China in Transition

China's Rising Foreign Exchange Reserves:
A symptom of misallocation of funds

Chi Hung KWAN
Consulting Fellow, RIETI

The rising trend of China's foreign exchange reserves is continuing, coming to $316 billion as of the end of March. However, as I have repeatedly stressed in this column, this may lead to an inefficient use of China's national savings. The rationality behind letting savings - a precious resource for a developing country such as China - flow to industrialized nations with abundant funds is especially questionable. My view, that it is not necessarily beneficial for China to have more foreign exchange reserves, was flatly refuted by Qiu Xiaohua, deputy director of China's National Bureau of Statistics (China Busisiness Times, December 16, 2002), and more recently by Li Yang, a member of the Monetary Policy Committee of the People's Bank of China (Zhongguo Xinwen Zhoukan - China Newsweek, May 9, 2003).

Mr. Li, especially, argues that China does not suffer from a shortage of funds. As the basis for this argument, he points to the fact that deposits greatly exceed lending in the banking sector and that domestic money is flowing overseas in search of higher interest rates. Furthermore, he says that although China's foreign exchange reserves are invested in foreign bonds, which are safe assets with low risk, the return on those investments last year was 5 percent, and that such good investment opportunities are hard to find in China.

However, the grounds for Mr. Li's argument only show that China's savings are not being utilized efficiently, and are not an indication that there is an excess of funds. As noted Chinese economist Fan Gang points out, capital stock in China on a per capita basis is but a scant 3.65 percent that of the United States, and the only reason the return on investments are nevertheless higher in the U.S. than in China is because China's savings have largely been misallocated to inefficient state-owned industries (note). Lending to state-owned industries is also the root cause of the banks' non-performing loan problem, so it may be argued that it is better to invest in U.S. Treasury securities. However, there are an abundance of private enterprises in China that are more profitable investments than U.S. Treasury securities. Unfortunately, private firms in China face discrimination both in terms of receiving loans from banks and procuring funds through capital markets, and such fund demand is not sufficiently realized.

In contrast, multinational corporations the world over are racing to enter the Chinese market, and are actively trying to grasp the investment opportunities that come with China's growth. At the same time, there is a frequent flight of capital from China, such as the illegal money amassed by bureaucrats. On top of this, public funds also flow out of the country as foreign reserves are invested in foreign assets. As this shows, Chinese savings are being lent to other countries at low interest, while this money comes back to China in the form of direct investment by foreign companies and generates high profits.

Furthermore, there is no guarantee whatsoever that returns on foreign exchange reserve investments will continue to be high just because they have been so in the past. At first glance, it may seem that Chinese authorities have done well in securing returns of 5 percent when the yield on the 10-year U.S. Treasury bond last year was 4.6 percent, and that on the 3-month bill was 1.6 percent. However, this is more thanks to luck, in that exchange rates and interest rates shifted in China's favor, than the result of good fund management. In other words, because China's foreign exchange reserves are invested in major currencies like the euro and the yen as well as the U.S. dollar, if, as was the case last year, the euro and yen rise against the dollar, returns increase when evaluated in dollar terms. For example, if 20 percent of foreign exchange reserves are held in euros, a 10 percent appreciation of the euro raises returns of the foreign reserve investments by 2 percentage points. In addition, the global decline in interest rates is also a factor that pushes up the returns on bonds, which China is investing in. However, Chinese authorities should also be prepared to see the returns on their investments fall should the dollar strengthen and interest rates rise, leading to appraisal losses.

It is not at all beneficial for China to continue to lend the precious savings of its people to inefficient state-owned firms via banks, or extend them at low interest to industrialized countries, such as the U.S., through capital flight and foreign reserve investments. For savings to be efficiently used, and to make better use of the vitality of private companies, authorities must improve the efficiency of domestic investment by beefing up the intermediary functions of the financial sector, focusing on the four major state-owned banks.

June 6, 2003
  1. Quoted from China Business Times (in Chinese), January 30, 2003.
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June 6, 2003