When Premier Wen Jiabao told this year's World Economic Forum in Davos that the Chinese Government was exploring more efficient ways to use its massive foreign exchange (forex) reserves to boost the domestic economy, he emphasized that the reserves could only be used overseas.
Zuo Xiaolei, Chief Economist of Beijing-based China Galaxy Securities Co. Ltd., recently wrote an article in the Securities Times explaining why the country's forex reserves can only be used overseas and how they can help stimulate domestic development. Edited excerpts follow:
China's forex reserves are assets of the People's Bank of China, China's central bank, instead of assets of the Ministry of Finance. The central bank purchased them from enterprises and individuals through issuing more domestic currency, the yuan. Any proposal involving spending China's forex reserves to boost domestic economy would require converting them into yuan. If more yuan is issued, it would increase the domestic money supply and finally provoke domestic inflation.
All in all, forex reserve assets have their real purchase power in overseas markets, and that's why Premier Wen said forex reserves could only be used overseas.
Also, it is unfeasible to hand out China's huge forex reserve assets to the people to boost domestic consumption. If the Chinese spend $1 trillion buying goods or services at home, they will first convert the money into yuan. The $1 trillion comes back to the central bank again. Worse still, the central bank has to buy back the $1 trillion for the second time, which means it will issue another sum of yuan equal to $1 trillion. If the Chinese spend the money overseas, it won't directly stimulate the country's domestic economy, and the central bank will lose $1 trillion of its forex reserve assets. Either way will give rise to a currency crisis or inflation and the depreciation of the yuan.
Through the proposal of backing up domestic development with huge forex reserves, Premier Wen expressed the Chinese Government's confidence in reviving the economy. It indicates China still has room for maneuvering and is able to adopt measures other than printing more money to ride out the crisis.
China's forex reserves, which hit a record $1.95 trillion at the end of 2008, ensure that the country has a strong capacity for external payments and will help to stabilize foreign direct investments and prevent large capital outflows.
Furthermore, a large forex reserve base will promote an increase in domestic investments by driving imports of, say, technology, machinery and equipment. It not only will boost China's economic growth, but also serve as an active response to issues of global concern such as environmental protection and global warming, if the technology and equipment we import are eco-friendly and energy efficient.
When China imports more, it also will benefit the economies of exporters. China can make a larger contribution to the revival of the global economy if the exporters lift restrictions on technology and certain goods exported to China.