While already under pressure to revalue its currency, the yuan, against the U.S. dollar, China also faces the challenge of stifling vast losses to its foreign exchange reserve, mostly denominated in U.S. dollars. These losses to foreign exchange (forex) reserves totaled $271.1 billion from 2003 to the end of 2010 due to an appreciating Chinese currency, according to Zhang Anyuan, a research fellow with the Academy of Macroeconomic Research under the National Development and Reform Commission, in an article to Securities Daily published on May 5, 2011.

In response, the State Foreign Exchange Administration (SAFE) said the yuan's appreciation will not lead to losses of China's forex reserves. This stance alone cannot dispel economists' worries as most agree that China should focus on ways to guarantee the value of its reserves.

Whether to preserve or increase the value of the assets, Zhang said China's most urgent task at hand is diversifying its forex reserves.

Losing or not

A popular assumption is that China's forex reserve investment yields are doing considerably well at about 3 percent a year. The level of management is among the top of various sovereign wealth funds worldwide.

But considering exchange rate costs between the yuan and the U.S. dollar, by the end of 2010, newly increased forex reserve since 2003 had lost $271.1 billion. If the exchange rate of the yuan hits $1 for every 6 yuan, which may quickly become a reality, losses will reach $578.6 billion, Zhang said. A financial hit like that certainly can't be made up with investment yields from the forex reserves.

To date, the yuan has appreciated nearly 5 percent against the U.S. dollar since June 2010 when China restarted the exchange rate regime reform. Taking inflation into account, the yuan's real appreciation against the U.S. dollar has surpassed 10 percent.

Admittedly, the losses are only rough estimates, Zhang said, but a detailed analysis won't change the fact that large sums of money are vanishing.

Worrying or not

To counter Zhang's article, SAFE issued a statement of its own.

To begin with, the statement said an appreciating yuan won't lead to losses in China's forex reserves because these reserves are denominated in U.S. dollars. Any exchange rate fluctuations will lead to changes in book values, but not losses or gains in real terms. This will not affect the direct purchasing power of the reserves, only reflecting different book values. Real losses or gains will be realized only when the forex reserves are converted into the yuan. For the time being China does not need to convert large reserve sums into the yuan. Moreover, after the yuan appreciates companies also have the benefit of reducing import costs.

Forex reserve book losses caused by the currency appreciation are also far less than the surplus of China's financial assets. Corresponding to the book losses of converting U.S. dollar-denominated reserves into the yuan is the book surplus of converting the yuan-denominated financial assets held by Chinese citizens into the U.S. dollar. By the end of March 2011, the balance of China's forex reserves stood at $3.04 trillion. According to the exchange rate at the end of March, China's yuan-denominated financial assets, including corporate and individual deposits, stocks, treasury bonds and insurance assets, were more than five times the country's forex reserves. This means that as the yuan appreciates, the book surplus of these financial assets will be more than five times the book losses of China's forex reserves. Considering the scale of other financial assets held by Chinese residents in stocks and bonds the book income of these assets will be much higher. Also, the above losses or incomes are both in book value and won't be realized without actual convertibility.

Also important, the actual purchasing power of the forex reserves is decided by their yielding rate and the inflation rate of the country where the investment is going. Over the years China's forex reserves have maintained stable yields with the yield rates much higher than the inflation rates of the United States, Europe and Japan. Therefore, the actual purchasing power of China's forex reserves is guaranteed. From 2000 to 2010, the average annual growth of consumer price index was 2.4 percent, 2.1 percent and -0.2 percent in the United States, Europe and Japan, respectively, all of which were lower than the average annual yielding rate of China's forex reserves.