The recent currency bill passed by the US Senate has once again drawn attention to the Sino-US trade issue and the colossal foreign exchange reserves accumulated by the PBoC, China's central bank, as a result of years of Chinese surplus. Chinese FX reserves have increased by 17.2 times from 166 billion USD in 2000 to 3.2 trillion USD in September 2011, an annual growth rate of 29.5% from 2000 to 2010. The pile of reserve assets on PBoC’s balance sheet is impressive, but is it good policy for China keep such a high foreign reserve?
A large foreign reserve on central bank’s balance sheet is a double-edged sword. On the one hand, the large foreign reserve is a precautionary holding for surplus countries, especially for Asian countries, which learned from the cases of Korea, Indonesia and Thailand in the 1997 East Asian Crisis that running out of FX reserves amid market turmoil could have catastrophical effects, possibly culiminating in international intervention and austerity.
Though FX reserves are a precious resource in a crisis, China's colossal 3.2 trillion USD foreign reserve also carries significant costs. The first kind of cost is distortion. China’s PBoC and State Administration of Foreign Reserves (SAFE) require that all corporations and household exchange their FX holdings into RMB. This mandatory currency-exchange policy has led to the rapid growth of foreign reserves, and also significantly increased money supply as a side effect. FX reserves are exchanged into high-powered money directly which now accounts for 76.5% of M1 in 2011, in comparison with 28.5% ten years ago. The rapid increase in money base creates inflationary pressure in the Chinese economy.
Second, there are sterilization costs. The PBoC can issue bills to withdraw the liquidity generated by FX reserve accumulation. The difference between the interest the PBoC pays on its bills and the interest it receives on US Treasuries is the sterilization cost. The nominal cost for the central bank is negative. Rather, it is the commercial banks that bear most of the sterilization costs, and our next post will discuss this in detail.
There are also opportunity costs, incurred from two sources: The first is the opportunity cost of not investing in assets with higher yields. SAFE has invested around 1.3 trillion USD into US Treasuries, which could have been invested into assets with higher returns, such as equities. The second opportunity cost comes from the fact that FX reserves are a form of “constrained saving”. From a macro perspective, FX reserves are an asset class that the government deliberately allocates national savings into. Without the mandatory currency exchange policy, the private sector could have used the funds to invest elsewhere, probably generating a greater social benefit.
In conclusion, the FX reserves are a double-edged sword. With the world’s largest holdings of FX reserves, China should do the cost-benefit analysis carefully. Such a calculation would likely lead to a moderation in the pace of FX reserves accumulation.
Central Banking Seminar
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