Testing times for China's foreign exchange reserves

Many experts say the country's huge investment in US treasury bills will run into trouble

China's forex exchange reserves, the largest in the world, reached a record $3.82 trillion (2.82 trillion euros) last year, almost twice as large as Japan's forex reserves, which are the second-largest in the world.

Since China's forex reserves started accumulating more than a decade ago, the increase has been widely regarded as an encouraging and beneficial development. With China gradually becoming the "world's factory" and enjoying an increasing trade surplus in the past decade, Chinese forex reserves ballooned.

During that period, the Chinese felt positive about growing reserves. However, now they are feeling more and more nervous about the situation. With the rolling out of the three stages of quantitative easing, the Chinese realized, with great disappointment, that the real value of their forex reserves had depreciated considerably due to US monetary policy, which is beyond the Chinese government's control.

To make matters worse, the US government's budget limit problem last October once again highlighted the possibility of a US default, which would not only affect its credit worthiness and the cost of US government financing, but also the value of China's reserves and the confidence of the country, which is the largest investor in US Treasury bills. Not only would China lose due to the reduced value of its investment in the US Treasury and related assets, but also it could be criticized for allowing the US government to maintain low interest rates and release unprecedentedly large amounts of liquidity into the global economy.

So what should China do to protect itself against the risk of a US default and devaluation?

As finance textbooks would preach in any investment context, to diversify is probably the most effective way to hedge against risks coming from a specific country or asset. Consequently, China should diversify its forex reserve assets. In fact, China has been trying to diversify those assets during the past few years. According to US Treasury statistics, US dollar-denominated assets make up about 49 percent of Chinese forex, down from 69 percent about three years ago. Clearly, Chinese forex reserve administrators have realized the risks associated with concentrated holdings in US dollar-denominated assets.

On the other hand, China has increased the proportion of US Treasury in its US dollar-denominated assets, primarily due to the heightened risk of exposure in US government agency securities from the subprime mortgage crisis. Nevertheless, given their relatively high correlation with the US T-bills in the grand scheme of things, such diversification within the US assets may not offer China a good enough hedge against fluctuations in US economic growth, the budget dilemma or a possible default.

This situation is closely tied to the crux of the problem that China's forex reserves face: the country intends to diversify its forex reserves into other sovereign treasuries or assets, but can find few alternatives to choose from. The European sovereign debt crisis has shaken investors' confidence in euro-dollar-denominated assets and Abenomics has cast doubts over the sustainability of Japan's government and fiscal situation. Ignoring the economic situation of these regions for a moment, one would find the market for such securities is small compared to that for US T-bills and agency securities. Given the massive size of China's forex reserves, withdrawing from such a market would have profound effects and would inevitably damage the value of China's reserves.

What is the solution? It may lie within China's borders. One very important function of a forex reserve is to serve as "ballast assets" that can be used to stabilize the value of a country's currency. Consequently, liquidity, immediacy and stability are crucial to forex reserve investments, and in this regard the US Treasury bills serve as a near-perfect choice.

However, many experts, including some Chinese central bank officials, believe that China's forex reserves are too large and a big chunk of them could be invested not for stability but for higher returns. If this is true, the real question becomes what the optimal size of China's forex reserves should be. Although China has been trying hard to diversify into non-US-denominated assets over the past few years, the ballooning size of its forex reserves increases rather than decreases China's exposure to risk, and that seems to be the cause of Chinese anxiety over US fiscal problems.

If this is indeed the problem, then China should deepen and expedite its financial reforms, letting market forces determine its domestic interest rate and international exchange rate. Once China stops its passive "sterilization" of the inflow of the US dollar into its forex reserves, China's forex reserve investment challenges - along with many other challenges, such as domestic inflation and high house prices - may be resolved once and for all.

The author is a faculty fellow at the International Center for Finance, Yale University; and deputy director of the Shanghai Advanced Institute of Finance, Shanghai Jiaotong University. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 01/24/2014 page11)