China’s headache in cutting forex reserves

China may have lost the best opportunity to reduce its colossal amounts of foreign exchange reserves.

By 1996, its reserves were $100 billion; they exceeded $1 trillion by late 2006 and doubled to reach $2 trillion by mid-2009; they further grew to more than $3 trillion by 2011.

As they continue to increase, the reserves are set to exceed $4 trillion by the end of this year.

Despite the large scale of reserves, experts generally hold that it is in the best interest of China if it can keep the reserves at around $1 trillion.

As the reserves increased rapidly in recent years, economists have long suggested that the authorities figure out solutions to withhold their growth. But it wasn't until 2013 that senior central officials admitted that the scale of reserves could be detrimental to China's economic interest.

Premier Li Keqiang said during his recent visit to Africa that the large pool of foreign exchange reserves has become quite a serious burden for China since it can stoke inflation as the central bank issues home currency to purchase foreign exchanges.

Inflation is not the only problem created by the increasing reserves. Given the sheer size of the reserves, it is very difficult for China to make proper investment in global markets. Now its level of returns is only about 3 percent.

Considering the de facto depreciation of the US dollar, China could be incurring huge losses from its holding of foreign exchanges. For example, in terms of the power to purchase oil (which has risen by more than three times over prices in early 2000s), the real value of China's current foreign exchange reserves could have been much less than its face value.

But for China, it is a Herculean task to reduce the scale of foreign exchange reserves.

In the first place, it must stop the reserves from continuing to expand. To that end, according to economist and former central bank adviser Yu Yongding, the most convenient method is for the central bank to stop intervention in the foreign exchange market. In this way, the renminbi could be appreciated and China's trade surplus would decline, leading to reduced foreign exchange reserve accumulation.

But even Yu admitted that the impact would be too drastic.

Another way is to raise the level of prices and salaries, which, however, would increase inflation, which will jeopardize the efforts of the government to control consumer inflation.

China has become trapped in a predicament in which there have been no good solutions to its problem of foreign exchange reserve pile-up. No matter what measures it takes, there would be a domino effect that affects certain sections of the national economy and produces unaffordable social or economic costs.

It could have been much easier to tackle the problem when the scale started to exceed $1 trillion. Lack of foresight, however, has cost China its best opportunity to solve the problem.

Essentially, the problem is rooted in China's mercantilist policy that favors increases in trade surpluses. Such a policy is reasonable when China experienced a serious shortage of foreign exchanges in the 1980s and 1990s, but it should be adjusted in accordance with changes in the amounts of the country's foreign exchanges.

When the scale has become as large as $4 trillion — the world's largest — and $2.8 trillion more than what Japan holds, it is high time China accelerated its economic restructuring to prevent its foreign exchange reserves from incurring more losses in the future.