China's forex management and RMB revaluation imperative

The last decade has seen spectacular growth in China's external trade, and the ballooning trade surplus has resulted in an exponential growth in its foreign exchange reserves. Management of this, now more than $2.5 trillion, has been a source of much controversy and one of the biggest challenges for policy makers in Beijing.

What makes the management of its forex reserves an even bigger challenge is the expectation of the inevitable renminbi (RMB) appreciation, which while making foreign investors loath to borrow in RMB and invest abroad (for fear of losses when the RMB eventually appreciates) also encourages hot money inflows into China for investing in RMB assets (in expectation of higher returns when RMB finally appreciates).

As Ronald McKinnon writes, China has used four strategies to manage its forex reserves - liquid official reserves in the State Administration of Foreign Exchange (SAFE); sovereign wealth funds (like the China Investment Corporation) which invests overseas in bonds, equities, or real estate; encouraging Chinese state-owned firms to invest abroad in oil, power, rail, or other construction sectors; and quasi-barter aid programs in developing countries which generate a return flow of industrial materials.

In managing its forex reserves, China has taken lessons from Singapore, whose own currency is not used for international lending and whose government tightly controls overseas financial intermediation. Its large savings and foreign exchange surpluses are lent to two giant sovereign wealth funds - the Government Overseas Investment Corporation (GIC), which invests in fairly liquid overseas assets, and Temasek, which is more of a risk taker in foreign equities and real estate - who minimize systemic currency risk from international investing.

Being government government owned and therefore backed by large forex reserves, these agencies are best positioned to cushion any currency shocks. Further, since the foreign assets are held by the government agencies, the possibility of capital flight when the currency appreciates is ruled out. Also, the Singapore Dollar is managed through a gentle "float" against the US Dollar, whose stability anchors Singapore's national price level.

With dollar prevailing as the global currency of choice, China, despite being the world's largest creditor nation, cannot use its own currency to finance foreign investments. Apart from the fact that dollar is the universal currency of clearing international payments, what makes China an "immature creditor" nation is the fact that the Chinese domestic financial markets are not fully developed, have interest rate restrictions and residual capital controls.

In view of all this, foreigners prefer not to borrow from Chinese banks in RMB or issue RMB denominated bonds in China. Therefore, apart from Chinese corporations investing abroad, the only way in which foreign private investors take shares (or buy into) in China's massive forex surplus is through Chinese banks, insurance companies and pension funds' acquisition of dollar-denominated liquid foreign exchange assets.

But this generates a currency mismatch risk for Chinese investors - their domestic liabilities (bank deposits, annuity, or pension liabilities) are all RMB denominated while foreign assets are dollar denominated. The threat of a dollar devaluation (or RMB appreciation), which is inevitable, therefore carries considerable risks for these Chinese investors. Private Chinese investors would therefore find it unattractive to hold dollar assets, thereby leaving the central government to do the financial intermediation of China's massive foreign exchange surpluses in the global markets.

While this hedges against any risk of capital-flight induced by currency appreciation, it hinders the deepening and diversification of the Chinese financial markets. In other words, so long as the RMB remains over-valued, or atleast the perception persists, Chinese private investors would be deterred from investing abroad and private foreign investors would think twice before raising debt in China. Yet another reason to get done with revaluation of the RMB.