How Foreign Reserves Could Make China Yet Stronger

December 29, 2004 • Commentary
A version of this article appeared in the Financial Times, December 29, 2004.

China’s economic performance in recent years has been extraordinary. Last year, growth in gross domestic product was forecast to exceed 9 per cent, with industrial production up a remarkable 16 per cent. Many fear that the country’s financial system may be too fragile to sustain such growth in the long term. Fortunately, the country’s burgeoning foreign exchange reserves could provide an ideal remedy.

At the root of the problems in China’s financial sector are the continuing subsidies directed to state‐​owned enterprises via the banking system. The purpose of these is to prevent unemployment and the loss of welfare benefits to former and current employees. Although the government has closed the worst loss‐​makers, the remainder continue to be subsidized.

In the long term this is likely to damage China’s currently high savings rate, the foundation of its economic miracle. At present, nearly 90 per cent of household savings are held in deposits with state‐​owned banks, partly because of the lack of alternatives. Most of these deposits are lent to SOEs. By contrast, most of the investment in the dynamic, private non‐​SOE sector that is propelling China’s industrial growth is self‐​financed, or dependent on foreign capital. With few of these non‐​state growth enterprises being willing — or allowed — to issue shares, trade on domestic stock exchanges is mainly in SOEs, whose non‐​transparent accounting practices and perceived lack of viability deter households from holding much of their savings in them directly. Hence the thinness and volatility of the domestic stock markets, as even a little news from the opaque SOEs can trigger big price movements.

This lack of adequate savings vehicles and the low return on deposits in state‐​owned banks pose a threat to China’s high rate of savings. This is likely to be compounded by the depressing effect on savings of an increasingly elderly population. But the state‐​owned banks cannot promote higher savings by raising their deposit rates without a rise in their lending rates to the unviable SOEs. These SOEs’ losses would then grow, leading the banks to advance more loans to cover them, with the result that the banking system would be burdened with yet more non‐​performing loans.

These microeconomic difficulties in using interest rates to stimulate savings that can then be fed into a well‐​functioning stock market have macroeconomic consequences. As the central bank is in effect prevented from using the interest rate to manage aggregate demand, heavy‐​handed (and, given the self‐​financed nature of most non‐​SOE investment, inefficient) administrative measures are needed to cool the economy.

Furthermore, given the fragility of the banking system, fully opening up the capital account of the balance of payments and moving to a completely flexible exchange rate system is ruled out. I do not think China’s export‐​led growth has depended on maintaining an undervalued exchange rate. As most of China’s manufactured exports are processed goods with little domestic value added, changes in the exchange rate would have little effect on companies’ profitability. The move to a flexible exchange rate is not only needed for a more efficient use of China’s national savings, but also to fend off the growing pressures for a revaluation of the renminbi from private speculators and China’s main trading partners.

Behind all these dangers to China’s economy lie the social burdens carried by the SOEs. These must be removed so the viable SOEs can prosper and the rest can be taken over or closed down.

Fortunately, China’s large build‐​up of foreign exchange reserves provides the answer. Last October, these stood at more than Dollars 600bn (Pounds 310bn), in a roughly Dollars 1,000bn economy. They are about 60 per cent of gross domestic product and are largely held in U.S. Treasuries. Apart from the absurdity of a relatively capital‐​poor developing country making these large, unrequited transfers to a rich country, China must have seen a loss in the real value of these assets. Since its peak in 2002, the U.S. dollar has depreciated by nearly 30 per cent in trade‐​weighted terms against big currencies.

There is a better way for China to use its reserves. At most, only a small proportion — say $100 billion — is needed to fend off any speculative attack in order to maintain the dollar peg. The rest — some $500 billion, as well as any future accruals — could be put into a social reconstruction fund under the central bank. This would function like any other big pension fund, such as that for the World Bank, whose annual return, averaged over 10 years, has been about 8 per cent. If the proposed fund for China could match this, it would yield an annual income of $40 billion, or 4 per cent of GDP, which could be used gradually to cover the SOE’s social burdens. The SOEs could then be treated as normal enterprises, to be privatized if viable and closed down if not.

This would bring many benefits. It would end the need for the subsidies that are sapping the banking system’s vitality. Banks could instead concentrate on mobilizing domestic savings and transferring them to high‐​yielding investment projects. SOEs with market‐​traded stocks would have more incentive to adopt transparent accounting. The authorities would be able to use interest rates as the primary means of managing demand. With a more robust financial system, the renminbi could even be allowed to float. In time, as the SOE problem receded, the income from the fund could become the basis for a fully funded pensions system for China’s ageing population.

There are good reasons to worry about the robustness of China’s financial system, it is true. But a country with $600 billion in reserves is not exactly devoid of options.

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