Treasury Today Country Profiles in association with Citi

ECR Research logo

Hidden implications of China’s excessive reserves

China’s accumulation of foreign exchange reserves has received much attention and been cause for lively political debates over recent years. For various reasons, outlined in this article, China has accumulated the largest amount of foreign exchange reserves in the world, adding up to around 44% of the total size of its economy.

China’s reserves are quite above the recommended level by the IMF. Moreover, there are substantial costs attached to the process of reserve accumulation. This begs the question whether it is in China’s advantage to have such a high level of foreign reserves. What is clear, however, is that China’s reserves are as high as they are due to a combination of an export-driven growth model and an exchange rate policy that holds the value of the renminbi artificially low to support the export sector. As a by-product of this strategy, foreign reserves are accumulated.

To slow down the accumulation of reserves, China has to encourage consumption growth
Diagram 1: To slow down the accumulation of reserves, China has to encourage consumption growth

Source: Thomson Reuters Datastream/ECR

These reserves, however, could easily constrain exchange rate reforms: it is widely believed that the renminbi would strengthen vis-à-vis the US dollar and other currencies if it were allowed to move freely against the dollar. Given that most foreign reserves are denominated in US dollars, the further the renminbi weakens vis-à-vis the US dollar, the higher the losses on China’s foreign reserves expressed in renminbi. This acts as a hurdle to letting USD/CNY float.

As a result, this increases the pressure on China to:

  1. Invest in higher-yielding alternatives to counterbalance the loss on reserves from a strengthening renminbi.

  2. Reform the economy such that there is no longer an accumulation of foreign reserves.

Higher-yielding alternatives?

Firstly, to offset the high costs attached to the system in which such huge reserves have been accumulated, there have to be significant revenues as well. Before 2007, China’s reserves were managed by the State Administration of Foreign Exchange (SAFE), which is a subsidiary of the PBoC (People’s Bank of China). It was claimed that SAFE achieved too low a return due to a conservative investment strategy. Therefore, the Ministry of Finance established its own sovereign wealth fund: the Chinese Investment Corporation, CIC. CIC increasingly became a competitor of SAFE as the management of reserves is split between these two. This has encouraged SAFE to invest in riskier, but higher yielding assets. Unfortunately, SAFE does not disclose its returns.

Many analysts still claim that China’s reserves are not wisely invested, generating very low returns:

  • The largest share of the reserves is invested in US Treasuries. The price for US Treasuries has gone up (yields have declined) in recent years, from which China has gained. This is offset, however, as the US dollar has lost a large share of its value vis-à-vis the renminbi. If USD/CNY drops further (as a result of the Fed’s policy of quantitative easing and renminbi appreciation) this reduces the value of China’s dollar-denominated assets.

  • Diversifying reserve holdings leads directly to downward pressure on the dollar and dollar assets, which implies a further loss on China’s foreign exchange holdings.

  • If China seeks to repatriate foreign assets to invest domestically, repatriation of the funds would potentially cause too much upward pressure on the renminbi.

In other words, Chinese reserves are more or less trapped into low-yielding US government paper.

China seeks to become less exposed to US Treasury market
Diagram 2: China seeks to become less exposed to US Treasury market

Source: Thomson Reuters Datastream/ECR

Overall, the broadly disappointing returns on China’s reserves act as considerations for China to slow the accumulation of reserves and even reduce reserve holdings. The government could achieve this by speeding up the reform of the domestic economy. If the economy relies less on investment and export growth there is also less reason to keep the renminbi artificially weak to stimulate exports. Thus, currency interventions are no longer required, and will become an ever smaller source of foreign reserve accumulation. In addition, a smaller trade surplus (exports are already visibly slowing and at a three-year low) or trade deficits also mean that another source of reserve accumulation is shrinking.

Consequences for China’s currency

So what does all the above mean for the renminbi? We believe a continued gradual appreciation of the renminbi (a gradual decline in USD/CNY) is still the most likely outcome:

  • Should the renminbi strengthen too rapidly, it will depress the value of the current foreign reserves holdings (see above). With growth elsewhere still disappointing, and domestic wages on the rise, the export sector will also come under too much pressure if it faces a stronger renminbi and thus see its competitiveness decline as well.

  • Should the renminbi strengthen too slowly, the pressure to get the domestic economy to rely less on export and investment growth would subside. This would also imply that the build-up of foreign reserves continues (especially if other central banks continue to expand their balance sheets, and liquidity keeps flowing to emerging markets including China). This would result in more upward pressure on the renminbi, but to prevent the currency from strengthening too much, the PBoC would have to intervene – which entails further excessive reserve accumulation.

Therefore, we expect a ‘middle-of-the-road’ policy with continued gradual downward pressure on USD/CNY and on balance some foreign reserve accumulation – albeit less than in the past. Given that (real) yields on government bonds of Western countries will likely remain very low or negative during the coming years (see ECR’s recent Global Financial Market reports for more information), China will continue to seek alternatives to invest its reserves more wisely. This means:

  • Reduced demand for US dollars and other US assets.

  • A bigger portion of the existing reserves will be invested for commercial considerations. Thereby, China will invest more in order to securitise its future energy needs, for example in Australian mining companies, or it will accumulate much-needed commodities.

  • China will continue to diversify its reserves into gold as a hedge against inflation, putting the price of gold under upward pressure. It has already become the largest producer and accumulator of gold reserves last year.


As described, we still believe the longer-term trend in USD/CNY is downward. The more China reforms its financial markets and makes the renminbi an increasingly attractive investment for foreign investors, the further USD/CNY will be under downward pressure. For example, a few central banks like those of Nigeria and South Korea are already allowed to hold a proportion of their currency reserves in renminbi. During the course of 2012, we feel USD/CNY will drop to 6.20 and further in anticipation of such reforms.

For the shorter term, however, we believe that the uncertainty about the world economy and slowing (export) growth in China will be met with sideways trading in USD/CNY. To prevent too much weakness in the export sector as a result of declining demand from the Western economies, we think the People’s Bank of China will not allow the renminbi to strengthen substantially during the coming weeks to perhaps months. In addition, we think the US dollar will strengthen in the near term as a result of less Fed quantitative easing than initially expected. The longer the US economy continues to show surprisingly positive results (see ECR’s US interest rates reports), the longer the sideways trading in USD/CNY could last, given that this would support the US dollar via higher US interest rates. Later on, if the euro crisis again escalates, safe haven flows could also support the US dollar and keep USD/CNY under upward pressure.


We believe that a lot of positive news about the euro is already discounted in the EUR/CNY rate, and foresee that the Eurozone debt saga will intensify again later this year. This means downward pressure on the euro, while we expect the renminbi to strengthen further later this year. On balance, we expect EUR/CNY to drop to 7.50 and further in the months to quarters ahead.

Relative to the economic weight of China, the Chinese currency – renminbi – is vastly underrepresented in global trade and financial transactions. However, this is changing gradually and many economists expect the renminbi ultimately to become the most used currency after the dollar. This means the importance of the renminbi for corporates will only increase, especially when the renminbi is allowed to move freely against the dollar. ECR Research has introduced a new service focusing on the developments in China, their influence on the world economy and the consequences for the renminbi exchange rate.