Chinese foreign direct investment to other countries has been increasing rapidly in the past few years. It increased 12 percent from USD 173 billion in 2014 to USD 194 billion in 2015. The increment in 2014 compared to 2013 was also large, at 15 percent. Although the data for 2016 is not yet available, one can see that this trend is not ending, as the government’s “One Belt One Road” mega project is going ahead at full steam. Chinese President Xi Jinping has signed a large number of projects which range from high speed trains, roads, ports, energy facilities to other commercial agreements with many countries. By investing aggressively in various parts of the world, China is transferring the foreign exchange reserves it earned through trade surplus over the years to other countries and intends to earn investment return from these activities.
However, the situation of China’s foreign exchange reserves is not very optimistic. Due to reasons such as economic slowdown and capital outflow, the balance of the foreign exchange reserves is diminishing. It has decreased by 13 percent from USD 3.8 trillion at the end of 2014 to USD 3.3 trillion at the end of 2015. From Figure 1, one can see that even on a monthly basis, the reserves are diminishing fast. Until the end of May 2016, the reserves were less than USD 3.2 trillion.
Figure 1. Foreign Exchange Reserves of China (January 2016-May 2016)
Amount (USD 100 million)
Amount (USD 100 million)
Data Source: People's Bank of China
While China is investing beyond its borders, investors in China is also eager to move money out of the country. Under such a situation, the devaluation of the renminbi (RMB) seems unavoidable. Therefore, the inevitable happened in February 2016 when the RMB experienced a sharp devaluation. The Chinese government came up with three measures to salvage the situation. First, it utilized foreign exchange reserves to protect the RMB, amounting to USD 100 billion monthly. Second, it controlled capital outflows. And third, it engaged in the reform of the RMB exchange rate generative mechanism.
Indeed, all of these measures have been effective so far. For example, the recent exit of the UK from the EU caused large fluctuations in global currencies, but for the RMB, the scale of devaluation was much less, at only 1 percent.
However, in the long run, these measures are entirely inadequate. First of all, from a simple mathematical calculation, a monthly spending of USD 100 billion of foreign exchange reserves just to protect the RMB from devaluation will reduce the foreign exchange reserves to zero in less than three years.
Secondly, controlling capital outflows will affect investors’ confidence in China. In the long run, there will be fewer business owners who want to invest in China. Meanwhile, since the RMB will soon be included in the International Monetary Fund’s (IMF) basket of currencies that makes up the special drawing rights (SDR), the action of controlling capital outflows would obviously be contrary to the IMF’s guidelines for being an international currency.
Lastly, based on recent announcements from the People’s Bank of China, the exchange rate of the RMB is now reflected in two parts: one is the closing rate of the last transaction day, and the other is the change in the exchange rate of the currency basket. The currency basket does not just include the China Foreign Exchange Trade System, but also the currency baskets of the Bank of International Settlements and the SDR. From this mechanism, one can see that China places great emphasis on the stability of the exchange rate.
However, a basic question about the value of currency needs to be asked: what is the fundamental value of the currency? Does it reflect the fundamentals of the country’s economy? As long as this concern is not properly addressed, any deviation of the fundamental value will be identified as a speculative opportunity which will put the currency in danger again.
Therefore, although all those measures might have successfully averted disaster, there must be some fundamental changes to be put in force in the long run. These may include:
1) Change the mindset that China has excessive capital
China has to recognize that its investments abroad are not because of capital surplus. On the contrary, capital invested abroad involves huge opportunity costs. For example, the decreased level of foreign exchange reserves would make the RMB more vulnerable. Moreover, from the IMF Formula for Adequate Reserves,1 the minimum foreign exchange reserves for China is USD 2.7 trillion. The current level of USD 3.19 trillion cannot justify the claim that China has excessive capital, especially since its foreign exchange reserves are now on a decreasing trend. Instead, China has a pressing need to protect its foreign exchange reserves.
As a matter of fact, China has to be diligent and careful on every dollar spent. The adequate anticipated investment return must be in place before any decision is made. And the expected return must be sufficient to compensate any cost, including any opportunity cost involved.
For the “One Belt One Road” project, China may be in a better position as the organizer of financial resources instead of the bearer of all financial responsibility. It will give more flexibility to China not just politically but also financially. For example, China may increase its efforts to entice other countries to pour more capital into the projects through some form of commercial based organizations instead of investing in individual projects directly. In this sense the Asian Infrastructure Investment Bank’s operational principles are in the right direction.
2) Design a well-thought-out process for the RMB’s internationalization
There are so many lessons that China can learn from the Japanese yen. Internationalization may bring more risks although it has some benefits. There are economies that prefer non- internationalization even though they have sound economic fundamentals and openness, such as Singapore.
As the RMB’s internationalization is inevitable, and it will soon be in the SDR currency basket, one thing that China needs to do is to carefully consider the process. There are many questions to be asked. For example, how can the process be smooth? What is the proper procedure considering the current situation of the financial system and economic outlook? How can it maximize the benefits from the RMB’s internationalization and minimize the risks at the same time? One thing is for sure: a sudden open and free flow of capital without any control will be a disaster. The RMB’s internationalization must be a controlled, disciplined and well-thought-out process.
3) Continue to seek a better RMB exchange rate generative mechanism
Stability is very important, but it is not enough. If the goal of the foreign exchange reserve policy is only stability, such stability will definitely not be achieved. China has to come up with a mechanism that not only makes the currency safe and stable, but also reflects the fundamentals of the economy. Particularly, China must consider the interactions between the interest rate, inflation rate, trading patterns, as well as economic outlook.
A good example would be the Singapore dollar. The Monetary Authority of Singapore manages the Singapore dollar on a managed floating basis. The exchange rate is managed against a basket of currencies of their major trading partners and competitors. And the weights of various currencies are based on their importance to the economy. At the same time, Singapore gave up controlling the interest rate. The interest rate and inflation rate are determined through the management of the foreign exchange rate. Then, the foreign exchange rate, inflation rate and economic fundamentals will be consistent. At the same time, the currency is stable allowing some degree of fluctuation. There is one thing that needs to be highlighted though, Singapore can achieve this goal only because the country has a well-designed system and a very large amount of foreign exchange reserve compared to their M2 (ratio is almost 1 to 1).
1. Minimum FX Reserves = 10% of Exports + 30% of Short-term FX Debt + 10% of M2 + 15% of Other Liabilities