Taking a Sensible Approach to the Changes in China's Foreign Exchange Reserves

By Pan Gongsheng, Deputy Governor of the People's Bank of China and Administrator of the State Administration of Foreign Exchange

Foreign exchange reserve is an objective indicator of the achievements in China's reform and opening-up and its development of foreign economy, and also the result of the functioning of the balance of payments. Since the 18th CPC National Congress, China's economic development has stepped into a new normal, with the balance of payments finding an equilibrium amid fluctuations, and foreign exchange reserves registering slower growth rather than high-speed growth as it previously did, and even falling in a certain period, which should be looked at and analyzed objectively and sensibly, rather than fretfully. Foreign exchange authorities are required to refine the foreign exchange administration system, and make use of the positive roles foreign exchange reserves play in serving the real economy and maintaining China's economic and financial security, in a bid to embrace the 19th CPC National Congress with excellent performance.

First, foreign exchange reserves change as a result of robust macroeconomic performance

In 1992 the reform target of building a socialist market economy was set at the 14th CPC National Congress; in 2001 we joined the WTO, which injected strong impetus for the fast development of China's economy and society. Since the outbreak of the global financial crisis in 2008, China has entered into a new normal of economic development along with the changes in environment and conditions internally and externally, and its foreign exchange reserves have declined from a high level after the long-term growth. But overall, China's foreign exchange reserves remain adequate and within a reasonable range.

China has taken the top spot worldwide for years for high foreign exchange reserves. Along with the establishment of the socialist market economic system and the deepening of the opening-up strategy, China has adapted to the holistic development trends of the world economy, and actively participated in the international division of labor and cooperation. In the midst of expanding opening-up, China has borne witness to rapid economic growth for consecutive years, fast expansion in foreign trade, use of foreign capital and outbound investments, and continued surpluses in the balance of payments. As a result, China's foreign exchange reserves hiked from USD 21.7 billion in the beginning of 1992 to a historical high of USD 3.99 trillion in June 2014. Statistics show that the top 10 countries/regions by foreign exchange reserves as at the end of March 2017 include China, Japan, Switzerland, Saudi Arabia, Taiwan, Hong Kong, Brazil, South Korea, India and Russia. To be specific, China's foreign exchange reserves accounted for 28% of the world's total, far higher than those of the rest of the world.

China's foreign exchange reserves are characterized by cyclical changes. Since the advent of this century, China has seen two stages in the changes of its foreign exchange reserves. In the first stage, which began in 2000 and ended in 2013, a tremendous amount of global capital flew into emerging economies and sent China's foreign exchange reserves surging, from USD 154.7 billion at the beginning of 2000 to USD 3.82 trillion in 2013, representing an annual increase of more than 26%. In the second stage that began in 2014, along with the outflows of global capital from emerging economies, China's foreign exchange reserves peaked in June 2014 and dropped afterwards.

China's foreign exchange reserves are adequate. However, there is no universal metric on how much foreign exchange reserve a country holds should be reasonable. In the 1950s to 1960s, the widest used metric for foreign exchange adequacy ratio was the import for 3-6 months. Later as the demand for foreign exchange reserves expanded to guarding against the inadequate debt servicing capability, the widest used metric for the adequacy ratio became the 100% short-term debt. Since 2011, the International Monetary Fund (IMF) proposed the comprehensive standard for foreign exchange adequacy ratio, based on the capital demand of every country for guarding against crises. Foreign exchange reserve is a continuous variable that dynamically changes under the impact of various factors, and therefore, in measuring whether foreign exchange reserves are at a reasonable level, the macroeconomic conditions, level of economic liberalization, capability of using foreign capital and international financing, and maturity of the economic and financial systems of a country should be taken into full consideration. In China, no matter which metric is adopted, its foreign exchange reserves are adequate and help satisfy the demand for economic and financial development.

Second, foreign exchange reserves are crucial to promoting China's economic development

Since the 18th CPC National Congress was held, Secretary-general Xi Jinping has proposed the thoughts of building a community of shared future for mankind, achieving mutual benefit and seeking common development in promoting opening up in all respects, based on his understanding of the current international trends of peace, development, cooperation and win win. Based on in-depth study and their understanding of Secretary-general Xi Jinping's new thoughts on opening up, foreign exchange authorities have been active in innovating and improving the foreign exchange reserve management system and utilization mechanism, and played a critical role in adjusting macro policy, serving the national strategy and maintaining financial security.

Foreign exchange reserves are key to ensuring the robust performance of China's macro-economy. For the moment, China adopts the well-organized floating foreign exchange rate system that is adjusted based on the supply-demand in the market with reference to a basket of currencies. As an important stabilizer of macroeconomic performance, foreign exchange reserves play a key role in maintaining the capability of international payment, guarding against financial risks, and withstanding the impact of crises. When the global liquidity is adequate, market participants will sell the redundant foreign exchange funds to promote the growth of foreign exchange reserves. When the global liquidity tightens, market participants will hold more foreign exchange assets and reduce overseas debt, leading to lower foreign exchange reserves. Foreign exchange reserves actually function like a reservoir that avoids significant inflows and outflows of cross-border capital and resulting deviation from the economic fundamentals, and makes room for economic restructuring and industrial transformation and upgrading. The adequate foreign exchange reserves also help China withstand the significant external impact from the Asian Financial Crisis of 1997 and the global financial crisis of 2008, safeguarding China's economic and financial security.

Foreign exchange reserves have effectively served the opening-up strategy. Secretary-general Xi Jinping stressed that opening up is a must at the new stage of development, with focus on cooperation and mutual benefit. Following the opening-up strategy, foreign exchange authorities have coordinated big pictures in China and the rest of the world, and expanded diversified use of foreign exchange reserves in the principle of "ensuring paid use of foreign exchange reserves with higher benefits and effective regulation in compliance with laws and regulations", providing significant amount of funds for the economic development of China and the world. In recent years, foreign exchange authorities have developed and expanded various channels such as entrusted loans and equity investment to provide foreign exchange funds to financial institutions and physical economic sectors such as commercial banks and policy banks, establishing the mechanism for use of foreign exchange reserves featuring clearly defined roles and responsibilities, definite goals, multiple tiers, and diverse products, with focus on supporting the Belt and Road Initiative, international production capacity and outfit manufacturing cooperation, enterprises going global, and imports and exports in key areas, so as to serve the development of the real economy. As the world economy is recovering slowly, and economic and trade globalization are faced with serious challenges, diversified use of foreign exchange reserves will be favorable for Chinese companies to effectively use the domestic and overseas markets and resources, facilitate the organic integration of China into the international community, and promote international cooperation in economic affairs.

Reasonable utilization of foreign exchange reserves has helped achieve the goal of "letting the public hold more foreign exchange". In the face of the demand of market participants for purchasing foreign exchange and their willingness to hold foreign exchange, foreign exchange authorities have deepened the foreign exchange administration reform, yielded policy dividends, and made exchange easier, which have boosted the endeavor to let the public hold more foreign exchange. As for the holders, China has diverse forms of outbound investors such as foreign exchange reserves, China Investment Corporation, social insurance funds, financial institutions and enterprises, indicating remarkable progress has been achieved in the diversification of foreign exchange holders. From the second quarter of 2014 to the end of 2016, foreign exchange reserves in China's International Investment Position fell by around USD 1 trillion, matching with residents' net foreign assets that rose by USD 0.9 trillion, which is a direct testimony to "letting the public hold more foreign exchange". For the private sector, the foreign exchange they held in the period was to fund ODI, servicing of foreign debt, travelling and studying abroad by domestic residents. For the government sector, as foreign exchange reserves on the asset side of the central bank drop, those on the liability side will fall accordingly, showing "letting the public hold more foreign exchange" does not displace the balance in the central bank's balance sheet that adopts the double-entry bookkeeping system. Horizontally, by the third quarter of 2016, China's foreign exchange reserves as a percentage of external assets are at a reasonable and medium level among major developing countries. Vertically, as at the end of 2016, the share of the external assets held by the private sector surpassed 50% for the first time, the highest level since China began to disseminate the data on international investment position in 2004; foreign exchange reserve assets accounted for 48%, down by nearly 20 percentage points from the level of the end of 2009. This shows that China's external economic and financial exchanges are shifting from the dominance of government investments to equal investments by the public and the private sectors.

It should be emphasized that China is not interested in strengthening competitiveness through currency depreciation, and does not need to do so. The central bank provides the market with foreign exchange liquidity, avoiding exchange rate overshooting and the herd effect, and safeguarding stability in the market. China's endeavor to strike a balance between enhancing exchange rate flexibility and maintaining exchange rate stability will be favorable for the international community, effectively avoiding the negative spillover effect due to the disorderly adjustment of the RMB exchange rate and the competitive depreciation among major currencies.

Third, effectively use foreign exchange reserves to serve the reform and opening up, and international cooperation in economic affairs

Reform and opening up is the necessary path towards national prosperity. Carrying out opening up in all respects is a key strategic step proposed by Secretary-general Xi Jinping at the new historical starting point. Foreign exchange authorities must develop the concepts of development that stress innovation, coordination, green, opening-up and sharing, with focus on accelerating the building of the new open economic system, and making full use of foreign exchange reserves' role in the construction of an open economy to make new contributions to realize the two centenary goals (namely, to complete the building of a moderately prosperous society in all respects when the Communist Party of China celebrates its centenary in 2021, and to turn China into a modern socialist country that is prosperous, strong, democratic, culturally advanced and harmonious when the People's Republic of China celebrates its centenary in 2049) and the Chinese dream of the great renewal of the Chinese nation and the prosperity and development of the world economy.

Foreign exchange reserves will be stabilized amid volatility. The economic and financial variables often fluctuate and develop in cycles, rather than taking the form of linear transformation. This holds true for the changes in foreign exchange reserves. Despite many uncertainties in external environment, China's economic and financial fundamentals will remain stable with strong momentum for growth in the long term, and cross-border capital flows will evolve towards an equilibrium. First, China's economy remains in the mid and high-speed growth range, and as the supply-side structural reform advances, the quality and efficiency of its economic development will be enhanced in the future. China's economic fundamentals will continue to ensure the stable position of the RMB in the global currency system, and the RMB exchange rate will remain stable at a reasonable and even level. Second, the external debt deleveraging has been basically completed and Chinese enterprises' use of external debt has rebounded since the second quarter of 2016. Third, the surplus under the current account in China has remained at the reasonable level. As anticipated by the IMF, China will continue to post surpluses under the current account in the coming five years, which will ensure the stable supply of foreign exchange in China. Fourth, as the RMB joins the SDR basket and the reform, opening-up and development of China's financial market are deepened, the RMB assets will become an important part of the global allocation of financial assets and attract foreign investors to invest in the Chinese market, and the foreign exchange under the financial account will be stably supplied. Fifth, the complementarity of currencies and asset prices in the international financial market, coupled with the diversified layout of China's foreign exchange reserves, will ensure sound diversification and be favorable for the stability of China's foreign exchange reserves. Overall, China's foreign exchange reserves will be stabilized in the midst of volatility going ahead.

Further efforts shall be made to optimize the role of foreign exchange reserves in stabilizing the balance of payments. The general work guideline of making progress while maintaining stability is an important principle of the CPC in state governance and a methodology for ensuring sound economic performance. Following the logic of stable macro policy, foreign exchange authorities shall go all out to ensure stable growth and provide a favorable external environment for the stable and healthy development of the economy, and for the stability and harmony of society. In the complex and changing economic and financial environments, internally or externally, foreign exchange reserves need to recover the basic feature of maintaining the stability of the balance of payments, which is a necessary requirement for settling major contradictions and problems in China's economic development and for ensuring robust macroeconomic performance.

The purpose of foreign exchange administration and utilization is to serve the economic development in China and the world, and therefore foreign exchange reserve administration and utilization shall be integrated into the big picture of the CPC and the state to align domestic development with opening up, and the domestic development with the world development, in a bid to promote common development. Following the work plans of the CPC and the State Council and the general work guideline of making progress while maintaining stability, foreign exchange authorities shall take up responsibilities and forceful measures to coordinate the diversified use of foreign exchange reserves, and invest its funds in the strategic areas that ensure the Belt and Road Initiative, international production capacity and outfit manufacturing cooperation, and to promote common development and prosperity between China and the rest of the world.

The operation and administration of China's foreign exchange reserves shall be enhanced. In the principle of safety, liquidity, value preservation and growth, efforts shall be made to conduct prudent, standardized and professional investment and operation with regard to foreign exchange reserves, optimize and dynamically adjust investment portfolios and strategies, and show respect for rules and practices in international markets so as to maintain and promote the stability and development of the international financial market.

(The original text is available in the 13th issue of Qiushi Journal for 2017.)