• Wed
  • Sep 24, 2014
  • Updated: 8:03am
Jake's View
PUBLISHED : Thursday, 07 August, 2014, 5:46am
UPDATED : Thursday, 07 August, 2014, 5:46am

Easy way out for foreign inflows comes with a price in China

Both the banking system and the PBOC lose money on the statutory reserve solution

"Frankly speaking, foreign exchange reserves have become a big burden for us."

Premier Li Keqiang
Business, August 4

You might reasonably expect quite a number of lifted eyebrows in China at this sort of appraisal by the premier of its foreign reserves.

After all, these reserves of US$4 trillion are by far the world's largest and almost the size of the annual gross domestic product of the United States.

They constitute so enormous a pool of foreign capital that countries around the world salivate at the prospect of being the beneficiary of only a little of it, or quake in fear at the ease with which China can now buy out their companies or acquire other assets considered national treasures.

Are savings so great not a measure of strength and standing of which any nation can be proud?

Short answer: no, they are not. The premier is absolutely right in calling them a big burden. They are actually not even savings. The People's Bank of China, the official holder, is in hock for every cent of them. This is only the sort of wealth that would allow you to call yourself a millionaire if you borrowed US$1 million from one bank and deposited it in another.

What has happened here is that in order to rig the exchange rate of the yuan at officially designated levels, the PBOC has been forced to mop up vast foreign-currency inflows from trade receipts and foreign investment.

It was either this or two other choices: (1) let the US dollar circulate widely within the country as an everyday currency of transaction or (2) let the yuan exchange rate find its own value without guidance. The PBOC was repelled by both of these options.

How then to conduct the mopping up?

Easy. Establish a statutory reserve requirement, a percentage of every bank's deposit base, which must be placed with the PBOC and held there in "cold" form, not again circulated back into the system.

Statutory reserves are an old-fashioned tool of monetary control now largely abandoned in countries with sophisticated financial systems. There are none in the US, for instance. Nor in Britain, Canada or Australia. And in the euro zone, they amount to only 1 per cent.

But in China they have been steadily raised to a stinging level of 19.5 per cent at present. This has armed the PBOC with 21.6 trillion yuan (HK$27.2 trillion) for buying up foreign-currency inflows.

Now take note of several anomalies there. The PBOC talks of statutory reserves as a tool of monetary control. Nonsense. These reserves constitute a currency-rigging fund only. They have no monetary effect. They are not kept cold but pumped right back into circulation when exchanged for foreign currency.

In addition, the banking system loses money on them. The PBOC pays an interest rate of only 1.62 per cent on statutory reserves, which is well below bank intermediation costs and cost of funds. If the difference were only 1 per cent, the loss would still come to 216 billion yuan a year.

But the PBOC also loses money. Over the past four years, the yuan has strengthened by almost 10 per cent against the US dollar, which means the PBOC has weak dollar assets to pay off increasingly strong yuan liabilities. This unrecognised foreign exchange translation loss now amounts to about US$520 billion.

But why worry? The solution is so easy. A central bank can print money whenever it wants.

Yes, Mr Li, you are in a fix. And don't let anyone tell you any longer that there is an easy way out. All these easy solutions just make things worse.



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This article is now closed to comments

I’ve long felt the burden of the reserves
but I ain’t clear about your “in hock” explanation
‘if you borrowed US$1 million from one bank and deposited it in another”
I’d remind you the parable of talents (Mathew 25:14-30)
and ask: Why?
Why, also, despite all the shortcomings you‘ve outlined
the reserves are still kept in treasury as digitized accounts
with the USD portion subject to IEEPA
There are lots of whys for which there aren’t satisfactory explanations
I wish you would try harder and come up with more interesting analyses
......Because the money inflows to exporters for example, do not go to directly to the PBOC. They go to the exporting company who exports the purchased god to the american buyer. The American buyer must send the Chinese exporter dollars to complete the purchase. The exporting company cannot keep most of those incoming dollars and they are instead exchanged for RMB.
Where would the PBoC get all of that the RMB to buy all the dollar inflows? They print it. Normally printing money causes a lot of domestic inflation. However, the PBoC issues bonds to mop up that extra printed money in circulation.
Who buys these bonds? Mostly state banks. So, for every dollar of foreign reserves, China has an equivalent amount of domestic debt. China buys treasuries because it has no choice because a dollar has no value in China. You cannot buy steel or cement with it, nor can you pay employees with it. The only choice of investment the PBoC has are treasury bonds. Any questions?
"After all, these reserves of US$4 trillion are by far the world's largest and almost the size of the annual gross domestic product of the United States."

Whoops... U.S. GDP is at least four times larger than that. Did you mean to say almost the size of China's GDP?


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