China in Transition

The More Foreign Exchange Reserves the Better?

Chi Hung KWAN
Consulting Fellow, RIETI

China's foreign exchange reserves have increased sharply in recent years. In 2002 alone, they grew by $74.2 billion to reach $286.4 billion at the end of the year. The former figure is equivalent to 6% of China's GDP, while the latter amounts to a year's worth of the nation's imports. In June last year, I wrote in this column that China's foreign exchange reserves had already exceeded their optimal level. This view was reported by the Chinese media and aroused a lot of interest, but there were quite a few who were critical of my argument. The authorities, in particular, have stuck to their longstanding position that "the more foreign exchange reserves, the better."

Qiu Xiaohua, deputy director of China's National Bureau of Statistics explained the official view as follows (China Business Times, Dec. 16, 2002). First, foreign exchange reserves are necessary as a defense against currency speculation, and serve as funds for economic reforms. Second, abundant foreign reserves are a necessary condition for promoting the use of the yuan as an international currency. Furthermore, China's foreign exchange reserves are not excessively large when compared with those of Japan that amount to over $400 billion. Yet, such thinking can lead one in the wrong direction, and need to be corrected.

Let me first say that I have no objection to the argument that foreign exchange reserves are necessary as a measure to maintain currency stability. But it should be recognized that a high cost accompanies the holding of foreign exchange reserves. As a developing country, China is charged high interest rates as a risk premium when it procures funds from overseas. But if it invests its foreign exchange reserves in US Treasury bonds, it can only gain low returns. This negative spread in interest rates means that income is transferred from China, a poor country, to the United States, a rich nation.

Foreign exchange reserves, just like domestic infrastructure and production facilities, are part of national assets, and their main source of funding is domestic savings. Given a country's total assets, the best portfolio should be decided by balancing return and risk, and it is not necessarily true that it is better to have more foreign exchange reserves (Note). In fact, the savings of the Chinese public have not been utilized efficiently, as can be seen in the fact that while low-return foreign exchange reserves are increasing, China's national project to develop the western part of the country faces a funding shortfall. Funds to push forward with reforms can also be financed by taxes and government bond issues, and there is no need whatsoever to rely solely on foreign exchange reserves.

The argument that foreign exchange reserves need to be increased for the yuan's internationalization is putting the cart before the horse. The biggest aim of having one's currency used internationally is to reap seigniorage (the difference between the value of money and the cost of its production). For example, the United States can procure funds at low interest (or no interest, in the case of dollar notes) on the basis of its creditworthiness alone by issuing dollar notes and treasury bills, which have a high degree of liquidity.

But in a case like China's, where trust in the currency must be gained through the possession of a large amount of foreign exchange reserves, the cost of the endeavor completely offsets the benefits of issuing the currency, and there is no merit whatsoever of the yuan's internationalization. Furthermore, under the current circumstances in which China's banking sector is still weak, as symbolized by the problem of non-performing loans, caution is needed when proceeding with the liberalization of capital account transactions that is a precondition for the yuan's internationalization, not to mention the currency's internationalization itself. If not, it will only heighten the risk of a financial crisis. The recent sharp growth in foreign exchange reserves is already aggravating the real estate bubble by pushing up property prices through the increase in money supply.

Moreover, as economic circumstances in Japan and China are different, it is meaningless to simply compare the two. First, while Japan's foreign exchange reserves do exceed those of China in absolute terms, they are only about 10% of its GDP, a far cry from China's 25%. Also, interest rates in Japan are much lower than those in the U.S., and so U.S. Treasuries are not necessarily a bad investment for Japan. This contrasts with China, whose capital stock is still small so that the marginal productivity of investment is high. Furthermore, the Japanese economy is suffering from a lack of domestic demand, and authorities need to shore up the economy by expanding external demand and must stem the yen's rise by intervening in currency markets. In contrast, both China's economy and exports are doing so well that it looks like it has become the "sole winner" in the global economy.

The idea that it is better for a nation to hold a large amount of foreign exchange reserves is based on mercantilism, under which the amount of foreign reserves held is considered an important indicator of a country's strength. But as we can see from the fact that the U.S., as a superpower, does not have a huge amount of foreign reserves, it is clear that there is no clearcut relationship between foreign exchange reserves and national power. The goal China should pursue is the betterment of the lives of its people, and this can only be achieved through institutional reforms and by investing in domestic human capital and physical capital such as production facilities and infrastructure. The government should stop lending the precious savings of its people to the U.S. government at low interest and instead use it more efficiently to develop its economy.

February 14, 2003
  1. Individuals, or households, can hold assets in highly liquid forms such as cash and deposits, and also diversify their investments into other assets that involve high risk but also offer high returns. As a matter of fact, people who are really rich hold more stocks and real estate than cash.
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February 14, 2003