The real significance of the accumulation of China's foreign reserves.
We all know that a balance sheet is always in balance, with total assets equal to total liabilities, which include capital and reserves. It is important to look at both sides of the balance sheet when, for example, examining the financial position of an entity. When we see the foreign reserves of the Mainland, appearing on the asset side of the balance sheet of the People's Bank of China, reaching US$1 trillion – which is a very big amount (the biggest amount of foreign reserves held by any jurisdiction) – we should also be mindful of the corresponding increase on the liability side.
The corresponding increase on the liability side can take different forms, notably an increase in the amount of money borrowed by, or the accumulated surplus of, the central bank. The accumulation of foreign reserves on the Mainland is the result of a current account surplus, capital inflow and exchange control. Technically, the accumulation involves the People's Bank of China buying foreign assets through creating renminbi liabilities on its balance sheet and crediting the renminbi clearing accounts held with the Bank by the commercial banks with the amount required to take the foreign assets off their hands. As a result, "high-powered" money is created, and the monetary base is increased. To prevent this increase in the monetary base from leading to too-loose monetary conditions, which might encourage imprudent lending by the banks or cause inflation, there is a need to "sterilise" the undesirable monetary effects of the injection of money. This is done by the People's Bank of China, on the one hand, increasing the reserve requirement ratio (now at 9%) and, on the other, issuing paper to the banks. Whether it is in the form of the monetary base or paper issued to and held by the commercial banks, the increase on the liability side takes the form of an increase in borrowing by the People's Bank of China, rather than an increase in capital and reserves. Liabilities need to be repaid, although they can be replaced by other liabilities through rolling over the paper on maturity, as many central banks do.
The People's Bank of China obviously has to pay interest on the money borrowed. Currently the yield of, for example, three-month paper issued by the People's Bank of China for the purpose of sterilising the monetary effects of capital inflow is about 2.5%. This of course is lower than the yield of the foreign assets held as foreign reserves are accumulated – the yield of US Treasuries is about 4 to 5%, and so theoretically reserve accumulation can be profitable. The problem, however, is the continuing appreciation of the renminbi exchange rate, which gradually reduces the value of those foreign assets in renminbi terms, to the extent that a larger holding of foreign reserves is not necessarily a good indication that the financial position of the central bank is stronger.
By comparison, although there has been little accumulation of foreign reserves in Hong Kong, where there is an increase in foreign reserves held in the Exchange Fund, chances are that this is matched by an increase in the Accumulated Surplus, or the capital and reserves, of the Exchange Fund. And since there is no interest paid on the Accumulated Surplus, foreign reserve accumulation in Hong Kong does mean that the Exchange Fund's financial position is improved. This is one reason why we pay very little attention to our world ranking in terms of holdings of foreign reserves.
One trillion US dollars is of course a huge number and there are many foreign assets that it can buy, apart from the usual liquid financial obligations issued by the developed countries in their currencies. For a big and fast-growing developing country like China, there are many needs to be satisfied, such as the continued availability of strategic commodities, which is quite a legitimate area for some strategic allocation of financial resources. Indeed, this is in the national interest. Although this involves giving up the liquidity of some of the foreign reserves, the return on such investments extends to well beyond just the financial yields of the assets that are accounted for in the balance sheet of the central bank holding the foreign reserves.
Joseph Yam
4 January 2007
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