In February 2006, China overtook Japan to become the country with the highest levels of foreign exchange reserves. In October this year, it is expected that China's foreign exchange reserves will top US$1 trillion.

Ding Zhijie, Vice President of the School of Finance and Banking at the University of International Business and Economics pointed out that at the end of September, China's foreign exchange reserves had topped US$987.9 billion, just $12.1 billion away from the US one trillion dollar mark. The trade surplus in October was $23.8 billion. Trade surplus usually accounts for 65 percent of additional foreign exchange reserves, which means that in October, this amount will be greater than $12.1 billion.

One trillion US dollars is equivalent to 20 percent of global foreign exchange reserves and 45 percent of China's total economic output last year. It is three times the total amount of bank notes currently in circulation. One trillion US dollars could be used to pay for 15 months worth of imports, pay off all of China's short-term foreign debts six times over, construct 40 Three Gorges Project, build 3.2 million primary schools and buy 46,000 Boeing 747 airplanes.

In the current situation, people are likely to question the scale of China's foreign exchange reserves. Is it good for China's foreign exchange reserves to be growing so fast? Given the continuous depreciation of the US dollar, is it still profitable to base foreign exchange reserves on the dollar?

In terms of scale, there is still no definitive argument as to what an appropriate level of foreign exchange reserves is.

To date, the international community has only reached a consensus on the minimum level of foreign exchange reserves. According to traditional theory, the level of foreign exchange reserves should be no lower than the amount of foreign exchange needed to pay for 3 to 4 months worth of imports. After the Asian Financial Crisis, it was proposed that foreign exchange reserves should be no smaller than the scale of the country's short-term foreign debt. Based on these theories, China's foreign exchange reserves should be no less than US$200 billion. Consequently, the current level of reserves is more than adequate. However, if some special factors such as imports, debt payment, foreign exchange controls, profit remittances by foreign-funded enterprises and the special period of economic transition are taken into consideration, China's foreign exchange reserves should be much higher than $200 billion, although there is no specified amount.

If we consider the special factors of exchange controls perhaps even one trillion US dollars is low. Currently, the Chinese government is the major owner of the reserves, holding around 68 percent. In some developed countries, the proportion of government ownership is quite low. In Canada, the government holds only 3.8 percent of the country's foreign exchange reserves. In Italy the proportion is 3.5 percent; in Germany, 2.1 percent; the United States, 1.7 percent; France, 1.5 percent; and in Britain, a mere 0.5 percent. The British government only holds US$43 billion of foreign exchange reserves. Almost all Britain's foreign exchange assets are held privately, but if they were taken into consideration, the country's assets in foreign exchange would be US$8.28 trillion, far higher than those of China.

In terms of growth rate, the surge in foreign exchange reserves has caused mixed feelings.

China is a developing country, experiencing rapid economic growth and undergoing a structural transformation. Undoubtedly there are many uncertain factors. During this process, the rapid growth of foreign exchange reserves are like letters of credit, helping to increase its international liquidity and strengthen the confidence of foreign countries in China's economy and currency. The reserves function as a stabilizer, helping the country deal with unexpected incidents and guarding against financial risks. It is also a vast resource which can be drawn on to provide the funding needed to expand reforms and China's opening up.

However, it should be noted that there are three disadvantages to high-speed growth of foreign exchange reserves. Firstly, it is not conducive to the implementation of an independent monetary policy and effective macro-controls. In order to keep the RMB exchange rate at a stable level, the central bank sets aside foreign currency reserves to purchase foreign exchange in the market when an oversupply occurs. The central bank must invest an equivalent amount of RMB when purchasing foreign exchange (known as foreign exchange reserves for monetary supply). Therefore, the rapid growth in foreign exchange reserves also means a rapid increase in the amount of RMB that the central bank must provide. This implies that the amount of base money passively issued by the central bank is also growing quickly. Statistics show that at the end of September, the amount of base money invested in the form of foreign exchange reserves for monetary supply, was equivalent to 116.3 percent of the total amount of base money. In other words, nearly all the base money has been for foreign exchange reserves for monetary supply. The RMB currency issuance has become US-dollar-oriented. Moreover, the central bank has no choice but to withdraw the remaining 16.3 percent by hedging. In these circumstances, it's almost impossible for China to adopt an independent monetary policy.

The rapid increase in base money has promoted the excessive growth of monetary credit, which will lead to investment expansion, increasing pressure on inflation, asset bubbles and more. It will also increase the vulnerability of the banking system and ultimately impact the effectiveness of macro-controls.

Secondly, the rapid growth of foreign exchange reserves is not conducive to creating a favorable external environment for China's economic development. The surge of foreign exchange reserves will inevitably draw the attention of the international community to China's international trade status and the value of RMB, and is likely to cause disputes.

Thirdly, it is not conducive to China's economic structural readjustment. Once foreign currency reserves for money supply becomes the main channel of currency issuance, the eastern region of the country would eventually be able to attract more money as they can absorb more foreign currency, while the central and western regions would remain an inferior position. Secondary industry would also receive more money than tertiary.

From a structural point of view, the dollar-denominated currency structure is reasonable.

At present, the US dollar is still the currency of settlement in China's foreign trade, investment and financing activities. It is also the primary currency of international settlement and deposits. The proportion of US dollars in international currency reserves has not fallen below 60 percent since 1998, while non-US dollar assets have shown limited capacity in activities in financial markets. Due to the low mobility of non-US dollar assets, it is rather difficult to conduct settlements and transactions in any other currency. Experts believe that the current currency structure, dominated by the dollar, is in line with national conditions and is therefore reasonable.

Although the dollar is depreciating, the value of China's non-US dollar assets is appreciating correspondingly. Therefore, the assets denominated in the dollar are appreciating. In reality, non-dollar and non-government assets have increased quickly in recent years. China no longer needs to convert dollars into other currencies for external payments, which means that there is no loss in the exchange. The depreciation of the US dollar will only show profits on the book, but China's foreign exchange reserves will experience no real losses.

By People's Daily Online