Page 2 of 2 China's excess liquidity trap
By Pieter Bottelier
international price increases for certain key commodities, not by excessive
domestic credit expansion. From the end of 2006, the PBoC tightened monetary
policy to the point that the amount of loanable funds in commercial banks
actually contracted, creating higher and considerably more volatile short-term
interest rates in the domestic money market.
On average, the central bank has sterilized a little over 70% of the additional
domestic money supply that resulted from net foreign exchange reserve increases
since 2002. This was accomplished through a combination of open market
operations (sale of central bank bills) and increases in bank reserve
requirements.
From the fourth quarter of 2007, domestic short-term interest
rates in China began to exceed short-term interest rates in the US for the
first time since late 2005 . Since then, the PBoC has incurred losses on
sterilization through open market operations, whereas it generally made a
profit on such operations earlier. This may explain why the bank began to rely
more heavily on upward adjustment of bank reserve requirements instead of the
sale of central bank bills. Such adjustments shift part of the cost of
sterilization from the central bank to commercial banks.
If an upward adjustment of the reserve requirement ratio merely skims off the
extra liquidity resulting form an increase in foreign exchange reserves - as is
usually the case - the measure should not be characterized as "monetary
tightening", as the financial press often erroneously does.
Although sterilization has become more problematic since domestic short-term
interest rates began to exceed US rates, China can continue its policy of
suppressing nominal yuan appreciation and sterilize resulting excess liquidity
in the banking system for some time. It does have to be concerned, however,
about the PBoC's capital base and the soundness of its balance sheet (which can
be negatively affected by open market operations) while the profit margin of
commercial banks is negatively affected by increases in the reserve requirement
ratio. Therefore, there is a limit to sterilization; the policy cannot be
continued indefinitely without generating increasingly serious alternative
problems.
China's decision to accelerate yuan appreciation may have been inspired, in
part, by the increasing costs of sterilization. Since December 2007, nominal
appreciation of the yuan against the dollar increased from about 5% per annum
since the currency was officially de-linked from the dollar on 21 July 2005 to
about 20% (annualized) though mid-April. The policy appears to have changed
again thereafter. Nominal appreciation against the dollar slowed (perhaps
because the decline of the dollar itself seems to have bottomed out), but
appreciation against a representative basket of currencies continued, albeit at
a very slow pace.
Challenge to the value of foreign exchange reserves
Since 2002, the value of the dollar has declined by about 30% against a basket
of important convertible currencies. Since China is believed to hold the bulk
of its huge foreign exchange reserves in dollar-denominated financial
instruments, this is obviously a matter of grave concern to the government. But
it is not easy to protect the international value of China's reserves precisely
because they are so huge and because the dollar share of those reserves is so
large.
Since the international value of the dollar has become so unstable, China is
faced with the question of what the denominator to monitor changes in its
reserves and guide policies to protect their value should be. Alternatives to
the US dollar include the euro, various baskets of currencies, gold, or even
baskets of commodities. It is not known if China uses any of these alternative
denominators. What is clear, however, is that China cannot diversify its
reserves out of dollars quickly without putting downward pressure on the
international value of its main reserve asset and putting upward pressure on
interest rates in the US, which could slow US growth and hence US demand for
Chinese exports.
So what can China do to protect the value of it reserves? One option is to
diversify the currency composition of reserves slowly by reducing the dollar's
share in incremental reserve assets while increasing the share of currencies
that are expected to appreciate. Another option is to try and increase the
return on dollar reserves by substituting higher yielding non-US government
securities for low-yielding Treasuries. Both options entail risks. According to
a recent report by the US Congressional Research Service, China reduced its
holdings of Treasuries during 2007, but there is no indication that is also
reduced its holding of total dollar securities.
Additional strategies that are actually being pursued include the promotion
direct investments abroad by Chinese corporations and the relaxation of
restrictions on private capital outflows for portfolio investment, travel and
tourism. China is not only the world's number one destination of foreign direct
investment (FDI), but among emerging economies it has become the largest source
of outward FDI. The recent creation of China Investment Corporation, a
$200 billion sovereign wealth fund capitalized from foreign exchange reserves,
is another illustration of China's policy to promote outward investment.
Through these policies, China is also trying to secure the supply of critical
raw materials from abroad, improve market access for its exports, diversify
trade - both geographically and in terms of commodity composition, and increase
the scale of production and the profitability of its corporations. In other
words, China has begun to employ its huge foreign exchange reserves for
broad-based long-term development, not just as hedge against possible future
balance of payments problems.
Ultimately, the best policy for dealing with excess foreign exchange reserves
is to avoid large balance of payments surpluses. Ways to achieve this objective
include allowing the real exchange rate to appreciate faster, making the
nominal rate more flexible, opening the capital account and liberalizing
domestic interest rates.
Pieter Bottelier is a senior adjunct professor of economics at Johns
Hopkins University.
(This article first appeared in ChinaStakes.com. Used with permission.)
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