The Challenge of Foreign Exchange Reserve Accumulation

1
The Challenge of Foreign Exchange Reserve
Accumulation The Analysis of Sterilization
Operation of PBC
Li Yang Institute of Finance Banking Chinese
Academy of Social Sciences 2007.6.7. Beijing
China

2
Introduction

• Since the beginning of the new century, Chinas
  macroeconomy has been characterized with saving
  constantly exceeding investment.

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Funneled into Foreign Exchange Reserve
Accumulation

• As a natural consequence of this situation, China
  has been carrying a surplus in both current
  account and financial capital account, which in
  turn funneled into foreign exchange reserves
  accumulation. Under the existed system of foreign
  exchange administration, the rapidly-accumulated
  foreign exchange reserves have enforced Peoples
  Bank of China (PBC) to release a huge amount of
  monetary base in the purchases of foreign
  exchange. The excessively rapid growth of money
  supply imposes a potential inflation pressure on
  the national economy.

4
A Biggest Challenge to PBC

• This is the biggest impact that financial
  globalization brought to Chinas monetary
  operations.
• Faced with this problem, China's monetary policy
  assumes the main task of neutralizing the adverse
  effects of foreign exchange reserve accumulation
  on money supply and domestic economic
  development.

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• In this presentation I will describe the
  sterilization operations of Chinas monetary
  authorities, analyze their successes and failures
  based on a framework of Chinas monetary
  transmission mechanism.
• Finally, I will discuss some possible alternate
  solutions.

6
I . An analysis framework

• The primary objective of China's monetary policy
  is to maintain a moderate growth of money supply.
  The setting and changing of monetary base has
  generally played a subsidiary role in the policy
  process.
• For the convenience of analysis, its helpful to
  draw an equation first for the supply and demands
  of the monetary base in China based on the PBCs
  operations (Table 1).

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Simplified PBC Monetary Base Equation
8
An Equation for Analyzing the Policy Process of
PBC

• The left side of the equation is the supply of
  monetary base. It implies that the increase of
  any item among Claims on other depository
  corporations, claims to governments, government
  securities, and foreign reserves will lead to the
  increase of monetary base, and vice versa.
• The right side of the equation is the demand for
  monetary base. It implies that the increase of
  the supply of monetary base will induce
  corresponding increases in cash in circulation,
  deposit of financial corporations, central bank
  bonds, deposits of government, own capital, or
  other items, and vice versa.

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• If PBC want to keep the overall level of the
  supply of the monetary base, there is a trade-off
  among the items on the supply side. For example,
  if foreign reserves increased, the PBC could
  reduce claims to financial corporations to
  balance its effect,etc..
• The similar trade-off also exists on the demand
  side. For example, to keep the supply of monetary
  base unchanged, if the PBC needs to reduce the
  volume of cash in circulation, it can attain the
  goal by issuing central bank bonds and/or rising
  required reserve ratio to the financial
  corporations, etc..

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II. 19942002 Foreign Exchange Reserves Become
Main Collateral Asset Of The Monetary Base

• Chinas foreign reserves accumulation entered a
  growth track in 1994 when the reform of foreign
  exchange administration system started. Since
  then, the portion of foreign reserves as the
  collateral assets of the monetary base has been
  increasing gradually (see figure 1).

Share of FX to the Monetary Base
11
FX Take the Place of PBC loans

• As a response to this trend, the PBC begun to
  reduce the claims to the depository corporations
  and other financial corporations.
• Since the decreasing of central bank loans was
  also a precondition for the reform of China's
  commercial banks, this adjustment on the
  structure of PBCs assets carried out smoothly.

12

• At the end of 1997, the PBC decided to terminate
  the mandatory planning on the lending of
  state-owned commercial banks, which indicated
  that Chinas macroeconomic management would be
  implemented in a more indirect style.
• As an important part of that reform, the PBC
  resumed open market operations on May 26, 1998.
  Therefore, Repo operation started to be employed
  as a sterilization instrument in the August of
  that year.

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Repo Operations Bear Some Innate Weaknesses

• As Chinas monetary policy operation framework
  was still in an early stage of its transition,
  the PBCs Repo operations bear some innate
  weaknesses.
• First, the quantity of government securities held
  by the PBC was quite small, which, to a great
  extent, restricted the scale of repo operation.
• The second problem is more technical in nature,
  i.e. Repo operation is only suitable for the
  management of short-term excess liquidity. In the
  situation that the accumulation of excess
  liquidity is a long run trend, its effectiveness
  is quite limited. Thus, when Chinas foreign
  reserves surged in 2002, the PBC immediately
  found itself trapped in an awkward position with
  no any securities to sell for sterilizing
  operation.

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III. Sterilization Operations on the Demand Side
Issuing Central Bank Bonds

• As an alternate way out of the above quandary, on
  September 24, 2002 the PBC decided to convert
  immature repos into central bank bonds with the
  same maturities and then used the later as the
  instrument for repo operations. This decision
  brought out the central bank bonds on the center
  stage in Chinas monetary policy operations.
• In early 2003, Chinas foreign reserves showed an
  increase of 74.2 billion dollars. The PBC
  realized that this growth trend might persist,
  which implied that neutralizing the excess money
  supply induced would be a long-term task of
  Chinas monetary policy. Since the financial
  instruments for sterilization operations were
  scarce, the PBC chose central bank bonds as the
  primary tool for its operations.

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Central Bank Bonds Become the Second Largest Type
of Securities in the Financial Markets
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Central Bank Bonds Played Important Roles

• (1)The PBC obtained an active, flexible and
  scale-unlimited instrument for the monetary
  policy operation.
• (2)Successive rolling issuance, competitive
  bidding, and active secondary markets (inter-bank
  markets) trading have made central bank bonds
  rate a de facto benchmark rate for Chinas
  monetary markets, which in turn accelerated the
  marketization of interest rates in China.
• (3)Moreover, the development of central bank
  bonds market provided effective tools for the
  management of liquidity and risk for all kind of
  financial corporations.

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The Weaknesses of Central Bank Bonds(1)Costs

• Central bank bonds are liabilities of the PBC,
  and the later needs to pay interests for them. So
  comes the operation costs related the issuance
  (see figure 2). However, if we take the return of
  the foreign exchange reserve into account, the
  picture will be different.
• The purpose of issuing central bank bonds is to
  neutralize the excess money supply induced by
  buying foreign assets, and the foreign assets
  bought by the central bank will generate yields.
  So, to calculate the net costs related central
  bank bonds operations, we must subtract the
  returns to corresponding foreign assets from the
  interests paid for the central bank bonds issued.
  
• Based the calculation, the interest costs of
  central bank bonds will be much lower.

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Interests Paid for Central Bank Bonds (Unit
Billion Yuan)
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The Weaknesses of Central Bank Bonds(2) Impact
on Market Rates

• Issuing central bank bonds implies that the PBC
  impose an excess demand on the financial markets.
  This operation will inevitably influence the
  supply of and demand for funds and the evolution
  of interest rates in markets. So the large-scale
  issuance of central bank bonds makes the PBC
  virtually the biggest market maker.
• Thus, the PBC is performing two conflicting
  roles market-maker and supervisor, which
  evidently increases the complications of
  financial management and exacerbates the
  difficulties in the coordination between the two
  primary objects of monetary policy, that is,
  money supply and interest rate. In extreme case,
  if the PBC care the operation costs related to
  the operation of central bank bonds, it will be
  suspected of manipulating the interest rate,
  which undoubtedly deviates from its market
  neutral status and market stabilizing function.
• In fact, the several failed biddings in central
  bank bonds issuance in recent years reflected the
  concern of market participants on the PBCs dual
  identities.

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The Weaknesses of Central Bank Bonds(3)
Sustainability of sterilization operations

• Central bank bonds are issued in market. To
  attract investors, the rates of central bank
  bonds have to be kept on a relative high level.
  This trend may induce more foreign capital
  inflows and so impair the goal of stabilizing the
  exchange rate. In this regard, the sterilization
  operations are unsustainable.
• This concern is logically valid. Certainly, if
  the Fed continues its high interest rate policy
  adopted since June 30, 2004, the problem will not
  be so serious. However, once the United States
  stops raising interest rates, the worry will
  become true.
• Apparently, China has already encountered the
  problem since the end of last year.

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IV. Sterilization operations on the Demand side
raising required reserve ratio

• In fact, the PBC has already noticed the
  weaknesses of large-scale issuance of central
  bank bonds. Therefore, since 2004 the PBC has
  been trying to find alternate solutions. Raising
  the required reserve ratio is one of these
  alternates. Since 2004, the PBC has increased the
  required reserve ratio for 6 times. At present
  the required reserve ratio for financial
  corporations in China has reached the high level
  of 10.5.
• As a substitute for central bank bonds issuance,
  raising the required reserve ratio has the
  advantage of low cost. Currently, 1-year central
  bank bonds rate is about 2.7 and the interest
  rate that PBC paid to the financial corporations
  for their required reserves is only 1.89. The
  later is much lower than the former.

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The Flaw of Chinas required reserve system

• However, although raising the required reserve
  ratio instead of issuing central bank bonds has
  the advantage of lower operation costs, the
  effectiveness of this measure is questionable.
  The whole problem originates from the flaws
  embedded in Chinas required reserve system.
• The main flaw in Chinas required reserve system
  is that the central bank should pay interests for
  the reserves of financial corporations. The
  evidence shows that this arrangement distorts the
  role of deposit-reserves and provides incentives
  to obtain interest income from the central bank,
  and thus weakens the function of reserves as a
  tax on financial corporations.

23
More

• Besides the required reserves, Chinas financial
  corporations also have kept high level of excess
  reserves in PBC. The reserve dynamics of Chinas
  financial corporations shows that, though the
  required reserve ratio was increased successively
  to a level of 10.5, financial corporations still
  keep an excess reserve ratio close to 3. This
  means that the rise of the required reserve ratio
  didnt decrease the excess reserve ratio
  effectively.
• The effectiveness of reserve system depends on
  the overall level of reserves, which is the sum
  of required reserves and excess reserves. If the
  (upwards) adjustments of required reserve ratio
  cant eliminate excess reserves, the
  effectiveness of the reserve system will be
  greatly dammed. This seems to be exactly the
  problem faced by PBC for a long time.

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V. Sterilization operations on the Supply side
currency swap

• On November 25, 2005 the PBC invited public
  bidding for a one-year currency swap among 10
  domestic commercial banks.  
• In this transaction, the PBC sold 6 billion
  dollars to the commercial banks and promised to
  buy them back with RMB one year later at 7.85
  yuan per dollar. In the early December 2005, the
  PBC conducted another open market operation via
  currency swap, but this time with no detail
  information released.
• In the perspective of monetary operation,
  currency swap is equivalent to Repos, and during
  the transaction period it can decrease the
  foreign assets held by the central bank.

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More Practices Needed

• It is a new trend in international community to
  use financial derivatives including swap to
  implement monetary policy.
• As swap can virtually guide the future direction
  of exchange rate behavior, it must be coordinated
  with exchange rate policy. Unfortunately, the
  central bank of China still lacks experiences in
  this area.

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VI. Conclusion possible directions for reform

• The above analysis shows, in face of rapid
  accumulation of foreign exchange reserves,
  neither issuing central bank bonds nor raising
  required reserve ratio is enough for the
  sterilization. And both of the two instruments
  have some innate weaknesses. This is why market
  keeps doubting the effectiveness of the PBCs
  monetary policy, although the later has conducted
  a series of sterilization operations in a high
  frequency and large-scale style.
• The key problem is that, the accumulation of
  foreign reserve is in so large a scale and
  persists for so long time that no existing
  sterilization techniques can cope with it
  effectively.

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Re-allocating the Nations Foreign Exchange Assets

• Facing this problem, it is natural for us to
  resort to the reform of foreign exchange
  administration system. The primary objective of
  the reform is to cut the rigid link between
  foreign reserves accumulation and the growth of
  monetary base, so as to release the
  unidirectional pressure of foreign reserve
  accumulation on money supply. The basic idea is
  to reform the existed foreign exchange reserve
  management system by re-allocating the nations
  foreign exchange assets(figure 4).

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Suggested Re-arrangement of Foreign Exchange
Assets
Foreign Exchange Assets
Official Foreign Exchange Assets
Non-governmental Foreign Exchange Assets
Foreign Exchange Assets Held by Enterprises
Householding
Official Foreign Exchange Reserve
Other Official Foreign Exchange Assets
(PBC)
(Other Official Bodies)
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• Some key points should by emphasized about the
  distribution of the official foreign exchange
  assets among monetary authority and other
  official bodies.
• Based on a properly defined of adequate level
  of foreign assets held by the monetary authority,
  the large and fast-growing official foreign
  exchange assets can be separated into 2 parts
  one part is under the management of the central
  bank to provide liquidity for monetary policy
  conduction and exchange rate management the
  other part can be held and managed by other
  official accounts outside of the central bank,
  such as national foreign exchange investment
  corporation. Since the later has to raise money
  for the purchase of foreign assets by issuing
  bonds in the markets, the transactions on it will
  be independent of the change of monetary base.
  Therefore the pressure of sterilization
  operations on the central bank will be greatly
  relaxed.

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• We believe that, without the troublesome impacts
  of surging foreign exchange reserves, monetary
  policy will play a more active, effective and
  independent role in macroeconomic management in
  China.

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• Thank you!