Li Yang Institute of Finance & Banking Chinese Academy of Social Sciences

1. The Challenge of Foreign Exchange Reserve Accumulation——The Analysis of Sterilization Operation of PBC Li Yang Institute of Finance & Banking Chinese Academy of Social Sciences 2007.6.7. Beijing China

2. Introduction • Since the beginning of the new century, China’s macroeconomy has been characterized with saving constantly exceeding investment.

3. Funneled into Foreign Exchange Reserve Accumulation • As a natural consequence of this situation, China has been carrying a surplus in both current account and financial & capital account, which in turn funneled into foreign exchange reserves accumulation. Under the existed system of foreign exchange administration, the rapidly-accumulated foreign exchange reserves have enforced People’s Bank of China (PBC) to release a huge amount of monetary base in the purchases of foreign exchange. The excessively rapid growth of money supply imposes a potential inflation pressure on the national economy.

4. A Biggest Challenge to PBC • This is the biggest impact that financial globalization brought to China’s monetary operations. • Faced with this problem, China's monetary policy assumes the main task of neutralizing the adverse effects of foreign exchange reserve accumulation on money supply and domestic economic development.

5. In this presentation I will describe the sterilization operations of China’s monetary authorities, analyze their successes and failures based on a framework of China’s monetary transmission mechanism. • Finally, I will discuss some possible alternate solutions.

6. I.An analysis framework • The primary objective of China's monetary policy is to maintain a moderate growth of money supply. The setting and changing of monetary base has generally played a subsidiary role in the policy process. • For the convenience of analysis, it’s helpful to draw an equation first for the supply and demands of the monetary base in China based on the PBC’s operations (Table 1).

7. Simplified PBC Monetary Base Equation

8. An Equation for Analyzing the Policy Process of PBC • The left side of the equation is the supply of monetary base. It implies that the increase of any item among Claims on other depository corporations, claims to governments, government securities, and foreign reserves will lead to the increase of monetary base, and vice versa. • The right side of the equation is the demand for monetary base. It implies that the increase of the supply of monetary base will induce corresponding increases in cash in circulation, deposit of financial corporations, central bank bonds, deposits of government, own capital, or other items, and vice versa.

9. If PBC want to keep the overall level of the supply of the monetary base, there is a trade-off among the items on the supply side. For example, if foreign reserves increased, the PBC could reduce claims to financial corporations to balance its effect,etc.. • The similar trade-off also exists on the demand side. For example, to keep the supply of monetary base unchanged, if the PBC needs to reduce the volume of cash in circulation, it can attain the goal by issuing central bank bonds and/or rising required reserve ratio to the financial corporations, etc..

10. II. 1994～2002: Foreign Exchange Reserves Become Main Collateral Asset Of The Monetary Base • China’s foreign reserves accumulation entered a growth track in 1994 when the reform of foreign exchange administration system started. Since then, the portion of foreign reserves as the collateral assets of the monetary base has been increasing gradually (see figure 1). Share of FX to the Monetary Base

11. FX Take the Place of PBC loans • As a response to this trend, the PBC begun to reduce the claims to the depository corporations and other financial corporations. • Since the decreasing of central bank loans was also a precondition for the reform of China's commercial banks, this adjustment on the structure of PBC’s assets carried out smoothly.

12. At the end of 1997, the PBC decided to terminate the mandatory planning on the lending of state-owned commercial banks, which indicated that China’s macroeconomic management would be implemented in a more indirect style. • As an important part of that reform, the PBC resumed open market operations on May 26, 1998. Therefore, Repo operation started to be employed as a sterilization instrument in the August of that year.

13. Repo Operations Bear Some Innate Weaknesses • As China’s monetary policy operation framework was still in an early stage of its transition, the PBC’s Repo operations bear some innate weaknesses. • First, the quantity of government securities held by the PBC was quite small, which, to a great extent, restricted the scale of repo operation. • The second problem is more technical in nature, i.e. Repo operation is only suitable for the management of short-term excess liquidity. In the situation that the accumulation of excess liquidity is a long run trend, its effectiveness is quite limited. Thus, when China’s foreign reserves surged in 2002, the PBC immediately found itself trapped in an awkward position with no any securities to sell for sterilizing operation.

14. III. Sterilization Operations on the Demand Side: Issuing Central Bank Bonds • As an alternate way out of the above quandary, on September 24, 2002 the PBC decided to convert immature repos into central bank bonds with the same maturities and then used the later as the instrument for repo operations. This decision brought out the central bank bonds on the center stage in China’s monetary policy operations. • In early 2003, China’s foreign reserves showed an increase of 74.2 billion dollars. The PBC realized that this growth trend might persist, which implied that neutralizing the excess money supply induced would be a long-term task of China’s monetary policy. Since the financial instruments for sterilization operations were scarce, the PBC chose central bank bonds as the primary tool for its operations.

15. Issuance Outstanding at the end of 2006 2006 2005 2005 2006 All All Q4 Q1 Q2 Q3 Q4 Government Bond 886.6 704.2 225.1 160.0 265.4 269.9 191.5 3,649.3 Bearer 233.3 200.0 50.0 60.0 79.4 54.2 39.8 784.5 Registered 653.3 504.2 175.1 100.0 186.0 215.7 151.7 2,864.8 Central Bank Bonds 3,657.4 2,746.2 853.2 1,320.0 903.0 816.2 613.1 3,230.0 Financial Bonds 922.0 711.7 211.5 70.0 307.1 173.7 380.0 2,538.8 Policy banks 865.0 605.2 183.8 65.0 287.0 169.0 352.8 2,283.6 Commercial banks 52.5 103.6 27.7 5.0 18.6 4.7 24.2 230.4 Others 4.5 2.9 0 0 1.5 0 3.0 24.8 Corporate Bonds 99.5 65.4 19.0 22.0 28.8 6.6 44.1 283.2 Short-term Financing Bonds 292.0 142.4 88.2 56.9 85.3 75.3 76.0 266.7 Asset-backed Bonds 11.6 7.1 7.1 0 5.7 0 5.9 18.8 Foreign Bonds 0.87 2.13 2.13 0 0 0 0.87 3.0 Convertible Bonds 14.3 0 0 0 0 2.7 11.6 5.9 Total 5,884.3 4,379.1 1,406.2 1,628.9 1,582.3 1,344.4 1,323.1 9,995.7 Central Bank Bonds Become the Second Largest Type of Securities in the Financial Markets

16. Central Bank Bonds Played Important Roles • (1)The PBC obtained an active, flexible and scale-unlimited instrument for the monetary policy operation. • (2)Successive rolling issuance, competitive bidding, and active secondary markets (inter-bank markets) trading have made central bank bonds rate a de facto benchmark rate for China’s monetary markets, which in turn accelerated the marketization of interest rates in China. • (3)Moreover, the development of central bank bonds market provided effective tools for the management of liquidity and risk for all kind of financial corporations.

17. The Weaknesses of Central Bank Bonds:(1)Costs • Central bank bonds are liabilities of the PBC, and the later needs to pay interests for them. So comes the operation costs related the issuance (see figure 2). However, if we take the return of the foreign exchange reserve into account, the picture will be different. • The purpose of issuing central bank bonds is to neutralize the excess money supply induced by buying foreign assets, and the foreign assets bought by the central bank will generate yields. So, to calculate the net costs related central bank bonds operations, we must subtract the returns to corresponding foreign assets from the interests paid for the central bank bonds issued. • Based the calculation, the interest costs of central bank bonds will be much lower.

18. Interests Paid for Central Bank Bonds (Unit: Billion Yuan)

19. The Weaknesses of Central Bank Bonds:(2) Impact on Market Rates • Issuing central bank bonds implies that the PBC impose an excess demand on the financial markets. This operation will inevitably influence the supply of and demand for funds and the evolution of interest rates in markets. So the large-scale issuance of central bank bonds makes the PBC virtually the biggest market maker. • Thus, the PBC is performing two conflicting roles: market-maker and supervisor, which evidently increases the complications of financial management and exacerbates the difficulties in the coordination between the two primary objects of monetary policy, that is, money supply and interest rate. In extreme case, if the PBC care the operation costs related to the operation of central bank bonds, it will be suspected of manipulating the interest rate, which undoubtedly deviates from its market neutral status and market stabilizing function. • In fact, the several failed biddings in central bank bonds issuance in recent years reflected the concern of market participants on the PBC’s dual identities.

20. The Weaknesses of Central Bank Bonds:(3) Sustainability of sterilization operations • Central bank bonds are issued in market. To attract investors, the rates of central bank bonds have to be kept on a relative high level. This trend may induce more foreign capital inflows and so impair the goal of stabilizing the exchange rate. In this regard, the sterilization operations are unsustainable. • This concern is logically valid. Certainly, if the Fed continues its high interest rate policy adopted since June 30, 2004, the problem will not be so serious. However, once the United States stops raising interest rates, the worry will become true. • Apparently, China has already encountered the problem since the end of last year.

21. IV. Sterilization operations on the Demand side: raising required reserve ratio • In fact, the PBC has already noticed the weaknesses of large-scale issuance of central bank bonds. Therefore, since 2004 the PBC has been trying to find alternate solutions. Raising the required reserve ratio is one of these alternates. Since 2004, the PBC has increased the required reserve ratio for 6 times. At present the required reserve ratio for financial corporations in China has reached the high level of 10.5%. • As a substitute for central bank bonds issuance, raising the required reserve ratio has the advantage of low cost. Currently, 1-year central bank bonds rate is about 2.7% and the interest rate that PBC paid to the financial corporations for their required reserves is only 1.89%. The later is much lower than the former.

22. The Flaw of China’s required reserve system • However, although raising the required reserve ratio instead of issuing central bank bonds has the advantage of lower operation costs, the effectiveness of this measure is questionable. The whole problem originates from the flaws embedded in China’s required reserve system. • The main flaw in China’s required reserve system is that the central bank should pay interests for the reserves of financial corporations. The evidence shows that this arrangement distorts the role of deposit-reserves and provides incentives to obtain interest income from the central bank, and thus weakens the function of reserves as a “tax” on financial corporations.

23. More…… • Besides the required reserves, China’s financial corporations also have kept high level of excess reserves in PBC. The reserve dynamics of China’s financial corporations shows that, though the required reserve ratio was increased successively to a level of 10.5%, financial corporations still keep an excess reserve ratio close to 3%. This means that the rise of the required reserve ratio didn’t decrease the excess reserve ratio effectively. • The effectiveness of reserve system depends on the overall level of reserves, which is the sum of required reserves and excess reserves. If the (upwards) adjustments of required reserve ratio can’t eliminate excess reserves, the effectiveness of the reserve system will be greatly dammed. This seems to be exactly the problem faced by PBC for a long time.

24. V. Sterilization operations on the Supply side: currency swap • On November 25, 2005 the PBC invited public bidding for a one-year currency swap among 10 domestic commercial banks.   • In this transaction, the PBC sold 6 billion dollars to the commercial banks and promised to buy them back with RMB one year later at 7.85 yuan per dollar. In the early December 2005, the PBC conducted another open market operation via currency swap, but this time with no detail information released. • In the perspective of monetary operation, currency swap is equivalent to Repos, and during the transaction period it can decrease the foreign assets held by the central bank.

25. More Practices Needed • It is a new trend in international community to use financial derivatives including swap to implement monetary policy. • As swap can virtually guide the future direction of exchange rate behavior, it must be coordinated with exchange rate policy. Unfortunately, the central bank of China still lacks experiences in this area.

26. VI. Conclusion: possible directions for reform • The above analysis shows, in face of rapid accumulation of foreign exchange reserves, neither issuing central bank bonds nor raising required reserve ratio is enough for the sterilization. And both of the two instruments have some innate weaknesses. This is why market keeps doubting the effectiveness of the PBC’s monetary policy, although the later has conducted a series of sterilization operations in a high frequency and large-scale style. • The key problem is that, the accumulation of foreign reserve is in so large a scale and persists for so long time that no existing sterilization techniques can cope with it effectively.

27. Re-allocating the Nation’s Foreign Exchange Assets • Facing this problem, it is natural for us to resort to the reform of foreign exchange administration system. The primary objective of the reform is to cut the rigid link between foreign reserves accumulation and the growth of monetary base, so as to release the unidirectional pressure of foreign reserve accumulation on money supply. The basic idea is to reform the existed foreign exchange reserve management system by re-allocating the nation’s foreign exchange assets(figure 4).

28. Suggested Re-arrangement of Foreign Exchange Assets Foreign Exchange Assets Official Foreign Exchange Assets Non-governmental Foreign Exchange Assets Foreign Exchange Assets Held by Enterprises & Householding Official Foreign Exchange Reserve Other Official Foreign Exchange Assets (PBC) (Other Official Bodies)

29. Some key points should by emphasized about the distribution of the official foreign exchange assets among monetary authority and other official bodies. • Based on a properly defined of “adequate level” of foreign assets held by the monetary authority, the large and fast-growing official foreign exchange assets can be separated into 2 parts: one part is under the management of the central bank to provide liquidity for monetary policy conduction and exchange rate management; the other part can be held and managed by other official accounts outside of the central bank, such as national foreign exchange investment corporation. Since the later has to raise money for the purchase of foreign assets by issuing bonds in the markets, the transactions on it will be independent of the change of monetary base. Therefore the pressure of sterilization operations on the central bank will be greatly relaxed.

30. We believe that, without the troublesome impacts of surging foreign exchange reserves, monetary policy will play a more active, effective and independent role in macroeconomic management in China.

31. Thank you!