What view should be taken of China's huge foreign exchange reserves?

International payment imbalance and insufficient consumer demand leads to the rapid growth of foreign exchange reserves.

There are many reasons for the growth of foreign exchange reserves.

One of the primary reasons is the imbalance of international payments. In recent years, with the rapid growth of China's trade surplus and foreign investment, foreign capital has streamed steadily into the country. As a result, the amount of revenue from international payments is larger than that of expenditure. In the inter-bank foreign exchange market the supply of foreign exchange has continued to exceed the demand. In order to keep the RMB exchange rate at a stable level, the central bank has had to buy large amounts of foreign exchange, resulting in the rapid growth of foreign exchange reserves.

Probing further into the causes, it is possible to see that the major cause of the imbalance in international payments is insufficient domestic demand, especially consumer demand. There is an identical equation for national income: savings minus investment equals exports minus imports. Income equals savings plus consumption, so when China's consumption rate fell after reform and opening up, the savings rate rose quickly, reaching 47.9 percent last year. When the savings rate exceeds the investment rate, exports will exceed imports, thereby creating a trade surplus and triggering an imbalance in international payments.

Secondly, the purpose of implementing a foreign-related economic management policy in the long term is to encourage exports, restrict imports, encourage the inflow of foreign exchange and restrict the outflow of foreign exchange.

Another reason for the growth relates to the inadequate formulation system for the foreign exchange rate, tax rate and factor prices. The RMB exchange rate is the price of foreign currency in RMB. As the price lever and the "invisible hand", the exchange rate, through floating, should be able to regulate the supply and demand of foreign exchange. In the past the RMB exchange rate has been too stable and lacked the necessary flexibility. It cannot correct the oversupply. In addition, foreign capital is now given super-national tax treatment; cost factors have been held down artificially; foreign investors and exporters have certain advantages when they pay for land, water and utilities; and they do not pay the real cost of labor because of the imperfect social security system. These factors have contributed to the tendency of one-sided foreign trade development and promoted the inflow of foreign exchange.

How should the momentum be slowed?

To slow the growth momentum of foreign exchange reserves, consumer demand must be further expanded, foreign economic and financial policies need to be adjusted, and the price mechanism for determining the exchange rate improved.

What should be done to cope with huge foreign exchange reserves?

Experts believe that growth of the incremental amount should be slowed and the stock amount should be better used.

To weaken the momentum of growth, a suitable remedy must be found.

There must be a focus on expanding domestic demand, especially consumer demand, changing the previous export-driven model with over-reliance on investment, and establishing a consumer-led model of economic development. Of particular importance is the promotion of private consumption, particularly by low-income farmers and urbanites.

Foreign economic policy should be adjusted and the current tendency to encourage exports and restrict imports changed. The excessive incentives to export should be reduced, as should exports that require a lot of energy to produce. The same goes for products that cause a lot of pollution and use a lot of resources. There should be a reduction of restrictions on imports and the importation of advanced technology and equipment should be encouraged. Instead of allowing foreign investment to flow in blindly, it should be carefully channeled and used to support Chinese enterprises expanding overseas.

The foreign exchange management policy should be adjusted and the current tendency towards easy inflow and difficult outflow should be reversed. Individuals should be allowed to purchase foreign exchange reserves.

A this point, the improvement of the formulation mechanism for the exchange rate, the tax rate and factor prices is essential. The "invisible hand" should be brought into full play. We should slowly improve the RMB exchange rate formation mechanism and increase the flexibility of the exchange rate; gradually unify the tax policy for foreign and domestic-funded enterprises; allow the prices of land, energy, electricity and transport to be determined on the market; and develop effective policies on land, labor protection and social security, so as to eliminate any price-distortion caused by artificial cost-lowering.

How should the foreign exchange reserves be used?

Like any other financial resources, foreign exchange reserves cannot be taken for granted. Moreover, a second tender situation should be prevented from happening.

With foreign exchange reserves soaring, the importance of spending money has grown.

Some people suggest that China use a part of its foreign exchange reserves to purchase strategic resources such as oil and minerals. Others believe a part of it should be invested in social security, education and medical and health services.

These recommendations are both good, but before foreign exchange reserves are drawn upon, there are two prerequisites that need to exist.

Firstly, the foreign exchange reserves cannot be taken for granted. Foreign exchange reserves are formed mainly in two ways: one, the fiscal department authorizes the central bank to use surplus funds or funds raised through issuing bonds to purchase foreign exchange. Countries that do this include the United States, Japan and Singapore. In such circumstances, foreign exchange reserves are financial money. The government can use the money freely. The other way foreign exchange reserves are formed is when the central bank releases or issues base money and then uses this to purchase foreign exchange. China has built up its reserves the latter way. In such circumstances, the foreign exchanges reserves belong to the central bank, and therefore cannot be taken for granted. If they were used, an overdraft would occur, which would trigger inflation and impact economic and financial stability.

Secondly, the use of foreign exchange reserves must not create a second tender. If foreign exchange reserves are converted to RMB, this will occur. The first tender occurs when the banks purchase foreign exchange. If these banks then sell the foreign exchanges on the inter-bank market, eventually the foreign exchanges will be acquired by the central bank. It is then that the secondary tender takes place. As a result, the central bank has to increase the amount of base money, which, in the current situation of excess liquidity, has no benefit at all.

Experts believe that foreign exchange reserves can be used for equity investment, for example, investment in state-owned commercial banks. This is also consistent with the central bank's functions. However, at present, it is not appropriate to apply this model to all banks.

Better management is needed to ensure that the reserves are put to good use. Today, China is one of the most advanced countries in terms of foreign exchange reserve management. Experts suggest that in addition to guaranteeing safety and mobility, China should aim for a higher profit, continue to expand foreign exchange reserves investment, and improve investment earnings, so as to maintain and realize the added-value of reserve assets.

By People's Daily Online