Using Foreign Exchange Reserves to Guide the Renminbi

Since 2014,there have been constant debates about whether the central bank should step into the market and use its foreign exchange reserves to deal with the unprecedented pressure on the currency from capital outflows. Some observers have insisted that there was no use to employing foreign exchange reserves to combat currency depreciation expectations. Such arguments were based on the failure of several Southeast Asian countries in protecting their currency during the Asian financial crisis of 1997-1998. However,if we never use our abundant foreign exchange reserves,what's the point of accumulating them?

Having the ability to respond to concentrated capital outflows and reassure nervous markets are key reasons for accumulating foreign exchange reserves. This capacity can protect the real economy from the shock of foreign exchange rate gyrations. Having a firm attitude towards using foreign exchange reserves is related directly to the market's trust in the central bank. If investors believe the central bank is determined to stabilize the market,can market panic be dispelled. If that goal is accomplished,capital flight pressures will gradually ease and the foreign exchange market will eventually return to more normal operations.

Conversely,if the central bank hesitates in taking action,it may encounter attacks on the currency from within the country as well as abroad. That may lead to continued market panic and loss of control over the exchange rate. Ultimately,that could mean the loss of foreign exchange reserves. Even if the central bank eventually finds the resolve to use its reserves to control market volatility,it will end up having to pay a much higher price to achieve the same goal. And once people panic over possible devaluation and there is huge demand for foreign exchange purchases,it may be impossible to win confidence back and satisfy that demand.

Stabilizing Sentiment

Therefore,as long as the economic fundamentals are not yet locked into an irreversible trend,we should not give up in the face of heavy capital flows; neither should we casually leave it to the market to find the elusive "equilibrium rate" for the currency. Foreign exchange market equilibrium is a result of the interaction of many factors,including economic fundamentals,monetary policy,market speculation and investor expectations. Exchange rate equilibrium simply does not exist. Once the central bank relinquishes the initiative in guiding the market,it is bound to exacerbate the powerful imbalances in the market. Speculative capital will likely seize on this opportunity and mislead market expectations. The market will then completely ignore economic fundamentals and turbulence will follow. In the second half of 2015,there was considerable public speculation that the US dollar would surge to more than 7 renminbi,leading to serious imbalances in the domestic foreign exchange market. That was a wake-up call for us.

When foreign exchange reserves are used to stabilize irrational market volatility,the biggest concern is that if the reserves are used up,market panic will emerge once more and then the central bank will have no means of arresting market fears. Thailand,South Korea and a number of other countries encountered such problems during the Asian financial crisis. But for China,with its huge supply of foreign exchange reserves,the risk of a similar situation arising is minimal.

Forex Reserves Won't Disapppear

In addition to having a rigid exchange rate system,the Southeast Asian countries that failed to shore up their exchange rates all had another feature in common: they all had long-term current account deficits and relied heavily on foreign debt to maintain a payments balance. As their foreign exchange reserves were very limited,once the external financing capacity disappeared,these countries quickly ran out of reserves. South Korea,for example,recorded continued current account deficits in the years prior to the financial crisis. Between 1990 and 1996 it ran up a total deficit of US$48.5 billion on the current account. With huge foreign debts,South Korea was unable to accumulate sufficient foreign reserves to cope with sudden shocks from abroad. In June 1996,more than a year before the crisis,Korea's foreign exchange reserve had reached a peak of US$35.7 billion,but their short-term foreign debt exceeded that at US$59.8 billion.

The primary source of China's foreign exchange reserves is the current account surplus,and that stems mainly from the surplus in merchandise trade. For example,from 2000 to 2014,our country's total surplus from merchandise trade reached US$3.15 trillion. The total current account surplus over the same period was US$2.52 trillion. That translated into an increase of foreign exchange reserves of US$3.69 trillion. Even if we lose the ability to raise external financing in the short term,our foreign exchange reserves will be sufficient to ensure normal external payments.

According to conservative estimates,China's merchandise trade surplus will remain at around US$300 billion to US$400 billion in 2016. As long as foreign trade enterprises,especially export companies,have continued confidence in the renminbi's long-term stability,the basic security of our international balance of payments is assured. Conversely,if foreign trade enterprises take a negative view towards the currency due to expectations of depreciation,they would make a "rational choice" of holding onto foreign exchange as long as possible and buy more foreign exchange whenever possible. This is often referred to as "passive settlement and active purchases" of foreign exchange. Once foreign exchange purchases exceed settlements,our foreign exchange reserves will start to decline again. Making use of our foreign exchange reserves to curb market expectations of currency depreciation are not only an important function of foreign exchange reserves,but is also an essential component in maintaining a healthy and stable reserve position.

Limited Shorting Ability

China has strict requirements for foreign exchange business and purely specul