China's FX Reserves: Thinking Outside the Box
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China’s intention to diversify the asset allocation of its foreign exchange reserve has induced much discussion, although it has only muted market impact. By examining the change in forex reserves in 2005 in Asian economies, and data on US Treasury holdings, we believe that China will continue to play a critical role amongst Asian central banks’ demand for USD assets. However, any passive diversification by the Chinese authorities is unlikely to bring major market disruption, since it has been in fact taking place for some time.
China’s forex manager’s 2006 priorities include the need to improve FX reserve management and actively explore more efficient use of FX reserve assets. A number of Chinese economists, notably Professor Li Yang, a former Monetary Policy Committee member of the People’s Bank of China, and Tang Xu, PBOC’s research bureau chief, however suggested that China will not sell its current holding of USD assets. While the USD has weakened by approximately 3 per cent since the start of the year, we believe this was brought by a combination of factors, rather than by China’s reserve diversification. However, the importance of China’s reserve diversification move is nonetheless worth noting for two reasons.
China’s FX reserves are expanding at a rapid pace. Between 2001 and 2005, they rose over four times from USD 169bn to USD 819bn. At the current pace of growth, China could surpass Japan in January 2006.
More importantly, China represents a growing share of the rise in Asian forex reserves. In 2004, the FX reserves of Asian central banks, as shown in Chart 1, grew USD 535bn. Thirty-nine per cent of this growth came from China and 32 per cent came from Japan. Economies such as Taiwan, Malaysia, S. Korea and Singapore also experienced a strong rise in their reserves partly because of their action to support the weakening USD.
In 2005, the USD rebound coincided with a slower pace of reserve accumulation in these economies. The total rise in forex reserves fell to less than USD 250bn in 2005, using the latest available data, which was less than half the expansion in 2004.
The only exception here is China, her FX reserve rose USD 209bn in the year on the back of its record high trade surplus of USD 102bn, USD60bn inflow of foreign direct investment and other capital inflows. This represents over 80 per cent of Asia’s FX reserve growth in 2005, and one-third of the world’s total increase.
Such a trend is likely to continue in 2006. The renewed weakness in USD we have seen so far in 2006, and our medium term bearish view of USD against Asian currencies, may result in more forex accumulation by Asian central banks, similar to 2004. Yet, China is likely to remain dominant in the picture.
Take the trade surplus as an example: China’s USD 102bn surplus in 2005 will be tough to repeat this year. The National Development and Reform Commission forecasts exports and imports will expand by 15 per cent and 18 per cent respectively, resulting in a surplus of USD 97bn. With the more moderate growth in the global economy, we view that China’s trade surplus in 2006 is likely to be smaller than 2005, but nonetheless significant.
In sum, China’s forex reserve growth is likely to dominate the region in 2006. Therefore, its policy on asset allocation could have a strong influence on Asian central banks’ policy, making it a significant development of global financial flows.
Although the SAFE1 statement on its 2006 priorities was the first official comments on reserve asset diversification, China has been seeking alternatives to US Treasuries for some time. According to the US Treasury, China held about USD 247bn in US Treasury bills, bonds and notes by the end of October 2005, or equivalent to one-third of China’s official foreign exchange reserves. As illustrated in Chart 2, there is a divergence between China’s FX accumulation and net addition in US Treasuries. The gap was particularly wide in 2004 and 2005. With an average monthly increase of USD 17bn in FX reserves, the average increase in US Treasuries was only a quarter of this value. A caveat with this observation is that the Chinese holdings of Treasuries include both the government and the private sector, such as Chinese banks. Hence, it is possible that Chinese banks have been aggressively selling UST, while the Chinese government aggressively buying. But for China as a whole, its net purchase of Treasuries is still substantially lagging behind its total FX reserve accumulation. The change in the value of FX reserves could also be affected by valuation and exchange rate changes, but given a strong USD throughout most of 2005 and rising US short rates, which imply relatively less gain in reserves from these two factors, we therefore believe that some diversification has taken place in 2005.
China has been looking at financial assets other than US Treasuries for some time. The question is what are these alternatives? Data to help answer this question is scarce. Further to the traditional financial products, the Chinese authorities may consider more innovative use of its reserve capital. For example, in 2004, the government injected USD 45bn of capital from the forex reserves into two state-owned commercial banks, China Construction Bank and Bank of China, to boost their capital bases.
Given SAFE’s objective to use the FX reserves to support national strategy and the macro-economic adjustment policy, other less conventional options are also possible. One such possibility is to build China’s strategic oil reserve. This was mentioned by PBOC’s Tang Xu, who said that such a strategy is plausible although it will not consume a sizeable proportion of China’s FX reserve. Although PBOC governor denied that China will use its FX reserves to finance the building of stockpile, nonetheless we believe this is a proposition worth considering. As our calculation below illustrates, it is possible to fund the stockpile without making a huge dent in China’s FX reserves, making this strategy a viable option.
China launched its strategic oil reserve project in 2003. The construction of the infrastructure began in 2003 and the first stage of construction is expected to be completed in 2008. In this first stage, China is expected to accumulate about 100mn barrels of oil, or equivalent to 15-20 days’ worth of consumption. Using our 2006 year-average forecast oil price of USD60 per barrel, the strategic reserve would cost about USD 6bn. Indeed, this is less than 1 per cent of China’s USD 819bn FX reserve.
There are further considerations to China’s strategic oil reserve. China may wish to expand its stock in the long run to match international standards. Currently, the IEA requires oil importing members (China is not an IEA member) to hold emergency reserves equivalent to 90 days of imports, either held by the private or public sector. Assuming China chooses to adopt this particular benchmark, a daily import of approximately 2.6mn bpd implies a strategic reserve at least double the size of the current plan. Of course, the private sector may also choose to build their own reserve. Yet, even if it is fully paid for by the government, possibly out of FX reserves, the overall cost is still manageable.
Readers should note that this is NOT a call to rush out and long oil. One reason why this plan may not take place in the near future is because the total size of Chinese imports has risen with the level of FX reserves. Furthermore, even if China chooses to pay for it with its FX reserves, similar to the passive diversification away from USD assets, we believe the Chinese authorities will execute in an orderly and gradual manner.
Taking a broader perspective, the possibility of China devoting part of its FX reserve to commodities and less conventional investment products would prompt other Asian central banks to rethink how they can more effectively use their reserves. Since the Asian financial crisis, Asian economies’ external position has improved significantly, and the accumulation of FX reserves plays a prominent role. It comes to a point where they may have more than what is needed to ensure smooth external payments and some CBs have already considered their options on how to use the capital more efficiently and help their own economic development. Hence, China is not necessarily a pioneer in this area, but it does highlight the issue of Asian CBs thinking outside the box when it comes to reserve management.
1State administration of foreign exchange