Late CA Sampat Jain
Replied 03 November 2007
Leveraging forex reserves smartly
Tuesday, 06 June , 2006, 12:32 (SIFY)
In February, China surpassed Japan to become the world's largest holder of foreign exchange reserves. According to the People's Daily, the official newspaper of the Chinese Government, this trend continued the following month, with foreign exchange reserves growing 32.8 per cent year-on-year to $875.1 billion.
Concerned by the economic impact of such high levels of reserves, the National Bureau of Statistics announced that steps were being taken to "relieve the pressure".
According to Zheng Jingping, spokesman for the National Bureau of Statistics, some of the steps include restriction on exports of high energy products, letting businesses and residents hold more foreign currency, and encouraging some qualified commercial banks to invest in overseas financial markets.
While excess the forex reserves has been a recent cause for concern, it will bring increased pressure on the Chinese authorities, already facing fierce criticism over the rigid exchange rate policy.
Defending the Chinese approach of gradual currency reform, Zhou Xiaochuan, Governor of the People's Bank of China, said in a recent speech that, "Under the managed floating exchange rate regime, the PBC will gradually reduce its managing role in the foreign exchange market in line with the situation, which will lead to a slower growth of the foreign reserves."
Such a "gradualist" approach finds its roots in the chief architect of China's economic reforms, Deng Xiaoping, who famously described it as "fording the river by feeling for the stones."
In the aftermath of the Asian financial crisis, central banks of Asian economies - including China and India - have maintained high levels of foreign exchange reserves to avert a possible currency crisis (see Graph). Though China and India were largely unscathed by the Asian crisis, their central banks have not taken chances either.
What is particularly noteworthy in the case of China is the massive surge in foreign exchange reserves after 2001, the year it joined the World Trade Organisation.
However, economists like such as Lawrence Summers, President of Harvard University, are now questioning the need and the economic rationale for holding such high levels of reserves. Using the Greenspan-Guidotti rule, he estimates that China holds 41 per cent excess reserves as a per cent of 2004 GDP. And that these excess reserves carry a huge opportunity cost that could well benefit the emerging economies if used in a long-term way, like such as investing in infrastructure.
China's economic woes
The current problems of the Chinese economy are complex. Apart from the everyday blame that China faces over the US current account imbalances, there is a genuine concern among experts over the overheating Chinese economy. |Hot Wheels: A Sify Special on latest 2-wheelers|
China's State Administration of Foreign Exchange (SAFE) believes that the excessively huge trade surplus in China's balance of payments indicates the country's overcapacity - domestic savings have exceeded domestic investment.
Huge inflows of foreign direct investment during the past five years, and overseas financing by Chinese firms have been the contributing factors. Over-investment has, thus, become a huge problem for the Chinese economy.
The monetary authorities in China have taken cognisance of these problems and, recently, the People's Bank of China raised interest rates of RMB loans. Explaining the rationale behind the loan interest rates hike, a Bank official said that though the Chinese economy maintained a steady and double-digit expansion "some acute problems still existed in economic operation as fixed asset investment grew excessively, money supply hovered at a relatively high level and credit expanded faster than desired, all these factors need to be addressed attentively."
In addition to the problems of over-investment and overcapacity, the malady of a fragile financial system makes the speculative flow of money a big cause of concern for the Chinese authorities. After the recent split share reform, experts are predicting a bullish Chinese stock market.
Moreover, speculation on the prospects of a stronger yuan brings a lot of hot money into the market, causing further foreign exchange accretions.
Keeping in mind all these factors, a huge stockpile of forex reserves has been thought of as a prudent policy measure. But the current level of reserves are much more than what would be prudent. Therefore, it would make good economic sense to use significant portions for productive purposes.
Lessons for India
Compared to China, India's foreign exchange reserves are relatively small but have significantly increased over the years. From just $27.355 billion in December 1997 (at the time of Asian financial crisis), India's forex reserves have risen to $162 billion this May.
In 2003, the IMF lauded India's reserve management policy and compared it to global best practices. The Reserve Bank of India has since then consistently seen accretion to the forex reserves while maintaining an appropriate level of import cover and effectively securing monetary stability.
There is an opportunity thus to use the excess reserves for infrastructure purposes, as suggested by the Planning Commission Deputy Chairman, Dr Montek Singh Ahluwalia.
Lawrence Summers, while delivering a speech at the RBI this March, said that if India can put to effective use the excess reserves, the returns could be as high as 1-1.5 per cent of GDP each year. Summers has estimated that India's forex reserves are in excess by 15 per cent of 2004 GDP. | Go to Sify Business Home page |
India is, therefore, clearly missing an opportunity to give a boost to building the appalling infrastructure by using the excess reserves. What is surprising is that, the Prime Minister, Dr Manmohan Singh, instead of putting the idea to work at home, has been trying to push this design through a pan-Asian FTA.
While the complexities and the lack of political will for such a free-trade agreement are now clearly evident, it is time the Prime Minister realised the opportunity cost of excess reserves and put them to use for immediate gains.
Both India and China must recognise the opportunity cost of excess foreign exchange reserves. However, the use of these excess reserves will differ from country-to-country and would depend on the prevailing economic conditions.
The current complexities of the Chinese economy are generic - over-investment, high current account deficit and a fragile financial system - and therefore compel the Chinese Government to follow a rigid exchange rate policy that can support its export-led involuted growth. Therefore, China prefers to maintain high levels of reserves to avert any external debt crisis and to deal with contingencies or financial risks. A steady and fast growing Chinese economy is what the world needs, for, if the Chinese growth engine sputters, it could just trigger problems for all the major economies of the world.
India, on the other hand, is well poised to take advantage of its excess forex kitty. A fast growing economy, a strong financial system, and stable monetary conditions are just the perfect prerequisites for any action in this regard.