China’s Tremendous Amount Of Foreign Exchange Reserves:Causes, Impacts And Quantitative Management

According to data released by the State Administration of Foreign Exchange (SAFE), the total amount of China’s foreign exchange reserves (hereinafter referred to as "FX") has reached＄3.18trillion up to March2011, accounting for30.3%of global FX. China has been the largest holder of FX since2005, with its amount1.5times higher than Japan, which ranks the second place of world largest FX holders. In1950s, China only has157million FX and did not exceed1000million before it took opening and reform policy in1978. Since then, however, China’s FX grew slowly and exceeded10billion and100billion in1982and1996by each. Chinese FX growth accelerated since2000s and exceeded1trillion,2trillion and3trillion in2006,2009and2012successively. Objectively speaking, the fundamental reason of China’s FX surging lies in the rising of its economic power and direct resons are establishment of "world factory" status, preferential policies and investment incentives to encourage investment after China’s accession to the WTO. The rapid growth of China’s FX enhances the its capacity to cope with the fluctuations of balance of payments, to stabilize foreign exchange rate, and strengthen investors’confidence on China’s ability to deal with monetary and financial crisis.Misfortune may be a blessing in disguise. China’s highly growth and tremendous amount of FX also provoke a series of problems:First of all. bound by the current exchange rate regime and mandatory FX sales and settlement policies, the inflation effect of FX becomes more and more obvious.Although China’s monetary authority has excuted sterilized policy very well, but the sterilization costs are rising; Second, high FX has posed intense pressure on RMB appreciation. At the same time, the volatility of monetary authority’s EMI has increased greatly. It seems that monetary authority is facing a dilemma between stabilizing RMB exchange rate and improving RMB exchange rate formation mechanism. Third, the autonomy of China’s monetary authority may be restricted due to the current exchange rate regime and tremendous amount of FX. In the background of global financial turbulence, how to increase the value of FX and how to effectively diversified FX assets to avoid risks? SAFE have not got effective solutions.What is the fundamental cause and direct cause of China’s high-speed growth of FX? What is the quantitative effect of tremendous amount of FX on domestic price level, RMB exchange rate pressure and monetary autonomy of monetary authority? How to cut off the inflationary channel of FX? How to ascetain China’s optimal quantity of FX? How to reduce China’s excessive FX under contemportorary international monetary system? East-Asia monetary and financial cooperation has inspired the foundation of "East-Asia Reserve Pooling", what is China’s cost and benefit in it? Will "East-Asia Reserve Pooling" reduce East-Asian countries’FX effectively? How to optimalize China’s FX management regime? All these issues will be studied in this dissertation.This dissertation argues that:(1)The institutional causes of China’s tremendous amount of FX lies in export-led economic growth mode, while the policial causes lies in mandatory FX settlement and sales, bank’s FX position limits and pegged exchange rate, the direct causes lies in current account surplus, capitial and financial account surplus and spectualtive capital flows:(2)Cut off the inflationary channel of FX is key to enhance monetary autonomy, reduce sterilize costs and EMP of RMB.To realize these goals, China should construct a "financial dominant, monetary appurtenant" FX management system and exchange rate formation system;(3)To compute China’s optimal quantity of FX, one should ascertain the motivations of FX holding and then build models on that basis.According to monetary approach, domestic financial market dis-equilibrium also affect balance of payments and FX.So, to ascertain China’s optimal quantity of FX, one should not neglect the monetary dis-equilibrium factors;(4)China should actively participate in the construction of "East-Asia Reserve Pooling",which could reduce FX competitive hoarding between East-Asian countries through "clubs effect" and increase overall capacity to cope with financial crisis.The exisiting studies shows that the influence of RMB has increased greatly in East-Asian economies.one example is that more and more East-Asian countries pegged their currency to RMB.China should further promote RMB internationalization,strengthening the status of RMB as "reginal dominate currency" and reducing East-Asian economies’ dependence on US dollar;(5)China’s sovereign wealth fund should learn mature management mode from developed economies, increasing management transparency and independence, strengthening construction of internal control mechanisms and external risk control system.The dissertation is divided into nine parts, the structural arrangement and the main contents are as follows:Chapter one is introduction. In this chapter. I introduce the research background, significance, research framework, research methods and the contributions of this dissertation.The second chapter is a brief introduction of FX management theory, including the meaning, function of FX. balance of payments adjustment theory, the classical methods to compute the optimal quantity of FX, the optimal currency structure and optimal asset structure of FX.Chapter Ⅲ firstly give an overview on China’s and the world’s FX, China’s FX management history. On this basis, I analysis of the causes of China’s tremendous amount of FX from institutional, policial and direct perspective. After that I forecast China’s FX growth rate.Chapter Ⅳ mainly analyse the impact of China’s FX surge on domestic prices levels. RMB exchange markets pressures, central bank’s independence and monetary authority’s autonomy.This chapter also evaluate the effectiveness of monetary authority’s sterilization policy and foreign exchange market intervention policy. Empirical studies show that:FX surging intrinsically linked with domestic inflation; monetary authority excute positive sterilization policies to disappoint domestic inflation, but the effectiveness need further observation. I use Mo del-Dependent Weymark index to measure the foreign exchange market pressure on the RMB exchange rate caused by tremendous amount of FX.Using monthly and quarterly data between1996and2011. I calculate China’s EMP (Exchange Market Pressure Index) and EMI (Exchange Market Intervention Index) and compared my result with seven other Model-Free measurements.Emperical results shows that:generally speaking,RMB is facing appreciation from1996.But that pressure shows significant differences in different periods:between1996and2000, China’s EMP is increasing,which means the appreciation pressure monetary authorities facing gradually reduced, also we can deduce that monetary authority is facing a certain of devaluation pressure; from2000to2006, China’s EMP index show some what downward trend, indicating that the monetary authority is facing strong appreciation pressure; After2008,China’s EMP index rise again, indicating that the appreciation pressure RMB gradually ease and devaluation pressure is cumunlating. In the sample period, China’s central bank intervention index is1.155, indicating that China’s central bank took intencified intervention policy. With ’Trilemma" problems China facing, my empirical result proves that China was able to guarantee the monetary policy independence, but did not find any evidence of high FX enhancing the independence of monetary policy.Chapter Ⅴ investigates the reasons for the FX growth of Asia, the overall of44Asian economies’empirical results show that:Foreign exchange reserves held by Asian economies has increased significantly in both absolute and relative share after the collapse of Bretton Woods System, which has gone far beyond the traditional theory. Why Asia economies prefer to hoard FX? Around this issue, I make a review on the motivation theory of FX accumulation, and then construct a panel data model of FX hoarding in Asia. The empirical results show that:In general, Asian economies’accumulation of FXs the presence of transaction motivation, precautionary motivation, mercantilist motivation and competitive motivation:From the stock point view, the transaction motivation and precautionary motivation based on the prevention of capital flight are of the largest influence, with the former is stable and the latter is the most important factor driving changes in FXs. Competitive motivation and precautionary motivation to prevent current account fluctuations are of upward trending, which became new factors driving the change of foreign exchange reserves; besides, FX holding motivation shows significant difference in different income groups and different exchange rate regimes groups.Chapter Ⅵ mainly using quarterly data between1992and2010to construct a reserve adjustment model under monetary disequilibrium framework including monetary factor to explore the quantitative characteristics of China’s optimal FXs. The empirical result shows that:China’s accumulation of optimal FXs reveals the presence of transaction motivation, precautionary motivation, mercantilism motivation, competitive motivation and the influence of exchange rate volatility. The transaction motivation and competitive motivation are of the largest influence, the precautionary motivation is of upward trending since2006, while the mercantilism motivation and exchange rate factor are of weak influence; Adjustments of reserve demand gap and monetary demand gap has significant influence on optimal FXs; China’s actual and optimal FXs are surging since2002: Export-led mode of economic development, capital controls, mandatory FX sales and settlements, limited exchange rate elasticity leads to lower adjustment coefficient λ,which finally leads to China’s high optimal foreign reserves. In this section I also compare the results from dynamic adjustment model of optimal FX with the traditional empirical results from ratio methods, cost-benefit methods.Chapter Ⅶ analyzes the main causes of the East Asian foreign exchange reserve pool being constructed, its performance and institutional defects. At first I investigate the economic motives of East Asian reserve pooling. And then estimates the benefits and the costs of ASEAN10+3joining East Asian reserve pooling using "Insurance Index (Coverage Ratio)". At last I explore the institutional deficiections of "East Asian foreign exchange reserve pooling" and the China’s role in the construction of the foreign exchange reserve pooling.Chapter Ⅷ analyse the improvement of China’s FX management model. This chapter outlines the institutional framework of China’s FX management system, and estimates the earnings ratio of China’s dollar-denominated foreign currency reserve assets. The results show that the overall nominal rate of foreign exchange assets earnings rate is2.59%between2012and2010, but the actual rate is only0.27%. I also evaluate the management performance of China’s foreign exchange assets using variation coefficient, I found that China’s asset management efficiency is lower than Belgium, Hong Kong(China), Taiwan(China), Japan, South Korea, but higher than developed economies such as UK,Norway.I deeply analyze this "paradox". To resolve the problems of China’s foreign exchange reserve management, I propose a framework of "financial dominate, central bank participate", which coordinate financial sector and monetary sector in FX management.This chapter refines the ideology of hierarchical management in accord to the FX’s function, as well as the investment management ideas. At the same time. I give some advices on FX management, governance structure, transparency and external supervision mechanism. Chapter IX is summary.Possible innovation:(1)I analyse the causes of FX from three perspectives including institutional causes, policial causes and direct causes, so my analysis is more comprehensive and in-depth;(2)I systematically investigate the impacts of FX on the domestic price, RMB exchange market pressure as well as the polcy independence of the People’s Bank of China; I also evaluate the effectiveness of central bank’s sterilization policies and the foreign exchange market intervention policies;(3)I use dynamic adjustment model to overcome the shortcomings of linear models in estimating the optimal quantity of China’s FX,which make my analysis more realistic.Meanwhile, I analyse the different motives of the high FX helding and make Static and dynamic decomposition, and then analyse the cause of China’s tremendous amount of FX’s increasing from the point of adjusting coefficient λ,Which rarely involved in previous studies;(4)Previous studies ananlysing the methods to reduce China’s tredmendous FX mainly from the perspect of the international monetary system reform,insted I analyze the role of "East Asian economies’reserve pooling" in reducing the foreign exchange reserve accumulation;(5) My analyse using not only the Asian panel data but also the Chinese time data series, so that my study is more comprehensive and robust;(6) For the first time I discussed the ideas of the mode "financial dominate, central bank participate" framework in FX management.Possible deficiencies:(1)I only use the time series data between1992to2010in the analysis of China’s optimal FX due to the availableness of data, which may affect degrees of freedom in my estimation. The problem of the propensity to import m is not consistent with the traditional theories and experiences, which I do not provide a convincing explainations;(2)Due to data limitation, this dissertation does not consider investing in gold;(3)Because of the limitation of space, I only calculated the optimal quantity of China’s FX. did not calculate the optimal currency structure and asset structure of China’s FX, both of which are very important for reserve management.