994.
This means that China’s surplus of savings over investment is approximately
hundreds of billions of US dollars, while importing considerable amount at the same
time.
China has been among the countries of high saving rate recently. However, because of
limited access to funding and the high cost of financing in the domestic financial
market, companies have to borrow capital from abroad. The fundamental reason for
such phenomena is that domestic savings was not used to support investment, or the
money was not invested in an efficient way.
 Negative Influence of Foreign Reserve Surplus
Apparently, it is necessary to hold a certain level of foreign exchange reserves at hand
for the purpose of currency stabilization. But excessive holding will harm the national
economy because holding is not without costs. The sufficient backup of reserves
helped the RMB avoid substantial depreciation during the Asian financial crisis.
However, this holding also follows the rule of diminishing marginal utility. For
42
instance, the utility of increase of reserves from zero to $100 billion will be larger
than the increase from $300 billion to $400 billion. When the actual amount overreach
the adequate point, the utility of holding every extra dollar will become negative,
reducing the overall utility of holding and probably will cause other financial
instability.
In addition, as a developing economy, China has to pay a high interest when
borrowing from overseas due to the country risk premium. Even though China has
been heavily investing the foreign assets in US treasury bills, which is backed by the
credit of the United States and deemed to be a safe asset with high liquidity, the
average yield rate is about 2%. Hence, the more foreign reserves China holds the
more costs it has to bear. Moreover, the capital that transferred from the low-income
China to the high-income US should be used in an efficient way rather than financing
the high current account deficit of the US. From this point of view, keeping
substantive foreign reserves while borrowing largely from creditor nations could be
regarded as exporting capital to foreign countries and importing the fund at a higher
interest rate. In this way, by all appearances the de facto opportunity of cost of
China’s holding of foreign exchange reserves is considerably high.
On the other side, over-holding of reserves will make China exempted from having
access to IMF concessional assistance. According to the IMF rules, member countries
have the right to withdraw 100 percent of their respective deposits when facing
adverse balance of foreign exchange deficit. Besides, they are also granted the right to
borrow 160 percent of their deposits for funding the macro-adjustment at a low
interest rate when their economies encounter structural problems. By contrast,
countries with a foreign exchange surplus, like China, become givers than receivers
when the world disequilibrium comes alone.
 Influence of Reserve Growth on Money Supply
A country’s money supply is closely related to the asset structure of its monetary
authority. In general, the reserve money is comprised of two deterministic
components: domestic credit and net foreign assets. Because China is following a
nearly centrally controlled foreign exchange policy, the people’s bank of China has to
buy the increasingly accumulated foreign exchange from the domestic market with a
43
large amount of RMB, the so-called “funds outstanding for foreign exchange”. As one
of the basic channels of currency issuance, the RMB equivalent of official foreign
exchange holdings is positively related to the amount of reserves, and other things
equal, the money supply would change accordingly as well. In absence of exchange
rate flexibility and changes in domestic credit, the up scaling of foreign reserves
would raise the monetary base, which in turn causing the aggregate money supply to
increase.
Percent
Reserve to M2 ratio, China
25
20
15
10
5
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
Figure 19: Relationship between China’s reserves and money supply
The proportion of the RMB counterpart of foreign exchange reserves maintains above
10 percent for most of the time in the 1990s. Similar to the shape of the regression
residual chart of China’s reserve holdings given earlier, the climbing begins from the
year of 2000 and starts accelerating from 2002. It is also worth noting that the share of
total reserves increased by 118.3 percent through 2000 to 2005, which means that the
level of reserves has been growing faster than money supply. The robust growth of
reserves leads to a substantial booming of currency issuance. Such increasingly strong
correlation between China’s money supply and foreign exchange reserves would also
to some extent uplift the potential of instability of its domestic monetary system.
Furthermore, the excessive money supply will invite a critical inflation problem since
the supply side of money grows faster than the demand side. To maintain the same
level of liquidity as before, people will tend to hold more money at hand, making
44
desired rate of hoarding moving upward. According to monetary approach to balance
of payments, the rate of hoarding equals rate of change of money supply. This set of
movements will further weaken the domestic consumption and result in a variety of
macroeconomic problems.
 Influence of Reserve Growth on National Economy
Being a less-developed economy, China has been promoting its national
industrialization for many years, during which it needs a great deal of crucial
resources, e.g. advanced technology, key equipments, and various scarce raw
materials. The desire for productive resources unavailable within the country requires
a transfer of part of the foreign exchange to support the purchase. On the other hand,
the profit margin of investment in China is far greater than the low yield earned by
foreign reserve holdings. When the growth of reserves declines, the capital provided
through the fiscal channel and bank credit system encourages the sustaining of heavy
investment. In other years, when the reserve level is accelerating, money issued goes
to the foreign exchange reserve account, and consequently crowds out the normal
demand for fund in the social system. Therefore, when the domestic industries are out
of capital, productions and investments are going to decrease, leading to such serious
social instabilities as the unemployment problem. Meanwhile, the giant national
foreign exchange account has negative impact on the undertaking change of China’s
economic structure. The share of tax revenue in national income has been declining as
economy grows. Hence, the insufficient fund would delay the speed of macro or
regional economic adjustment.
 Solutions
On the surface, the persistent dual-surplus should be responsible for the over
accumulation of foreign reserves. Yet among the variety of macroeconomic variables,
reserves and the balance sheet of national account are only of subordinate when
analyzing the interactions between them. It is unreasonable or even not worthy, for
the sake of lowering reserve levels, to proactively manage exchange rate, adjust trade
volumes, and make changes in the strategic choice of capital importing. Theory-based
solutions include reducing export and/or increasing import, devaluation of the RMB,
45
lessening the capital inflows and/or encouraging overseas investment, and even
ignoring capital flight, none of which is realistic or possible in the near future.
Accordingly, taking the surplus of foreign reserves as a consequence rather than the
source of external imbalance is a proper approach. Based upon the above analysis, to
fundamentally address the series of economic problems incurred by the excessive
holding of foreign reserves, a shift in economic policies should be taken into account.
In an open economy where capital mobility and floating exchange rate regime are
available, the amount set aside for foreign exchange market intervention is not
necessary since the market would adjust external disequilibrium automatically.
Therefore, to finally achieve the objectives of free conversion of the RMB and capital
account liberalization, China has to perform a series of economic revolutions, which
should be conducted in a gradual way in order to make the risks of policy shifting
under control.
At present, capital under current account flows freely but is subject to restrictive
controls for capital account transactions. All foreign investors who are willing to
participate in the Chinese financial market and domestic capitalists that plan to invest
abroad need to obtain the approval from the government. These administrative
regulations were placed to prevent capital speculations on the appreciation of the
RMB and financial market hazard. However, as the volume of trade grows and the
country’s integration with the global economy matures, the degree of such monitor
would be less effective and hinders the targeted performance of the national economy.
As the major motive of protection comes from speculation on the appreciation of the
RMB, China could release the pressure once a broader range of intraday volatility is
allowed. The current intra-day spread, 0.3 percent, obviously does not meet the need
for the adjustment of external imbalances. If a wider scope was to be followed, e.g. 1
percent, the country would have more incentive to speed up its economic reform,
especially within the financial sector. Besides, the sufficient fund of foreign exchange
will grant China a smooth progress through the changes over time.
When the currency stress is on a descending, bans on the capital account can be
expected to be uplifted. But also, gradualism should be given more preference. For
46
instance, in line with the WTO agreement, China has to open its financial market to
international financial institutions. The past protectionism of the Chinese financial
industry has been hobbling the development of the market mechanism.
Large
amount of non-profitable bank loans indicates that the intermediary is running at low
efficiency. By introducing more foreign competitors, the on-going restructuring of the
banking sector can be enforced. To manage the risks taken by the domestic financial
institutions, one option for the state is to enlarge the capital bases of major
state-owned commercial banks by injecting capital out of the official foreign
exchange reserves. Such actions would firm the competitive edge of the domestic
financial industry and making a higher yield as the redeployed fund would eventually
goes to the domestic market. In other words, this approach is consistent with investing
the excessive liquidity of reserves in the domestic market while benefiting the country
via making the shifted capital flow in the vessel of domestic financial system.
The current account surplus can be divided into three parts: government budget
surplus, savings of state-owned enterprises (SOEs) over investment by SOEs and
savings of private companies over investment by the privates. According to the
Central Intelligence Agency (CIA) data, China has been running a budget surplus for
many years. In 2006, the tax revenue reaches $446.6 billion whereas expenditure
increased to $489.6 billion. The economic activities by SOEs have a negative
contribution to the current account due to the heavy investment in the domestic
infrastructure. Hence, it is the private economy that underlies the sustaining current
account surplus. Reducing this surplus, which can be done by lowering each of the
three components, is meaningful because it would fundamentally help release the
pressure on RMB’s revaluation. However, solely increasing the government
expenditure on the improvement of social welfare could not address this issue
efficiently and effectively. The reasons why the saving rate of China is such high is
that there are many major social aspects remain underdeveloped as the entire
economy prospers, including education, health care system, etc. For this reason, the
internal turbulence can be viewed as the source of external imbalance. Once the
savings started to turn down, the current account would adjust as well.
In a nutshell, the accelerated accumulation of foreign exchange reserves is a result of
both internal and external imbalances. External account balance is a natural reflection
47
of a country’s domestic economy, covering consumption, production, saving, and
investment. The paradoxical situation of depositing too much while borrowing
heavily from abroad is perceived to be the source of internal economic problem. The
coexistence of the laggard domestic financial system is another weakness when China
is on the path toward foreign exchange reform. To radically reduce the excessive
holding of reserves, all the above-mentioned issued have to be addressed in a gradual
manner in case of disruptive risks.
48
Part V
Management of Reserves
Eligible reserve management, which aims to adequately assist the major functions of
foreign reserves, is supposed to follow three principles: (i) be consistent with the
exchange rate policy features; (ii) balance the risk-return trade-off; and (iii)
circumvent market turbulences. As the world foreign exchange reserves increased
considerably in recent years, the style they are managed by central banks has evolved
over time as well. Generally, the main trend in central bank reserve management is
characterized by two common features: the use of a broader range of investment
instruments and the shift in currency composition of reserves, both of which are
confirmed by the evidence on investment of foreign reserves in U.S. assets. Individual
frameworks for foreign reserve management employed by monetary authorities,
however, vary vastly across countries. Against such background, this section reviews
developments and trends of foreign exchange reserve management of major reserve
accumulators, elaborating on various frameworks and methods undertaken by them in
order to empirically provide suggestions on how should China improve its foreign
asset management in an explicit way.
5.1 Diversification: From a Dollar Dominated Reserve to a
Diversified One
A report from European Central Bank outlined several factors that determine the
currency composition of foreign reserves 19 . The first explanatory factor is the
exchange rate regime adopted by the monetary authority. If a country is not
employing a pure floating exchange rate system, the currency composition of reserves
should be closely related to its choice of anchor currency or basket. A unique symbol
of Asia is that currencies of countries in this region, more or less, are linked to the US
dollar, due to the strong paired commercial relationships. This feature makes the
Asian accumulators position the US dollar as part of their strategic considerations
with respect to the foreign exchange policy, rather than a simple weight of reserves.
19
See “the Accumulation of Foreign Reserves”, Feb 2006.
49
Furthermore, with limited access to the international capital markets, developing
countries view foreign reserves as a cushion for paying for imports and ensuring the
servicing of external debt. Hence, the composition would to a large extent imitate the
trade and financial flows. In addition, it is observed that central banks have
increasingly taken into account optimal asset portfolio referring to risk management.
Finally, besides these factors, the “market neutrality principle” is required to be
followed prescribed by the IMF.
Given the de facto existence of substantial increase of foreign exchange reserves over
the past years, a trend toward a diversified composition of reserves is observed. As
mentioned by Eichengreen (1998, 2005), “the importance of depth, breadth and
stability of the financial markets, and the degree of international transactions have
always played a decisive role when determining reserve currencies”. However, the
dominant currency, currently the US dollar, as well as the composition itself, is not
expected to change rapidly since non-gradual changes will lead to market turmoil.
Table 7: Currency Composition of Official Foreign Exchange Reserves (COFER)
(In millions of U.S. dollars)
All countries
1999
2000
2001
2002
2003
2004
2005
2006
1,781,653
1,936,570
2,050,064
2,408,619
3,025,701
3,748,730
4,174,991
5,037,283
Total Claims
978,562 1,078,041 1,119,975 1,202,599 1,463,332 1,745,578 1,895,457 2,161,412
In U.S. dollars
55
56
55
50
48
47
45
43
% as of total
39,827
41,795
42,398
50,533
61,605
89,400
102,230
145,213
In pounds
2
2
2
2
2
2
2
3
% as of total
87,939
92,077
79,189
78,143
87,605
101,784
101,767
102,560
In Yen
5
5
4
3
3
3
2
2
% as of total
3,172
4,087
4,372
7,314
5,016
4,419
4,144
5,667
In Swiss francs
246,950
277,605
300,969
427,318
559,208
658,333
683,545
833,292
In Euros
14
14
15
18
18
18
16
17
% as of total
22,168
22,720
20,043
27,897
43,811
49,636
48,708
59,307
In others
1
1
1
1
1
1
1
1
% as of total
Data Source: IMF Statistics Department COFER database
The above table shows the annual changes in currency composition at an aggregate
level. Since the reserve data for individual countries are strictly confidential, IMF
grouped the reporting countries into three parts, all countries, industrial countries, and
developing countries20.
20
It is the countries’ own will to report their reserve information to the IMF. In fact, these shares account for
50
Table 8: Currency Composition of Official Foreign Exchange Reserves (COFER)
(In millions of U.S. dollars)
Industrial
1999
2000
2001
2002
2003
2004
2005
2006
countries
726,113 783,171 789,427 905,573 1,121,070 1,318,343 1,295,046 1,395,259
Total Claims
528,404 565,639 570,976 618,223
783,799
935,234
946,133
995,748
In U.S. dollars
73
72
72
68
70
71
73
71
% as of total
15,675
15,959
15,053
19,116
17,176
24,994
27,451
35,380
In Pounds
2
2
2
2
2
2
2
3
% as of total
47,993
49,371
43,445
38,847
42,677
46,850
44,197
49,063
In Yen
7
6
6
4
4
4
3
4
% as of total
512
1,934
2,422
5,253
2,713
1,739
1,775
2,972
In Swiss francs
0.07
0.25
0.31
0.58
0.24
0.13
0.14
0.21
In Euros
249,977
277,976
250,286
288,068
% as of total 117,761 134,353 143,849 205,786
16
17
18
23
22
21
19
21
In others
22,066
28,323
21,373
19,450
% as of total 10,957 13,148 12,574 16,017
1.51
1.68
1.59
1.77
1.97
2.15
1.65
1.39
Total Claims
Table 9: Currency Composition of Official Foreign Exchange Reserves (COFER)
(In millions of U.S. dollars)
Developing
1999
2000
2001
2002
2003
2004
2005
2006
Countries
1,055,540 1,153,399 1,260,637 1,503,046 1,904,631 2,430,387 2,879,946 3,642,024
Total Claims
450,158
512,402
548,999
584,376
679,533
810,345
949,324 1,165,664
In U.S. dollars
43
44
44
39
36
33
33
32
% as of total
24,152
25,836
27,345
31,417
44,429
64,406
74,779
109,833
In Pounds
2
2
2
2
2
3
3
3
% as of total
39,946
42,706
35,744
39,296
44,928
54,934
57,570
53,497
In Yen
4
4
3
3
2
2
2
1
% as of total
2,660
2,153
1,949
2,061
2,303
2,680
2,369
2,695
In Swiss francs
0.25
0.19
0.15
0.14
0.12
0.11
0.08
0.07
% as of total
129,190
143,252
157,120
221,532
309,231
380,358
433,259
545,223
In Euros
0.12
0.12
0.12
0.15
0.16
0.16
0.15
0.15
% as of total
11,211
9,573
7,469
11,880
21,745
21,313
27,335
39,857
In others
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
% as of total
As noticed earlier, world total foreign exchange reserves have been increasing
substantially after the Asian financial crisis. It is also noteworthy that the share of US
dollar in global reserves has been reduced over time, especially for developing
economies. Nevertheless, industrial countries have more confident in US dollar than
sampled developing countries in the light of reserve holdings. Another remarkable
approximately 70 % of reserve holdings, excluding important reserve accumulating countries. All industrial
countries report to COFER since 1999, while only 80-90 (out of 160) developing countries contribute to the
database.
51
change in the currency composition is the increased weight of euro as part of foreign
reserves. The absolute value of euro held by industrial countries is more than doubled
from 1999 to 2006, and for developing countries, this number have grown 4.2 times
during the period. Hence, when limiting the analysis to developing countries, the
small ratios of euro as percent of total reserves held are not negligible. The euro effect
is supported by the booming economy of the euro zone and its continuous
appreciation against other international currencies. Only Japanese yen, of other
currencies, appears to have been significantly reduced in the world currency
composition. This could be explained by the motive to avoid the reduction of absolute
value of total reserves since yen had been depreciating considerably21.
As regards the overall market aspects, changes in currency composition of reserves
will result in a higher volatility in the foreign exchange market and international bond
market. Specifically, given the large US current account deficit, the US dollar is
expected to fall and thereby inflict losses on reserves. Taking into account the
risk-return trade-off, central banks would actively managed to diversify out the US
dollar influence by exchanging for other major currencies.
IMF documented China as an extreme example that the constraints imposed on
foreign exchange by the Chinese government lead to significant home bias22. It is
argued that People’s bank of China prefers centrally process the accumulated foreign
assets as by doing so the country could obtain the same benefit of diversification.
Further diversification is perceived to add limited value to its current holding.
5.2 Trend in Composition of Instruments
The spectrum of asset class in which managers of national foreign exchange reserves
invest has been enlarged as well. McCauley and Fung (BIS, 2003a) summarize the
evolution of reserve manager’s choice of instruments. The first phase is the mid-1970s,
when monetary authorities started to pursue higher return by diversifying short-term
debts out of treasury bills at the cost of taking more credit risks. Later, in the second
phase, reserves rush to instruments with longer maturities, leaving central banks a
market risk bearing position. In the 1990s, the preference on long-term instruments
21
22
The real effective exchange rate of Japanese yen depreciated 28% from 2000 to 2006.
See IMF World Economic Outlook, 2005b.
52
became more popular as they are widely believed to offer higher returns while
keeping risks at a limited and acceptable level.
Due to the limited availability of disclosures on instrument composition of foreign
official investments denominated in US dollar assets23, we analyzed the trend with
data provided by “Treasury International Capital (henceforth TIC)” system from the
United States department of the treasury24.
Table 10: Foreign Portfolio Holdings of U.S. Securities—World Total
In million $
Total
Equity
Total LT Debt
Treasury
Agency
Corporate
Total ST Debt
Treasury
Agency
Corporate
2000
3,558,182
1,709,158
48.0
1,849,024
52.0
884,346
24.9
261,213
7.3
703,465
19.8
2002
4,338,049
1,395,402
32.2
2,530,517
58.3
908,058
20.9
492,416
11.4
1,130,043
26.0
412,130
9.5
231,960
5.3
88,084
2.0
92,087
2.1
2003
4,978,607
1,564,386
31.4
2,938,762
59.0
1,116,441
22.4
586,102
11.8
1,236,219
24.8
475,459
9.6
268,602
5.4
97,126
2.0
109,731
2.2
2004
6,019,234
1,930,499
32.1
3,500,524
58.2
1,426,046
23.7
619,412
10.3
1,455,066
24.2
588,212
9.8
316,920
5.3
123,798
2.1
147,493
2.5
2005
6,864,260
2,143,885
31.2
4,118,353
60.0
1,598,616
23.3
790,615
11.5
1,729,122
25.2
602,022
8.8
283,763
4.1
150,016
2.2
168,242
2.5
2006
7,777,565
2,429,517
31.2
4,732,607
60.8
1,726,953
22.2
984,476
12.7
2,021,178
26.0
615,441
7.9
253,187
3.3
146,991
1.9
215,263
2.8
Data Source: TIC System, Department of the Treasury, U.S.
Note: Shaded numbers denote percentage as of total holdings within the same column.
From the table above, we can detect that the world total foreign holdings of US
securities had been doubled from 2000 to 2006. Most noticeably, the proportion of
long-term debt in 2006 is 2.6 times more than the 2001 level, whereas the short-term
debt share only increased 1.5 times in five years. Obviously, as the world accumulate
more reserves, managers (including both reserve managers and non-reserve managers)
weight less on liquidity with extra money at hand and are willing to extend their
23
This is because the confidentiality issues. Hence, private and official investments are not separated, making our
conclusions cautious.
24
Other information sources, such as the IMF, the BIS, the Federal Reserve, and the Bureau of Economic Analysis
(BEA), also provide similar record but with different measurement.
53
investment horizon in exchange for higher return along the yield curve.
Meanwhile, the share of treasury declined at a moderate speed with respect to a
corresponding increase in securities of higher risks and returns. In detail, for
long-term debt, both agency25 and corporate bonds are on an uptrend, whereas for
short-term debt, only corporate issues are getting more attractive to global investors
over time. Clearly, fund managers have been shifting some of their secured
investment toward securities with higher credit risks so as to take additional yield
spread pick-ups. This is particularly true for long-term agency bonds, as it grows 3.8
times during the five-year period.
Table 11: Foreign Portfolio Holdings of U.S. Securities—Total of Top 10 Reserve Holders
(Excluding China)
In million $
Total
Equity
Total LT Debt
Treasury
Agency
Corporate
Total ST Debt
Treasury
Agency
Corporate
2000
775,826
262,854
33.9
512,972
66.1
382,052
49.2
89,566
11.5
41,350
5.3
2002
1,053,987
224,045
21.3
655,459
62.2
411,843
39.1
147,411
14.0
96,204
9.1
174,481
16.6
117,889
11.2
47,596
4.5
8,997
0.9
2003
1,302,203
269,327
20.7
824,659
63.3
532,550
40.9
186,845
14.3
105,262
8.1
208,216
16.0
147,637
11.3
47,971
3.7
12,606
1.0
2004
1,645,404
330,722
20.1
1,090,790
66.3
754,698
45.9
196,269
11.9
139,822
8.5
223,889
13.6
157,993
9.6
51,929
3.2
13,967
0.8
2005
1,818,129
371,026
20.4
1,220,752
67.1
802,121
44.1
258,417
14.2
160,212
8.8
226,351
12.4
135,363
7.4
76,485
4.2
14,503
0.8
2006
1,971,188
423,424
21.5
1,338,363
67.9
800,503
40.6
350,077
17.8
187,783
9.5
209,399
10.6
102,949
5.2
86,625
4.4
19,825
1.0
Data Source: TIC System, Department of the Treasury, U.S.
Note: Shaded numbers denote percentage as of total holdings within the same column.
Overall, comparing with the world aggregate data, changes of top reserve holding
countries in shares of investment in different asset class are magnified in the same
direction. The reason to exclude China from the sample is to eliminate the odd effect
on the result since China’s holding is much more than that of other countries. The
25
Agency bonds refer to securities issued by government-sponsored enterprises (GSEs).
54
total value of US securities held by the nine reserve accumulators raises up to 2.5
times, indicating that such countries enhanced the magnitude of investment in the US
dollar dominated securities while stockpiling more reserves. However, since the
built-up of reserves also increased by 2.57 times through the same period, it is not
sufficient by far to conclude that the U.S. financial markets are given more emphasis.
The sharp decrease of investment in the equity market from 2000 to 2002 is in line
with the decline of major U.S. stock indices26 at that time.
Likewise, the trend of debt market is consistent with that of the world data, whereas
apparently, economies with large reserves other than China prefer holding bonds to
putting money in the equity market. Another difference between the two groups is that
large reserve nations are more risk-aversion than the rest since they are holding more
share of treasury and agency bonds and less corporate securities. This fact confirms
that, to some extent, those accumulated reserves are the intended results of
government behaviors; otherwise, they would seek higher returns instead of merely
earn the interests once the supply of reserves far exceed the demand for them.
Table 12: Foreign Portfolio Holdings of U.S. Securities—China, Mainland
In million $
Total
Equity
Total LT Debt
Treasury
Agency
Corporate
Total ST Debt
Treasury
Agency
Corporate
2000
92,231
1,398
1.5
90,833
98.5
71,056
77.0
19,622
21.3
155
0.2
2002
181,478
4,034
2.2
164,704
90.8
95,200
52.5
58,607
32.3
10,898
6.0
12,740
7.0
1,257
0.7
11,275
6.2
207
0.1
2003
255,497
1,896
0.7
250,082
97.9
146,634
57.4
91,147
35.7
12,302
4.8
3,518
1.4
494
0.2
2,532
1.0
492
0.2
2004
340,972
2,523
0.7
320,287
93.9
189,181
55.5
114,903
33.7
16,203
4.8
18,163
5.3
5,029
1.5
12,854
3.8
279
0.1
2005
527,275
2,542
0.5
485,020
92.0
277,087
52.6
172,002
32.6
35,930
6.8
39,714
7.5
20,724
3.9
18,345
3.5
644
0.1
2006
698,929
3,818
0.5
677,944
97.0
364,065
52.1
255,386
36.5
58,494
8.4
17,167
2.5
8,170
1.2
8,492
1.2
505
0.1
26
The US equity market experienced a depression from January 2000 (DJIA 12,000 points) to March 2003 (DJIA
7400 points).
55
Data Source: TIC System, Department of the Treasury, U.S.
Note: Shaded numbers denote percentage as of total holdings within the same column.
The structure of China’s investment in the US financial market is significantly
different from other countries. Most conspicuously, more than 90 percent of the
country’s foreign assets are invested in U.S. long-term debt, particularly more than
half of those in treasury bonds and more than 30 percent in agency bonds. Such
figures reflect the strategic nature of China’s foreign reserves. Moreover, the low
volatility of proportion of various instruments as percent of total investment indicates
that there is no clear trend in direction of China’s actions.
Admittedly, conclusions based on the TIC data analysis should be cautiously used to
explain the trend in composition of instruments harnessed by reserve managers as it
not only fails to distinguish the public investors from the privates, particularly for
those industrial countries with a well-developed private sector, but also has little
implication on the portfolio changes caused by trend in foreign exchange reserves
management style. Furthermore, the reserve investment portfolio can be viewed as a
country’s top secret. Given the confidentiality problem, only a paralleled simulation
can be considered applicable. However, it is reasonable to assume that reserve
managers, to some extent, have similar risk preference as the world reserve level
grows dramatically. It is also reasonable to rely on the trend in investment in
long-term debt and agency securities to draw a conclusion on the trend in the use of
financial instruments, because as pointed earlier, reserve managers have been seeking
a higher return while keep a relative level of liquidity.
5.3 Different Foreign Reserve Management Frameworks
In connection to the colossal increase in foreign exchange reserves, Norges Bank,
representing the Ministry of Finance in Norway, established a Government Petroleum
Fund in 1990 to operate part of its reserves. Given the large volume of oil export27
and the roaring oil price, the Norwegians have been enjoying a current account
surplus since a decade ago. A major consideration of the establishment of the Fund
was the declining feature of long-run oil production and the high volatility of oil price.
It is their responsibility to save part of the assets for future generation consumption by
27
The petroleum sector accounts for approximately 18 per cent of GDP, but only 3.5 per cent of total employment.
56
separating the current needs from the total accumulated reserves. In doing so, the
excessive amount of holding was allocated to external fund manager, providing
short-term fiscal stabilization through the oil price cycle. In addition, the Fund enables
the government to channel its capital abroad and obtain higher return under
regulations. However, it is important to keep in mind that the Petroleum Fund is
nothing but an accounting technique. As quoted by Leif Eide28, “it provides an
instrument for better, long-term budget discipline in a situation with government
financial surpluses.” More importantly, macroeconomic developments would be
roughly the same regardless the internal transaction behavior under a sound economic
policy.
Russia, on January 1, 2004, established a Stabilization Fund, managed by the Ministry
of Finance of the Russian Federation pursuant to procedure defined by the
government. Similarly, it was formed as a tool to absorb excessive liquidity, reduce
inflation, and insulate the Russian economy in case of volatility of oil and gas export
earnings. As of September 2007, the size of the Fund was $132, 91 billion29, most of
which comes from the export duty for oil and tax on the oil mining operations. The
capital of the Fund could be drawn to fulfill federal budget needs and other fiscal
targets, most probably used for early foreign debt repayment 30 . Suggested by
President Vladimir Putin’s budget address of March 2007, the Stabilization Fund will
be split into a Reserve Fund and a National Welfare Fund, which are to be invested in
foreign low-yield securities and riskier ones respectively.
A common feature between the Norwegian and Russian frameworks is that those fund
managed assets are not account for reserve holding because they are not used for
foreign exchange intervention, even though they might appear on central banks’
balance sheets. More typically, some countries follow a more straight way in reserve
management. Singapore is among the first-movers of the use external reserve
managers. The Government of Singapore Investment Corporation (GIC) was
established by the Government of Singapore in 1981. Its major capital sources are the
accumulated budget surpluses and the Singapore Central Provident Fund (CPF), a
28
Executive Director of Bank of Norway, EMEAP (Executive Meeting of East Asia and Pacific Central Banks)
reserves management seminar, Singapore, Feb 1997.
29
Approximately 3409, 07 billion rubles
30
Russia is a debtor to the IMF and the countries-members of the Paris Club. Transactions in 2005 under this
account amount to $18.3 billion.
57
national pension scheme. Noticeably, the assets managed by GIC, currently over $100
billion, are not related to foreign reserves. Bank of Korea, likewise, transferred part of
its reserves to an external institution31, while remaining the right to withdraw them in
case of emergency. Allocating part of the reserves holdings to a separate institution
when actual reserves exceed liquidity demand can be seen as a portfolio approach,
aiming at achieving higher long-term returns. European Central Bank referred this
method as heritage fund.
Another alternative to utilize excessive reserves is to sponsor domestic economic
developments. For instance, in Taiwan, 15 billion US dollars has been allocated to
banks for use in major investment projects to foster economic growth.
5.4 Which way should China follow?
There are several options for China in exchange for a high yield on reserves. For
example, the excessive liquidity can be invested in securities with a high risk/return
feature. To follow this approach, the country should hire external managers, like
Norway’s approach, to manage the funds. Nonetheless, massive investment would
make China a creditor nation while importing capital from abroad. Another option is
to make use of the money to purchase other forms of overseas strategic assets, which
is consistent with China’s recent financial aid to the African countries.
Basically, no matter whether the de facto reserve holding of China is excessive or not,
according to the large US current account deficit, it is highly risky to keep the dollar
cash in hand. The newly announced pegging target of foreign exchange rate in July
2005 indicates that the dollar risk is to be controlled. The slow-paced appreciation of
RMB is not only a release of international pressure, but also a shift toward freely
floating regime.
Apparently, evidence shows that China has been taking steps to diversify its reserve
composition with a moderate mode. In December 2003, the Central Huijin Investment
Company Limited (CHI) was established by the Department of Finance with a
paid-in-capital of 45 billion US dollars. The primary objective was to operate the
country’s foreign exchange reserves in a more efficient way. The company injected
31
The Korea Investment Corporation (KIC), operation began on 1 July 2005.
58
most of its assets to China’s four major state-owned commercial banks 32 . In
September 2007, China Investment Company Limited (CIC) was founded and its
initial capital was approximately $200 billion. Before its establishment, an attempted
action was made to purchase $3 billion share of Blackstone Corporation, which is
perceived to be a purely commercial deal.
Theoretically, however, developing economies like China are not expected to execute
large capital export activities since domestic investment is supposed to be higher than
that of industrial countries. The recent economic history of capital-abundant Japan can
be taken as an example for reference.
It is argued that increasing the level of domestic investment by consuming reserves is
an alternative to revaluing the RMB, particularly for those capital-intensive projects.
Foreign direct investments could thus be replaced with the country’s national saving.
Nevertheless, the root of the upward pressure of RMB will not be eliminated but
purely increased in the long run because the trade surplus still exists and China has to
convert its assets dominated in foreign currencies into RMB when investing in the
domestic market. Therefore, although the management of foreign exchange reserves is
effective in reducing the opportunity cost of holding, a shift in economic policies with
a long run sight is required to accompany the proactive reserve-related actions.
32
From Dec 2003 to Aug 2005, CHI injected $22.5 billion to Bank of China, $20 billion to China Construction
Bank, 3 billion yuan to Bank of Communications, and $15 billion to Industrial and Commercial Bank of China.
59
Part VI
Concluding Comments
The unprecedented scale of foreign exchange reserves held by China and many other
emerging economies has triggered a debate on the management of these strategic
assets. However, most of the argument deals the transferability of individual’s money
demand to a country’s demand for reserves, the optimality of holding, the motives
behind the substantial accumulation of reserves in recent years, and so forth. Few of
these researches attempt to apply such theories to a specific region or country.
Moreover, most of the theoretical conclusion was drawn based on a model of small
open economy, albeit with some relaxation of assumptions. When applying to China,
such a growing, big, and centrally-planned player with a distinct economic structure
in the global economy, conventional analysis might fail to tackle the realities.
This paper deals with the questions of how much to hold and what to hold for reserves
by combining an empirical analysis of 42 developing economies with a peer of the
dynamics of China’s economic and policies in the past decade. The major conclusion
from the quantitative part is that China has been holding an excessive level of foreign
exchange reserves with respect to the behaviors of other less-developed countries. To
avoid the future potential costs incurred by the surplus of foreign reserves, a two-step
approach is suggested to be followed. In the long run, China has to adopt a series of
changes in its economic policies, including gradually moving toward free conversion
of the RMB, liberalization of the capital account, etc. The short term solution would
be allocating the excessive liquidity to the capital market to achieve higher returns.
As forecasted by Roger (1993), the management of foreign exchange reserves has
acquired increased prominence among the range of issues facing many central banks.
The basic focus is on the amount and form of reserves. Concerning on the amount, the
prevailing doing is to quantify a “comfort zone” level of reserves and invest the
excess part. However, measurement problem is the biggest challenge since the reserve
management is mainly the concern of monetary authorities of developing countries,
which have many structural restrictions that are hardly quantified. Thus, the static
comfort zone is usually not capable of tracking the dynamics driven by major
60
economic events.
The principal function of keep accumulating is foreign exchange reserves is to obtain
insurance and security which worth the cost as long as the demand is not fulfilled.
Some economists too, propose to turn over a portion of quasi reserves to institutional
investment authority. In this way, isolated from political influence, they can invest
money in higher risk/yield investments and domestic spending. Since the management
of foreign exchange reserves is a country-level issue, international institutions, e.g.
the IMF and the World Bank, should seek to provide better facilities in assisting
member country’s reserve management. Stiglitz (2002) brings forward a novel
concept of “Global Greenbacks” to issue a new form of global money instead of
holding reserves in dollars, giving an extension of the use of SDRs.
Referring to Rogoff’s saying ahead of this paper, it is never easy to draw conclusions
on reserve related issues. Also, it is neither necessary nor possible to answer the
question whether a country is holding foreign exchange reserves at an optimal level
with a precise number. The main concern should be focused on a range of benchmarks
rather than a certain value33. Admittedly, this paper did not use a range approach but a
series of residuals comparing with the world average level, which utilizes an
underlying assumption that such average level is an ideal pattern for each economy to
self-mirror with. Clearly, conclusions based on this argument should be seen as
cautious because sample countries have different backgrounds and distinctive
economic structure. And also, the various levels of foreign reserves might be
stemming from different policy targets. However, the difference between adequacy
and optimality is defined before the empirical analysis is performed. In line with
Grubel (1971), both economists and policy makers are facing problems to relate
interpreted past changes to projected future ones. Therefore, a more sophisticated
reserve management system, including monitoring ratios, signaling liquidity,
managing excessive reserves, should be developed with further research.
Frenkel (2004) mentions that each of fixed and flexible exchange rate regimes has its
own advantages and a country has the right to choose the regime best suited to its
situations. One indubitable argument is that the de facto dollar pegging system has
33
Department of Finance, Beijing Normal University, develops a novel reserve management system based on
demand factor analysis and signal lamp model.
61
somewhat become inappropriate for China, indicating a dramatic change of the
composition of its foreign exchange reserves in the future. As discussed earlier, given
the existence of internal imbalance, China’s economy is expected to experience
inflationary pressure, which can be eased by the revaluation of the RMB. In addition,
the appreciation would also help reduce the balance of payments surplus and thereby
lessen the amount of foreign reserves that is perceived to be fully adequate and
excessive. As the composition of China’s capital inflows changes, it becomes more
difficult and costly to sterilize the inward capital over time, deteriorating the inflation
problem. Experience of other emerging economies shows that China should bear in
mind that the timing of exiting the current rigid exchange rate system is crucial in
determining the risks associated with the changes of currency policy. It is better to
switch the peg to other hard currencies or become freely convertible when the
currency is strong, and vice versa. Despite political pressure, an intermediate
exchange rate regime is viewed as more appropriate by the academic world. The need
for a wilder flexibility of exchange rate does not necessarily imply a floating system.
A gradual course of action might be better for China in case of taking too much risk.
While maintaining the mercantilist strategy to pursue export-oriented development by
keeping the RMB undervalued, China has created an abnormal dual-surplus and
thereby accumulate a large volume of foreign exchange reserves. Only a turnaround
of economic policy could fundamentally and effectively decrease the growth rate of
reserves and finally reduce the aggregate amount to an adequate level. However,
given the hundreds of billion dollars excessive reserves in existence, the Chinese
monetary authorities ought to proactively manage the excessive portion to acquire
higher return. Experiences of other pioneering countries have shown that hiring
external managers to invest such fund is the prevailing choice. Therefore, China could
strive to utilize such reallocated strategic assets for better use, e.g. purchase of key
technology, financing domestic public projects, investing in the domestic education
and health care system.
62
Reference
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66
Appendix A: Stylized Facts about China
Billion $
1200
Reserves of Foreign Exchange
1000
800
600
400
200
0
Figure 20: Top 10 largest reserve holding countries
Data Source: The World Factbook, Dec, 2006
Total reserves in months of imports
16
14
12
10
8
6
4
2
0
Figure 21: China’s import coverage of reserves
67
Reserve to GDP ratio (%)
40
35
30
25
20
15
10
5
0
Figure 22: China’s holding of reserves relative to its economic scale
Net FDI (in billion $)
80
70
60
50
40
30
20
10
0
Figure 23: China’s yearly net FDI flows
68
40
35
30
25
20
15
10
5
Imports as percentage of GDP
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
Reserve to GDP ratio (%)
Figure 24: Relationship between China’s import and its reserves
M2 as % of GDP
160
140
120
100
80
60
40
20
0
Figure 25: China’s broad money relative to its economic scale
69
Appendix B: Selected Data
Data Source: WDI (World Development Indicators, published by the World Bank)
IFS (International Financial Statistics, published by the IMF)
Reserves: Total reserves minus gold (current $)
Import: Imports of goods and services (BOP, current $)
Variance: 10-year variance of current account balance
Debt: Total external debt (DOD, current $)
Propensity of Import: Imports of goods and services as percent of GDP
Sample Countries: 42 LCDs (Less-Developed Countries). Covered regions include
East Asia & Pacific, Europe & Central Asia, Latin America & Caribbean, Middle East
& North Africa; African developing countries which have too much risk of political
uncertainty are excluded from the pool.
List of 42 sample countries
Albania
China
Guatemala Jordan
Pakistan
Romania
Argentina Colombia
Haiti
Malaysia
Panama
Thailand
Barbados Costa Rica
Honduras
Mexico
Papua New Guinea Trinidad and Tobago
Bolivia
Dominican Republic
Hungary
Mongolia Paraguay
Tunisia
Brazil
Ecuador
India
Morocco
Turkey
Bulgaria
Egypt, Arab Rep.
Indonesia
Nicaragua Philippines
Uruguay
Chile
El Salvador
Jamaica
Oman
Venezuela, RB
Peru
Poland
Sample period: 1990-2005
70
Appendix C: Curvilinear trend test
Table 13: Test for Import: No Curve Significant
1990-2005 (655 obs)
1990-1996 (287 obs)
1998-2005 (325 obs)
Coefficient
P-Value
Coefficient
P-Value
Coefficient
P-Value
-15.543
2.049
-0.018
0.004
0.000
0.068
-20.744
2.490
-0.028
0.032
0.004
0.137
-7.150
1.371
-0.005
0.341
0.033
0.735
Constant
Import
Sq-ln(m)
Table 14: Test for Openness: Significant Curve Trend
1990-2005 (655 obs)
Coefficient
P-Value
1990-1996 (287 obs)
Coefficient
P-Value
1998-2005 (325 obs)
Coefficient
P-Value
Constant
32.405
0.000
30.229
0.000
39.876
0.000
ln(m/GDP)
-5.158
0.000
-4.202
0.004
-8.856
0.000
Sq-ln(m/GDP)
0.594
0.001
0.450
0.039
1.077
0.000
Table 15: Test for Variance of Current Account: No Curve Significant
Constant
ln(var)
Sq-ln(var)
1990-2005 (655 obs)
Coefficient
P-Value
7.980
0.201
0.147
0.630
0.005
0.209
1990-1996 (287 obs)
Coefficient
P-Value
-7.290
0.497
0.850
0.110
-0.004
0.587
1998-2005 (325 obs)
Coefficient
P-Value
19.169
0.011
-0.340
0.353
0.010
0.024
Table 16: Test for External Debt: Significant Scale Effect
Constant
ln(d)
Sq-ln(d)
1990-2005 (655 obs)
Coefficient
P-Value
26.937
0.000
-1.508
0.013
0.055
0.000
1990-1996 (287 obs)
Coefficient
P-Value
24.040
0.047
-1.306
0.215
0.051
0.026
1998-2005 (325 obs)
Coefficient
P-Value
29.265
0.001
-1.635
0.025
0.057
0.000
71
Appendix D: Structure Test with Quadratic Variables
Table 17: Test of Structural Change in Demand for Reserves with Quadric Variables
Constant
1990-2005 (655 obs)
Coefficient
P-Value
-9.57
0.076
1990-1996 (287 obs)
Coefficient
P-Value
-18.685
0.048
1998-2005 (325 obs)
Coefficient
P-Value
-0.596
0.928
m
1.028
0
1.028
0
0.904
0
m/GDP
-0.062
0.89
-0.207
0.736
-0.685
0.375
Sq-ln(m/GDP)
var
Debt
Sq-ln(d)
-0.028
0.083
0.43
-0.009
0.658
0
0.35
0.358
-0.001
0.103
1.183
-0.026
0.909
0.002
0.151
0.156
0.053
0.076
-0.028
0.002
0.62
0.003
0.96
0.873
72
Appendix E: Regression Output
Table 18: Estimation of the Parameters
Constant
P-value
Std
In(m)
P-value
Std
ln(var)
P-value
Std
ln(d)
P-value
Std
D(China)
P-value
Std
D(Dominican R)
P-value
Std
D(Mongolia)
P-value
Std
D(Pakistan)
P-value
Std
D(Panama)
P-value
Std
D(Ecuador)
P-value
Std
D(Haiti)
P-value
Std
D(China98-01)
P-value
Std
D(China02-05)
1998-2005
-4.1
0
0.517
0.76
0
0.058
0.1
0
0.024
0.193
0
0.054
1998-2005
-2.106
0
0.448
0.686
0
0.049
0.094
0
0.018
0.196
0
0.042
0.761
0
0.161
-1.467
0
0.15
-0.511
0.002
0.166
-0.625
0
0.148
-1.13
0
0.147
-1.123
0
0.149
-0.953
0
0.174
1998-2005
-3.449
0
0.539
0.696
0
6012
0.097
0
0.023
0.233
0
0.054
0.756
0
0.211
1998-2005
-3.423
0
0.54
0.692
0
0.06
0.098
0
0.024
0.235
0
0.054
0.607
0.031
0.28
0.916
73
P-value
Std
Adj R-square
No.obs
90.20%
326
94.50%
326
90.50%
326
0.002
0.288
90.50%
326
74