Some economies in East Asia have built up large amounts of foreign exchange reserves in the past decades. Holding large amounts of reserves helped these economies to stabilize their macro economy and exchange rates under periods of market stress and rapid shifts in relative economic size. Generally, it has been a strategy to provide a defence against external shocks with damaging consequences for exports.
Rules aimed at limiting foreign reserves, in order to prevent currency manipulation, have been discussed over a long period of time. Yet there are to date no rules that come with effective disciplines – and it is unlikely that such rules can be agreed multilaterally, at least for the foreseeable future.
What measures has China adopted to cope with these challenges?
The first line of defense was assigned to the State Administration of Foreign Exchange (SAFE), part of the People Bank of China (PBOC), with the objective to diversify away from U.S. government securities. In essence, the purchasing of new U.S. Treasury bonds was going to decelerate, if not stop. This is not an adequate policy. Even if China would reduce its U.S. denominated foreign exchange reserves, it does not answer the question what China should do with all the assets it has already accumulated.
Improving the safety of its foreign reserves and the yields it can realistically expect is linked to improving China’s institutional structure for financial competition and openness. In order to transition some of its current reserves, China should “decentralize” and move capital into the economy guided by solid market mechanisms. Financial liberalisation would allow the country to consider redeployments of its foreign reserves – redeployments allowing for greater amounts of investment from China in America’s real economy.
Even if China’s foreign reserves seem destined to shrink, redeployment is necessary if China wants to gain better control over its reserves by reducing its exposure to larger systemic and macro risks. This Policy Brief offers a discussion around various alternatives for China’s government to achieve that aim – and especially takes stock of an idea to shift reserves into equity.
The author would like to acknowledge the many valuable suggestions and encouragement made by Benjamin Cohen, Fredrik Erixon, an anonymous referee, and the Editor
In the wake of the financial crisis, there has – yet again – been an animated debate about global imbalances and foreign reserve accumulation. In the decade before the crisis, emerging markets and low-income countries accumulated reserve holdings of over 5 trillion U.S. dollars. These reserves were a powerful defence against external turbulence in 2007-2009. The IMF (2011) argued: “Countries with adequate reserves generally avoided large drops in output and consumption, and were able to handle outflows of capital without experiencing a crisis”.
However, the IMF and many others have questioned whether higher reserves are always better and argued that excess reserves held by China and other countries are destabilising the global economy. The IMF argued in a much-discussed analysis that in the new post-crisis environment it is necessary to reconsider the adequate levels of reserves and establish a metric for the reserve needs of emerging markets and low-income countries. Furthermore, the Fund concluded that “holding large reserves entails costs, both directly for each individual country, and globally as large reserves are detrimental in the form of macroeconomic imbalances” (IMF, 2011).
Clearly, the Fund’s analysis suggests there is a strong correlation between excessive reserve accumulation and global imbalances. Moreover, it assumes that large foreign exchange reserves could be instrumental in altering exchange rates, consequently eroding the stability of the international monetary system. However, this view is contested.
One response has come from the Fund’s own Independent Evaluation Office (IEO). In a 2012 report, the IEO concluded that the IMF’s argument about foreign reserves held in emerging countries is not persuasive as it relates mainly to current account imbalances and not to reserves. In addition, the IEO argued that when compared to the expansion of global financial markets, the size of official international reserves does not appear excessive (Figure 1). Therefore, the IEO concluded, “in analysing the international monetary system the IMF should have placed greater emphasis on more pressing issues than reserves, for example the growth in global liquidity and capital flow volatility”.
Figure 1. Global bank assets and international reserves (in billion US$) Source: IMF-IEO 2010
The debate over imbalances and reserves offers more nuances than the short description exhibited above. But it is clear that there is no consensus among economists or in the community of global macro decision-makers about the right size of reserves or what effects that big reserves have on international macro policy. Some of the urgency in the debate has abated in the past two years as the structural growth in foreign exchange reserves has slowed down.
 As the IMF admits the precautionary motive was an important reason for the build-up of reserves in a number of emerging markets in the early 2000s following the balance of payments and banking crises of the 1997-1998 in Asia. The Fund also admits the precautionary benefits of reserves were perceived to have increased not only in emerging economies but also in some advanced countries, in recognition of new sources of vulnerability that were highlighted during the crisis (IMF 2011).