Foreign exchange reserves exceed the optimal level
“In all circumstances (no matter how serious the impact will be), foreign exchange reserves of USD 3.7 trillion are enough”
Caixin: China saw its foreign exchange reserves reach approximately USD 3.7 trillion at the end of the third quarter. Is this beyond the optimal level?
Yi Gang: Yes, I think so. There are those who are preparing for events that will be even more disastrous than the 1997 Asian financial crisis and the collapse of Lehman Brothers. But in my opinion, the USD 3.7 trillion in foreign exchange reserves is enough for any scenario.
Massive foreign exchange reserves can reflect China’s strong national power, improve confidence, and deter speculators from assaulting China. With these benefits, massive foreign exchange reserves offer guarantees for financial and economic security.
But the reserves need to be capped. Too much reserves will lead to fewer benefits and higher costs. It will not be cost-effective if the foreign exchange reserves exceed an equilibrium that lies between the marginal cost and the marginal benefits curves.
The marginal costs include the heavy pressures on resources and the environment imposed by the vast exports and the interest paid by the central bank to hedge against the excess liquidity that results as it acquires US dollars and increases the monetary base. Further, it is not an optimal choice if the central bank intervenes in the market; instead it is the market that should play a decisive role.
Caixin: Where does China sit on the curve now?
YG: For sure, China has exceeded the intersection of the two curves. But it is still uncertain how far it is from that equilibrium point.
What is the optimal level for foreign exchange reserves? Some say the reserves should be large enough to address several months’ needs for payments for imports, or to account for a certain part of the external debt, or they should be measured by the trade volume, investment volume, or even by stress tests that are designed to measure the volume of foreign exchange reserves required in cases of the most serious assaults. Passing all these measurements indicates that our foreign exchange reserves are already high enough.
Caixin: What are your ideas about diversifying foreign exchange reserves investments? Hasn’t there been talk about launching several funds for this purpose?
YG: Everyone is welcome to make suggestions regarding foreign exchange reserves investments but the suggestions must be conducive to sustainable development and beneficial for the nation and its people. The adoption of suggestions will depend on their performance.
Foreign exchange reserves that the central bank bought through market interventions correspond to the bank's liabilities on the balance sheet. These assets must be managed well or there will be grave macroeconomic consequences. So suggestions are encouraged and appreciated. The establishment of the China Investment Corp. (CIC), for example, proved to be a good solution. Thereafter, the China Reform Holdings Corp., dubbed CIC II, was also set up. Both firms have their own unique characteristics. Investments by the SAFE using foreign exchange reserves have also proved fruitful. These investments can be compared across the board.
In general, assets should match liabilities, which should be the case also for rights and obligations. We cannot have the kind of power that comes with no obligations. This means that if we are to manage an asset, we must take responsibility. If performance is poor, many would challenge any further adoption of such an approach. Given the fact that a relatively long period is needed to prove the results and the asset quality of an investment, assets should not be quickly transferred, otherwise it will be difficult to know which investments are fruitful. Therefore, efforts should be made at the institutional level to make sure assets are matched with liabilities and rights are matched with obligations, encouraging full incentives and proper competition.
Any further advice will be deeply appreciated provided it clearly states the responsibilities. But please make sure the mechanism and the tactics have the ability to yield good results.
The only solution is to pursue balanced international payments
"The market plays a decisive role in balancing international payments. In addition, the RMB exchange rate also matters—international payments will automatically be balanced when the RMB exchange rate reaches an equilibrium"
Caixin: How can we curb the further growth of the foreign exchange reserves? It seems that the reserves are still growing, which is partially due to the decision of the Fed to delay the QE tapering.
YG: The only solution is to achieve an equilibrium for international payments, with more spending on imports, travel, and services, as well as more outbound investments. As international payments become more balanced, the foreign exchange reserves will stop growing. This is the simplest solution.
Caixin: What did you mean when you said at a SAFE meeting, in conveying the spirit of the Third Plenary Session of the 18th CPC Central Committee, that China should "accelerate development of a market-based mechanism and institutions that promote an equilibrium in the balance of international payments?"
YG: Policy-wise, we can put more emphasis on the importance of imports to promote a balance of international payments. In fact, imports can create a lot of jobs and imports of key raw materials and energy resources are critically important to China.
Many imported commodities in the past that were in high demand by the middle classes were mistaken as luxuries and these imports were discouraged. Currently, as income is increasing rapidly, a large middle-income group has emerged. What they need, for instance, is imported commodities like apparel, notebooks, and cosmetics. It is necessary that we attach priority to these imports in terms of taxes and distribution channels, with the aim of bridging the wide pricing gaps. The pricing gaps between the domestic market and foreign markets can only be narrowed after the distribution channels are liberalized and tariffs are properly adjusted. Some people blame the pricing gaps with foreign brands that intentionally jack up prices in China. This is a bit absurd. But I believe that slightly higher prices are acceptable provided there is enough competition.
Caixin: The year 2012 witnessed a substitution of the capital and financial account deficit and the current account surplus for the double surpluses in China's balance of payments that began in 1999, indicating that the balance of payments has finally started to move in a self-regulating and self-balancing direction. But why did the double surpluses reappear this year?
YG: On the one hand, they are associated with cross-border capital flows. Most developed countries have been pursuing loose monetary policies, putting tremendous pressures on China. The United States, for example, has introduced a quantitative easing (QE) policy.
On the other hand, China's surplus in trade in goods is higher than it was last year, and it has exceeded USD 200 billion over the past 10 months. In addition, expectations of yuan trends among individuals and firms on the Mainland and in Hong Kong are important factors. Taking these factors into consideration, this year we are facing relatively stronger pressures from capital inflows.
Caixin: Abnormal cross-border capital flows have risen recently, resulting in increased volatility, especially in terms of the capital and financial account. How can we strengthen our ability to monitor and analyze cross-border capital flows and improve the early-warning system?
YG: The State Administration of Foreign Exchange (SAFE) has in place a comprehensive response plan that will be triggered when capital inflows reach a certain threshold. Rather than being tabled, this plan has been initiated three times and since its introduction in 2010 it has proven to be efficient.
In my opinion, administrative controls over capital flows usually have limited and temporary effects. A new measure to regulate capital flows usually proves to be very effective within the first three months but it becomes less effective later on as people discover countermeasures, in the same way that a virus becomes resistant to drugs.
The ultimate solution, as highlighted at the Third Plenary Session of the 18th CPC Central Committee, is to have the market play a decisive role in allocating resources, that is, leaving the market to play a decisive role in balancing international payments. In addition, the RMB exchange rate also matters—international payments will automatically be balanced when the RMB exchange rate reaches an equilibrium.
The market-based mechanism for setting the yuan exchange rate should be improved.
“In my opinion, the exchange rate is very close to an equilibrium level. But I hope that the mechanism will be more flexible and resilient"
Caixin: The Decision on Major Issues Concerning Comprehensively Deepening the Reforms (hereafter “the Decision”), deliberated and approved at the Third Plenary Session of the 18th CPC Central Committee, highlights that China will improve its market-based exchange-rate formation mechanisms for the yuan. What is your interpretation of this?
YG: Above all, a market-based exchange-rate formation mechanism for the yuan means that the RMB exchange rate will be decided by market supply and demand, which is the fundamental feature of the mechanism.
From this, there are three key takeaways. First, develop markets, making market access and market transactions more convenient by requiring fewer administrative approvals, and developing hedging products according to market demand. As there is still a long way to go in terms of deepening the foreign exchange market with more diversified products in China, it is necessary to develop the market. Second, increase the flexibility of the RMB exchange rate and allow it to fluctuate in both directions. The volatility range for the RMB exchange rate against the USD can be expanded as at present it is the narrowest of all major currencies, whereas interest rates in China are high, leading to almost no costs for conducting interest arbitrage. An expanded range of volatility can push up the costs of interest arbitrage but will not have a serious impact on companies. Third, it is hoped that the RMB exchange rate will remain stable at an equilibrium level and will not, as was the case in the past, be fixed based only on the USD.
These three key takeaways indicate our future work priorities. Put simply, China will continue to follow the marketization path while remaining stable.
Caixin: You said common people will benefit from a stronger yuan. But many exporters suffer when the yuan appreciates. How do you account for the yuan's highs and lows over the past years?
YG: The impact of the RMB exchange rate over the past few years needs to be viewed holistically. We know RMB appreciations hurt exporters. Now there has been talk about the yuan "being forced to appreciate" and that will have a very negative impact. But we also need to see the other side, that is, the benefits of a more market-based RMB exchange rate. First, China's economic strength has improved significantly, with last year’s GDP exceeding USD 8 trillion. Second, there are material benefits for the general public. Last year, for example, China imported more than 58 million tons of soybeans, more than 270 million tons of oil, and more than 700 million tons of iron ore. Had the yuan not appreciated, the soybean oil and bean pulp used for animal fodder would have been much more expensive. The more than 80 million people traveling abroad and those studying overseas could do so at lower costs.
Why do so many people criticize an RMB appreciation? Because export companies speak with loud voices, while common people and those who benefit indirectly are the silent majority.
But an RMB appreciation needs to be capped. I do not wish to see the yuan appreciate more than it should; an appropriate, balanced, and largely stable level is preferable. An important criterion for assessing whether an exchange rate is appropriate is the balance of international payments. As the balance of international payments reaches an equilibrium, the exchange rate will also be balanced.
Overall, the RMB exchange rate has been stable. According to the Bank for International Settlements, from 2000 to 2013 the RMB exchange rate against a basket of 52 currencies rose 17.3 percent and 21.9 percent in terms of the nominal effective exchange rate and the real effective exchange rate respectively. This was an average appreciation of more than 1 percent every year. This is absolutely in line with improvements in
Caixin: What do you think of the trends in the RMB exchange rate? Will the yuan continue to appreciate?
YG: In my opinion, the exchange rate is now very close to an equilibrium level. But I hope the mechanism can be more flexible and resilient.
Caixin: Does the reform aim to allow the yuan to freely float? Is a sound exchange-rate formation system the same as a free-floating exchange rate?
YG: It would be free-floating in most cases. The Third Plenary Session of the 14th CPC Central Committee set the goal of gradually making the yuan convertible. Basically, that means making it a free-floating currency as determined by the market. But this is not mutually exclusive with demands for the central bank to take actions that comply with and respect market rules in cases when a crisis or a special event might occur. In other words, free-floating does not mean the central bank cannot intervene under any circumstances. Getting this straight may dispel the concerns of most people.
Caixin: How far are we from free-floating?
YG: We are now very close to a free-floating level. In 2012, for example, most of the time the central bank did not intervene in the market.
Caixin: Even when we have a free-floating exchange rate in the future, will it be easy for the central bank to intervene in the market?
YG: Any intervention will have to be rule-based. That means the personal judgment of any official cannot be used to justify an intervention. There needs to be a certain set of rules that clearly states the preconditions, means, and extent of any intervention, with clear terms and conditions in place so that power remains in a transparent cage. Rule-based intervention stresses the role of the market in orientation and decision making, with the aim of improving market transparency and boosting market confidence. It is hoped that the market can be simple, ruled by law and fully competitive, with clear regulations and transparent information.
Caixin: Is the timing of the reform also a concern?
YG: There is indeed an argument for this. But if public opinion and ideas do not change, all that work will have been for nothing. Even if we pick the best time, things will change. In 2008, for example, when we hosted the Olympics, an appreciation [of the RMB] was put on hold for a year and a half because of public pressures—many people considered the Olympics a top priority and did not want anything to go wrong. In the future, however, will an RMB appreciation be put on hold again if there is to be another Lehman Brothers crisis or if exports weaken? In fact, weak exports are more of a reason not to stop a RMB appreciation because the yuan will depreciate when exports are weak. Exports will soon see a turnaround due to a depreciation of the yuan.
Whenever something unexpected occurs, people's first reaction has always been to call for suspending the RMB exchange-rate reform. This is not a problem regarding determination to reform but a problem of philosophy. It is very difficult to guide public opinion as by habit everyone always thinks exchange-rate flotation needs to be suspended whenever something uncalled for occurs.
Caixin: Making the yuan float freely is a step-by-step process. Is it possible to first allow that to occur in the Shanghai Free Trade Zone (FTZ)?
YG: Many people think in this same way. I think that in theory this assumption is flawed as China is but one market. If the Shanghai FTZ's policy has the front line open but the second line is under control, the assumption may work. But if it has the front line open and the second line is under control throughout the country, it would make the FTZ an offshore market with no direct connection to the mainland market. This makes no sense for the Shanghai FTZ, since we already have Hong Kong as an offshore market. If we cannot have the second line under control, we cannot make such an assumption work in the Shanghai FTZ, as capital moves freely between the FTZ and the rest of the mainland. This means the market in the entire country is free. This is where it becomes difficult.
Orderly capital account convertibility
"Capital account convertibility is designed to further protect and expand people's property rights"
Caixin: The Third Plenary Session of the 18thCPC Central Committee highlighted that capital account convertibility should be accelerated. What is the next step?
YG: Capital account convertibility was elaborated upon in the Decision. There was one sentence on interest rates and RMB exchange rates, but an entire paragraph on capital account convertibility. It reads: "Push ahead a two-way opening of the capital market, increase the convertibility of cross-border capital and financial transactions in an orderly way, build and fine-tune a system to manage foreign debts and capital flows under the framework of macro-prudential management, and accelerate capital account convertibility for the Renminbi." This shows how much significance the CPC Central Committee has attached to capital account convertibility.
China achieved current account convertibility in 1996 and joined the WTO (the World Trade Organization) in 2001. These two events made China a major trade power—the world's largest exporter and the world’s second-largest importer. These are the changes that current account convertibility has brought to China.
In fact, capital account convertibility is designed to further protect and expand people's property rights. For instance, under the planned economy urban residents were not allowed to buy housing. Later it became their right to choose whether or not to buy a home. This change protects their property rights and expands their rights to choose. In addition, in the past it was difficult for people to travel abroad for personal affairs, but now overseas tourism has become very convenient and part of their rights. The allocation of assets both at home and abroad has become an economic agent's right, while making the capital account convertible recognizes and expands such a right.
Efforts shall be made to drive capital account convertibility. The two-way opening of the capital market will make China an overseas investment power as well as a major destination for overseas investments. This definitely will be good for China.
Caixin: But many worry about outflows of capital and external shocks. How do you respond to this?
YG: Some worry that if we open up, capital will flee and China's stock market will crash. In fact, once we liberalize the market, a lot of capital will vie to come in. Another worry is that an open capital account will leave
The biggest worry is that many people interpret convertibility as an open door for hot money to freely flow in and out of China. That's unnecessary. This worry has been addressed in the Decision, which states that "efforts need to be made to create and fine-tune a system to manage foreign debts and capital flows under the framework of macro-prudential management.” In fact, we have already achieved a lot of progress toward this goal. China's system for balance-of- payments statistics is the most advanced in the world. While other countries base their statistics on sample payments, China counts each and every payment.
Caixin: Does capital account convertibility mean no control?
YG: A macro-prudential management framework must conform to the laws and market rules. Within these boundaries, capital can flow freely. What is macro-prudential management? It means you have a clear idea about capital inflows and outflows, understanding previous cases such as George Soros' attack on the British pound or on the Thai currency. Analyzing these cases, you should understand what has happened in the market and what kind of rules can be created to protect most investors and prevent cut-throat competition. This is the core philosophy of macro-prudential management. In addition, mechanisms for anti-money laundering, anti-terrorism financing, and anti-tax havens will be maintained. An IMF working paper once reported that imposing temporary controls on some capital accounts is possible under some special circumstances.
Caixin: Can the pilot program for capital account convertibility come into force immediately in the Shanghai FTZ? Is the scheme almost completed?
YG: Yes, the scheme is almost finished. The Shanghai FTZ will see a lot of progress in this regard, and some substantial and experimental steps will be taken. As it has been said, there are still major questions about the connections between the Shanghai FTZ and the rest of the Chinese market.
Caixin: The Decision highlights that efforts should be made to push ahead with a two-way opening of the capital market. Has any progress been achieved in the Qualified Domestic Individual Investors (QDII2) program?
YG: The scheme is being developed.
Being prudential at the macro level to prevent risks
"In this way, economic and financial security can be ensured and firms and individuals can enjoy maximum freedoms and conveniences. Those are the desirable outcomes of regulation"
Caixin: The State Administration of Foreign Exchange (SAFE) has launched measures to manage the banks’ synthetic position in foreign exchange settlements and sales, linking the limits of the consolidated position floors for foreign exchange settlements and sales to the foreign exchange loan-deposit ratio as a tool for macro-prudential management. Can you elaborate on the content and policy tools for macro-prudential management?
YG: In macro-prudential management, one should be prudent and watch out for risks. Take a maturity mismatch for example. If many firms focus on short-term growth, they will be warned. If they focus too heavily on short-term growth and market liquidity is reversed, they will be at risk. A currency mismatch is also something to watch out for. If the exchange rate changes drastically, there will be damage to a sound balance sheet.
Linking the banks' consolidated positions to foreign exchange loans, which was initiated in May, is a typical macro-prudential management approach, as foreign exchange loans involve the source of capital for foreign currency loans and matching the loan terms with currencies. When maturity and currency mismatches reach certain thresholds, limitations should be imposed on banks. The minimum requirement to avoid a currency mismatch is to require banks to sustain consolidated positions, while coupling their consolidated positions with loans to achieve balanced development and to make sure maturities and currencies are well matched.
Caixin: The revised Procedures for Reporting the Balance of Payments (hereafter Procedures) will come into force on January 1, 2014. I am wondering how the new procedures will facilitate enhanced monitoring of cross-border capital flows.
YG: The release of the Procedures will make monitoring much more sound. Our philosophy is that a strong statistical system for the balance of international payments should be in place while power should be in a transparent cage so as to ensure a sound monitoring of the statistics on the balance of international payments and cross-border capital flows while leaving monitoring transparent to the absolute majority of persons who obey the law. In this way, economic and financial security can be ensured and firms and individuals can enjoy the maximum possible freedoms and conveniences. Those are the desirable outcomes of regulation.
Caixin: RMB foreign debts, including trade financing, direct investments, and bonds, have gradually increased over the past two years. I am wondering how to manage these debts, and whether these debts should be incorporated into the foreign debt statistics.
YG: According to the rules of the balance-of-payments statistics, foreign debts should be incorporated into the scope of the statistics, regardless of the currency. In the US, for example, foreign debts are denominated in US dollars, which does not have an impact on the country's statistics on foreign debts. In other words, the country's foreign debts have not been offset by the use of the home currency. This is justified both in theory and in practice.
So far, the foreign debts published by the Chinese government have not included RMB foreign debts in order to maintain the old statistical methodology. However, this issue has been addressed in theory, that is, foreign debts should include all the liabilities between Chinese and foreign economic agents.
Cultivating a new benchmark for a market-based interest rate
"The conditions should include: 1. The benchmark interest rate adopted by the central bank has been replaced by the market-based interest rate; 2. Banks carry out their internal accounting based on the market-based interest rate"
Caixin: What is the next step in accelerating liberalization of the deposit interest rate?
YG: Currently interest rates of bonds and financial products have been liberalized, as have loan interest rates, whereas deposit interest rates still remain a big concern. They will gradually be liberalized as the conditions are met.
Instead of being low, China’s deposit interest rates are actually well in excess of those of the HKD, USD, YEN, and EUR. The one-year deposit interest rate is 3.25 percent, and the yuan is stable and appreciating. What other currency has such an interest rate?
Caixin: Will the deposit interest rate drop after liberalization?
YG: Most people believe that the deposit interest rate will rise after liberalization, but they need to consider the related problems if the deposit interest rate is to rise again.
Caixin: What do you mean by saying “when conditions are met”?
YG: There are two conditions: 1. The benchmark interest rate launched by the central bank has been replaced by the market-based interest rate; 2. Banks carry out their internal accounting based on the market-based interest rate.
The Shanghai interbank offered rate (Shibor), for example, might replace the current benchmark interest rate. If banks price their products and verify deposits and loans, and capital transactions between parent banks and branches are based on the Shibor rather than the deposit interest rate, then that will be a signal for liberalization.
The Shibor is just an example—the repo rate might be more important in the future. If a mature market-based benchmark rate can be identified to largely replace the benchmark rate launched by the central bank, it will be time to liberalize the deposit interest rate. But we worry that the market will become chaotic if the deposit interest rate is liberalized and no new benchmark interest rate has been found to replace the current benchmark.
Caixin: Is it possible that the deposit interest rate will be liberalized first in selected regions, such as the Shanghai FTZ, Wenzhou, or Qianhai?
YG: We encourage regions to implement the pilot program for deposit interest rate liberalization within the possible scope and we believe considerable innovations can be made. But any region that wants to liberalize the deposit interest rate must first satisfy two requirements: one, it must prove logically that it is ready in theory; and two, it must make sure that the market will remain stable and orderly when the pilot program is implemented and that the liberalization of the deposit interest rate is in the public interest.
Caixin: What are your ideas about the recent financial strains in the bond market?
YG: Certain volatilities in the market are normal since we want to allow the market to play a decisive role in allocating resources. We should be more tolerant of such volatility, but the central bank will not allow such volatility to reach a point whereby economic activities are impacted. But just as the interest rate is decided by market demand and supply, the bond price is decided by the demand and supply of bonds and we need to be poised to tackle the consequences of ups and downs in the interest rate. In principle, we should respect the market's role in allocating resources.
(Originally published in issue no. 26 of Century Weekly by caixin.com, 2013.)
