China’ s foreign exchange reserve stood at just a touch over US$2 trillion in July 2009 when Yi Gang – then a star economic professor – became head of the State Administration of Foreign Exchange.
In little over three years, the fund mushroomed to US$3.7 trillion, a sum that is more than twice the size of Australia’s GDP. How to manage this vast sum of money is a pressing issue for Chinese central bankers.
In 2011, The Economist created a fantasy shopping list for the Chinese central bankers; they could theoretically buy an entire year of oil production for three trillion, the entire inventory of the American department of defence or even gobble up Apple, Google, IBM and Microsoft for less than half of the reserve.
For years, China has seen the accumulation of foreign reserves as a sign of the country’s strength and status. It is also a direct consequence of the need to “sterilise” the large inflow of US dollars – earned from China’s export industry – in order to keep the exchange rate within a desirable range.
However, the Chinese central bank no longer sees the continuous accumulation of foreign reserves as a desirable end in itself. Yi, the deputy governor of the bank now says the size of the reserve is too large and he wants to start diversifying its holdings.
Diversification of such a large holding is easier said than done. US Treasury notes still offer the most secure and liquid market – even after the recent scare over Washington’s ability to honour its debt obligation.
Yi said he was open to all suggestions about how to invest the country’s vast holding, which may include “farming out” the management of funds to international fund managers, private equity firms and banks.
In fact, China Investment Corporation has established a $500 million resource fund to be managed by Australian bankers and managers for investment in small to medium cap resources projects.
However, diversification can only address the problem up to a point. Yi said the only cure for China’s oversized foreign reserves is to reduce the current account surplus – which means importing more.
“The only prescription is to achieve a current account balance. We need to import more, get people to spend more on overseas holidays, buy more services from abroad and invest more overseas,” Yi told Caixin magazine, “ this is the simplest solution.”
This signals a more radical departure from China’s mercantilist policy of encouraging exports and restricting imports. At the third plenum of the 18th Party Congress, Beijing stated its goal of adopting a market-based mechanism in order to achieve a current account balance.
Yi said Beijing had neglected the needs of the Chinese middle class and regarded some of the goods they wanted as “luxury goods” that deserved high duties.
It is impossible to talk about China’s large foreign reserve without mentioning the contentious issue of exchange rate policy, which is a festering sore between China and the United States.
The United States has consistently criticized China’s policy of keeping the yuan artificially low and Congress has been pressing Treasury to label China as a currency manipulator.
Yi says China is “very close” to floating its currency and as a matter of fact, the central bank had not intervened in the foreign exchange market for most of the 2012.
Chinese exporters have also been complaining loudly about the stronger yuan, which has appreciated 34 per cent against the US dollar since July 2005. However, China is also benefiting from the greater buying power that comes with a stronger currency.
As a major importer of commodities, China bought 58 million tonnes of soy beans, 270 million tonnes of oil and 700 million tonnes of iron ore last year. A stronger yuan helps China to offset the high cost of all these imports.
Yi, a former economics professor at Indiana and Peking universities, said the exchange rate between the yuan and the US dollar was very close to equilibrium and expected the yuan to float soon.
He didn’t however rule out intervention in the foreign exchange market by the central bank in the future. However, he made clear that future intervention must be rule-based and free from political interference.
“I want to put the power to meddle in the foreign exchange market inside a cage – and that cage must be transparent,” he said.
However, Yi freely admits there are powerful vested interests opposed to further appreciation of the yuan and public opinion is not necessarily on the side of the central bank.
When – and if – China floats its currency, it will be a major milestone in the country’s effort to integrate into the global economy. The changing attitude towards imports and the foreign reserve are welcoming signs that the country is playing its part in the great-rebalancing of the world economy.
Australian exporters should rejoice at the possibility of a further opening up of the largest market in the world.