Research On The Impact Of China’s Foreign Exchange Reserves On The Money Supply Endogeneity

There has been a debate about the money supply exogenous and endogenous in the economic research. But exogenous or endogenous money supply is not absolute. Money supply can be affected both by economic system and the central bank’s monetary policy. Only by a proper understanding of endogenous money supply process, the monetary authorities can take appropriate measures to regulate the money supply.Since China formally joined the WTO in the end of 2001, there has been a rapid growth of foreign exchange reserves with the rapid growth of export and foreign direct investment. Till Dec 2008, foreign exchange reserves of China have already been over 1.9 trillion and became the first in foreign exchange reserves all over the world. The large scale of foreign exchange reserves has a remarkable influence on China’s money supply. Till Feb 2013, China’s foreign exchange reserves reached 25 trillion yuan, which was 10 times of the foreign exchange reserves in Feb 2003. Till early 2013, the broad money supply M2 reached more than 100 trillion yuan, which was about 5 times of M2 that in early 2003. Excess money supply leads to high price level and large inflationary pressures in China.Since 2002, foreign exchange assets have become the most important source of monetary base. Although the monetary authority has issued large scale of central bank bills to sterilize the base money supply, the rapid growth of foreign exchange reserves made the monetary sterilization increasingly difficult. What’s more, a lot of maturity payment also weakened the hedging efficiency of central bank bills. Since the increase of foreign exchange reserves was decided by business activities, out of the direct control of central bank, base money issued from foreign exchange channel is a endogenous appearance. Therefore, the rapid growth of foreign exchange reserves has made China’s base money supply significantly endogenous.Meanwhile, the rapid growth of foreign exchange reserves has also generated endogenous impact on the credit supply and credit demand. On the one hand, since it is difficult to control the supply of base money, the central bank chooses to raise deposit reserve rates to control credit scale of commercial banks. But the large scale of deposit reserves has highlighted the liquidity of financial institutions. Moreover, the possession of central bank bills has also highlighted the liquidity of financial institutions. With more liquid assets, financial institutions can supply more credit. On the other hand, the growth of foreign exchange reserves may promote the growth of domestic investment in fixed assets by several ways, and highlight the credit demand.During the financial crisis, the growth rate of foreign exchange reserves decline, and its endogenous impact on basic money supply decreased. But the stock of foreign exchange reserves may generate endogenous impact on money supply by affect public confidence and expectations. When the stock of foreign exchange reserves is insufficient, the outbreak of financial crisis makes investors lose faith, the expansion of credit and money supply grows harder. When the stock of foreign exchange reserves is sufficient, the outbreak of financial crisis will bring little negative effects on public confidence, the target of loose monetary policy can be realized easily.For empirical analysis, the data are monthly observations for January 2002 to June 2014 of China. Jonansen cointegration test and error correction model regression results show that foreign exchange reserves are the main determinants of basic money supply in both long and short term. So, we can conclude that, foreign exchange reserves have significantly endogenous impact on China’s basic money supply.Granger causality test prove that foreign exchange reserves are Granger cause of both liquidity of commercial banks and investment in fixed assets. Liquidity of commercial banks is Granger cause of credit supply, and investment in fixed assets is Granger cause of credit demand. Distributed lag model regression results indicate that the changes in the liquidity of commercial banks this month have positive impact on the credit supply in the next month, changes in the investment in fixed assets this month have positive impact on the credit demand in the next month, and changes in the foreign exchange reserves have positive impact on the credit scale after a month.Data show that in both1998 Asian financial crisis and 2008 global financial crisis periods, the growth rate of foreign exchange reserves have declined, and the endogenous impact of foreign exchange assets on the basic money supply dropped significantly. But, China’s foreign exchange reserves stock is smaller in 1998, and it is difficult to achieve the goal of increasing money supply for the central bank by planning expansionary monetary policy. By contrast, the scale of foreign exchange reserves is so large, and the expansionary monetary policy leads to the money supply increase quickly.Since the empirical results show that the growth of China’s foreign exchange reserves does bring effects of endogenous monetary expansion, leading to increase in the price level and inflation, the government departments need to take measures to solve the problem. For example, some measures should be adopted to control the growth of investment, especially the excessive growth of local infrastructure investment and real estate investment. Government need to adjust the income distribution mechanism, and improve income distribution, to avoid inflation brought increased polarization between the rich and the poor. Interest rate liberalization should be promoted to insure a efficient allocation of credit capital. In addition, China needs to adjust the export and import structure, expanding domestic demand, to improve the balance of international payments, and improve the RMB exchange rate formation mechanism by increasing the RMB exchange rate float band. What’s more, when make monetary policy, the centraLbank should consider the size of foreign exchange reserves, and its impact on the public expectations and the monetary policy transmission.