A Look at China's Foreign Exchange Reserves

In the nearly four decades since China launched its reform and opening program，it has relied on export-driven economic development. Over this period，as part of the growing levels of economic exchanges，funds have flowed on a daily basis between China，its neighboring countries and the world's major economies. As a result of the inflows of funds from abroad，China's central bank accepts and manages foreign exchange on behalf of the state. It uses these foreign exchange funds to meet the nation's total overseas obligations. At the same time，it uses some of these funds to intervene in the foreign exchange market to reduce volatility in the renminbi exchange rate and ensure that the national currency remains stable and provides a favorable environment for China's economic development. In short，from the national perspective，the main purpose of foreign exchange reserves is to meet daily needs and ensure there are sufficient funds to cover any unanticipated events. These funds should not be viewed as a cash cow that produces high returns. To do so would be like investing all of a family's wealth in the stock market in search of big profits while ignoring considerable levels of risk.

Creating Foreign Exchange Reserves

As we examine foreign exchange reserves we need to look at the demand side of the economy as measured by the gross domestic product. Some of the nation's economic output is used to meet consumer demand as well as investment needs (including from the private and public sectors)，while the rest is exported abroad.

If we drill down and look at individual enterprises that export goods or services，we see that these exports are exchanged for US dollars or another foreign currency. The net exports of all these individual micro-level manufacturers are aggregated to form national macro-level exports. The US dollar income earned from all these exports will be reflected in the national balance of payments and recorded under the current account.

In addition，external funds are being brought in as foreign direct investment or securities investments under the Qualified Foreign Institutional Investors program. From a macro perspective，the sum of these funds is reflected in the national balance of payments and recorded under the capital account. As long as there are net inflows of foreign currency in these areas，the accounts will show surpluses under the foreign exchange reserve column of the nation's balance sheet.

Foreign currency funds entering the country generally are converted into renminbi for domestic use. Taking exports of domestic enterprises under the current account as an example，these funds need to be settled in renminbi in order to pay for the raw materials used in production，pay wages to workers and cover other local costs. Therefore，exporters convert foreign exchange income into renminbi，which later enters the bank accounts of these enterprises.

The exchange of foreign currency for renminbi is completed in the foreign exchange market through commercial banks. In this market，the banks act as intermediaries. As a result of these transactions，foreign currencies are concentrated in the hands of the central bank by way of the commercial banks. As we noted earlier，the renminbi funds flow into the bank accounts of the exporters. In some sense it can be said that the central bank is the ultimate market maker and ultimate liquidity provider for the market.

Foreign currencies are bought and sold on the interbank foreign exchange market where there are many market makers. As with other markets，if there are more buyers than sellers of a specific foreign currency -- such as the dollar -- the value of that currency will go up against the renminbi.  Conversely，the value or price will decline if there are more sellers of the currency than buyers. As the central bank is the ultimate liquidity provider for this market，it will sell dollars to relieve upward market pressure from dollar buyers to prevent the US unit from rising beyond the permitted trading range. Conversely，the central bank will intervene to buy dollars and sell renminbi to prevent the US currency from falling below its designated range.

Regardless of the currency transaction process，current account surpluses and capital account surpluses eventually end up on the central bank’s books，and these form the central bank’s foreign exchange reserves. At the same time，renminbi of equal value move off the central bank’s books. Without a mechanism to offset this，there will be an increase in the central bank's reserves as well as an increase in renminbi on the market if there are continued surpluses under the current and capital account.

The PBOC’s Balance Sheet

Before discussing what can be done with the nation's foreign exchange reserves，let's look at the central bank’s balance sheet. With reference to Western economic research，a nation's economic activity is comprised of various actors，such as consumers，producers，governments and the central bank. One of the functions of the central bank is to issue money and thereby provide the tools for other parties to complete their transactions. Here，the central bank can be understood as a maker or manufacturer of currency. This manufacturer has its own distinctive features，however，as the  purpose of producing money is designed to act on behalf of the state in providing the economy with the trading instruments and national credit necessary for transactions. It is not specifically a profit-making role. However，as a manufacturer，the central bank，like other manufacturers，should have its own balance sheet that objectively records its own external liabilities and total assets.

First，let's examine the central bank’s liabilities. The cash issued to the market by the central bank，along with the reserve deposits of commercial banks，constitute the monetary base，or sometimes known as reserve money. In addition to issuing bills，China’s central bank issues central bank bills in the interbank bond market in order to soak up liquidity. The monetary base and the various central bank bills issued by the central bank，together with government deposits and the central bank’s own funds，constitute the central bank’s total liabilities. The total amount and structure of the reserve money on the liability side can be adjusted by issuing or withdrawing central bank bills and other open market operations such as changing the reserve requirement on bank deposits.

The change in the total amount of money in circulation (for example，M2 money supply) in economic operations starts from the reserve money of the central bank’s liabilities，which is developed further through the commercial bank’s continuous deposit-loan monetary multiplier mechanism. Therefore，the increase or decrease of the central bank’s monetary base directly determines the increase or decrease of the total amount of money in the economy.

Turning to the central bank’s assets，when the central bank injects funds it must complete equal exchanges with commercial banks，government departments and the like. And it is not a free gift. This is done at a price. The central bank puts the monetary base in these commercial banks in exchange for government bonds and the like which are placed on the central bank's books，forming an important part of the asset side. This is domestic credit. Another part of the central bank’s assets are the foreign exchange reserves. The central bank takes the US dollars exchanged from renminbi taken on the liability side for assets listed on its books.

Regulating and stabilizing interest rates and regulating and stabilizing the exchange rate are the internal and external functions of the central bank. Interest rate adjustments can be accomplished by expanding or compressing the monetary base on the liability end，thereby affecting the total supply of money. The adjustment of the exchange rate is accomplished by expanding or reducing the foreign exchange reserves on the asset side. In conclusion，both the central bank’s monetary and exchange rate policies ultimately will be achieved in the asset-liability management. Understanding this critical to understanding the role and formation mechanism of foreign exchange reserves. This helps eliminate some misunderstandings regarding the foreign exchange reserves.

Foreign Exchange Reserves and Money Supply

The central bank’s asset-liability management is the source of changes in the total amount of money in the economy，such as the M2 money supply. That is，changes on both the asset side and the liability side may cause changes in the total amount of money in the economy. This means that the change in the balance sheet of the central bank causes a change in M2. Therefore，analyzing the time sequencing between the two is an impact-response process.

For instance，a one dollar increase on the asset side under the foreign exchange reserves means a corresponding amount of seven yuan as the input of base currency (assuming one US dollar equals seven yuan) on the liability side. Taking into account the multiplier effect (assuming a multiplier of 2，reflecting the repeated deposits and loans in the commercial banking system)，there will be an increase of more than 14 yuan in the economy as seen in M2. Therefore，the process of increasing foreign exchange reserves is a process of multiplying the renminbi in the economy.

However，the situation in reality is far more complicated because the central bank will undertake offsetting operations. For example，it is known that an increase of one US dollar in foreign exchange reserves corresponds to a monetary base of seven yuan on the liability side. At the same time，the central bank reverses the operation and sells seven yuan of government bonds in the open market in order to recover the equivalent seven yuan. In other words，the liability side of the central bank corresponds to two operations; one is to put seven yuan as base currency into the market while the other is to recover seven yuan. Ideally，on the balance sheet of the central bank