A clerk counts renminbi banknotes at a bank in Huaibei city in east China's Anhui province. Photo: AFP

China has built a foreign exchange-earning economy and accumulated US$3.3 trillion in reserves over the past few decades, but such policies are outdated and need to be adjusted.

Amid the Russian-Ukrainian conflict, the United States has punitively frozen $300 billion worth of Russian reserves. The incident shows that it is completely possible for the US to seize China’s overseas assets, particularly forex reserves, if it deems it necessary.

US inflation and foreign debt accumulation will lead to dollar depreciation. China should buy less US Treasury bonds, buy more commodities and strategic materials, and shift away from exports to domestic consumption.

It also should try to fulfill the Sino-US trade agreement as much as possible. It should spend its forex reserves. All these will help promote renminbi internationalization and improve the security of China’s overseas assets. (Translator’s summary)

Today, I want to talk about the reform of the international monetary system, the security of China’s foreign exchange reserves, and the renminbi internationalization.

After the collapse of the Bretton Woods system (a monetary management system based on a link between gold and the United States dollar in 1944 to 1971), the exchange rate of gold was replaced by the US dollar. The status of the US dollar was not weakened but strengthened.
Those who study international finance were confused by such a trend.

When the dollar was backed by gold, people did not have confidence in it. How come everyone trusts the dollar when it is not backed by gold?

The only reason is that people’s confidence in the dollar has not been shaken by the collapse of the Bretton Woods system.

The international monetary system, which is now called the dollar standard, has a fundamental internal contradiction. The word contradiction is neutral without any derogatory meaning.

The US has to maintain a current account deficit in order to provide the world with dollar supply. In fact, it is providing the world with a reserve currency.

After decoupling from gold, the US dollar is purely a legal tender, which has no intrinsic value. Its value is based on American credit. What is credit? It refers to a condition that the purchasing powers of money and debt remain roughly the same. A hundred-dollar debt should not be devalued to ten dollars because of currency depreciation.

With the growth of world trade, the international demand for the reserve currency, mainly the US dollar, is also increasing.

The greater the US trade deficit, the greater the chance that the dollar will eventually depreciate. The possibility that the US will fail to comply with its credit is also growing. This issue is essentially a dilemma.

The US had a net foreign debt of US$15 trillion at the end of 2021 while the US’ foreign debt-to-GDP ratio kept surging. The dollar can still remain stable due to many reasons.

Many countries in the world, especially China, have a strong demand for the US dollar as a reserve currency. They accumulate their foreign reserves by purchasing the US treasury bonds, which represent a large portion of the US foreign debt.

Among these countries, Japan, China, Luxembourg, the United Kingdom and Ireland have purchased US$3.6 trillion of US treasuries.

If the rest of the world divests or stops buying US treasuries, the dollar will depreciate. At the same time, the inflation caused by the US’ extremely expansive monetary policy will further weaken the dollar’s status.

For quite a long time, foreign investors have been worried by the rising net foreign debt-to-GDP ratio, national debt-to-GDP ratio of the United States, as well as the extremely loose monetary policy implemented by the US over the past ten years. All these may worsen the US’ balance of payments situation while inflation will fuel the dollar depreciation.

Russian-Ukrainian conflict

Now a new problem has emerged. After the Russian-Ukrainian conflict, the US has frozen US$300 billion in Russian banks. Such a move against a nuclear power, which was out of people’s imagination in the past, seriously damaged the credit of the US.

The status of the US dollar as an international reserve currency has been further impacted by other geopolitical factors. These are the current challenges faced by the international monetary system.

China has long accumulated US$3.3 trillion in reserves through dual surpluses, namely the current and capital account surpluses. I have a few comments on this phenomenon:

First, by any measure, China’s reserves meet the forex adequacy ratio requirement.

Secondly, China’s forex reserves have an extremely low yield and focus too heavily on overseas assets. As we have a surplus in the capital account, we borrow money and remit it to the US. Therefore, a considerable part of China’s forex reserves is borrowed, but not earned from the trade surplus.

The financing cost of such a part of forex reserves is very high. Although China has US$2 trillion of overseas net assets, its investment return has always remained negative for more than ten years, or almost 20 years.

This situation is in sharp contrast with the US. The US has a net debt of US$10 trillion but receives an annual investment income of hundreds of billions of dollars. The investment income of the US in 2021 amounted to US$200 billion. This is my second point.

The third point is that the geopolitical conflict between China and the US poses a serious threat to the security of China’s overseas assets, especially its forex reserves. In fact, I have been worried about this issue for some time. The US’s freezing of Russia’s forex reserves shows that it is completely possible for the US to seize China’s overseas assets, particularly forex reserves, if it deems it necessary.

In fact, an article published by the Financial Times in December 2013 raised this issue. If the US has a conflict between China, it can seize China’s overseas assets. The US will suffer losses, but China’s losses will definitely be bigger. It will cause a serious blow to the global economy.

Adjusting asset-liability structure

Here are two reasons why China’s overseas asset-liability structure needs to be adjusted:
First, it can boost its overseas investment income, which should not be negative year after year. This is a mismatch of resources and must be adjusted.

A very important part of the adjustment is to reduce the proportion of forex reserves in China’s overseas assets.

Second, it can improve the security of China’s overseas assets, especially forex reserves. The US-Russian conflict tells the world that not only the assets of the Russian central bank can be confiscated, but also the assets of the Russian oligarchs, who may be the friends of American people.

How to improve the security of China’s overseas assets is a very important issue we have to deal with.

China’s overseas assets include two parts: stock and flow.

In terms of stock, or so-called existing volume, there is not much that can be done to adjust the structure of overseas assets and liabilities. But still, there are several options.

First, China should reduce holdings of US treasuries and increase holdings of other forms of assets. In the past, we were worried about the devaluation of the dollar so we diversified our forex reserves to different currencies. In special circumstances, such as the conflict between Russia and Ukraine, such diversification is not very meaningful although it still can be an option for us.

Second, China can consider boosting its investment in strategic resource-producing countries, such as equity investment in Central Asia, especially in Arabian oil fields.

Third, China can consider confiscating foreign investors’ assets if the US seizes China’s overseas assets. However, we must be careful about this.

China should keep the promise and strictly protect the investment of foreign investors in the country.

In fact, a lot of so-called foreign investments in China are actively our own investments while the remaining foreign investors, including the American ones, are those who are relatively friendly to China.

Fourth, China can use some technical means, such as IT technology and digital currency, etc. I am not an expert in this area, but I think there are some ways that everyone can think of.

Eight measures to take

Just now I’ve said that for the stock, many things have been done and cannot be changed within the short run.

In terms of flow, there are many things that can be done in the long run.

I think it is absolutely important to correctly understand and implement the strategic thinking of dual circulation, which is a right policy direction.

Policy adjustments that could be considered under this guideline include:

First, China should adopt an expansionary fiscal and monetary policy to stimulate domestic demand and boost imports. We have maintained a large foreign trade surplus for a long time. Such a policy was good for China in the past but it should be adjusted.

To reduce trade surplus, China must have strong domestic demand. Without it, manufacturers rely on exports.

How can China have strong domestic demand? Apart from having long-term structural reforms, China should implement an expansionary fiscal and monetary policy in the short run.

Second, China should cancel the existing export policy as soon as possible. In the 1980s and 1990s, our slogan was to build a forex-earning economy. Many policies were aimed at stimulating exports, but now such policies are outdated and need to be adjusted.
It’s time to consider the cancellation of the export tax rebate policy, which was aimed at boosting exports.

Third, we must increase the import of commodities and strategic materials. We do not have enough oil depots and grain depots, so we have to build them. We must pay attention to this issue. China is a country with a population of 1.4 billion. China should increase its imports of food and energy.

Fourth, China should buy less US Treasury bonds but import more US products, trying to fulfill the Sino-US trade agreement as much as possible. Except for the part that cannot be completed due to irresistible causes, China should finish the doable part.

Fifth, China should spend its forex reserves by maintaining a trade deficit for a certain period of time. The goals of boosting imports and spending of excess forex reserves can be achieved by the implementation of the China-US trade agreement.

Sixth, China should implement a floating exchange rate policy but at the same time continue to intervene in markets. Forex reserves should be allowed to fluctuate to ensure market stability.

Professor Ray Dalio, founder of Bridgewater Associates, emphasized the need for China to maintain certain capital controls, which I think is very right.

In fact, although curbing the inflow of hot money and discouraging capital flight may slow the progress of renminbi internationalization, we have no better choice.

Seventh, China should diversify its overseas investments. One method is to convert trade surplus into overseas investment. Despite the US’ containment policy, we still have to walk this difficult path.

We do not know the whereabouts of a large amount of our overseas investments. But we should identify all of them and decide our future direction.

Eighth, China should make good use of its advantage in infrastructure investment, but at the same time beware of debt traps.

China’s balance of international payments and overseas assets and liabilities should not contain a large proportion of US assets.

China should not be a creditor, especially not to lend money to someone who is much more powerful, as the debt may not be repaid.

It’s not a good deal to be a creditor under the current geopolitical conditions.

This article first appeared in Guancha.cn (“Observer”), a Chinese-language news and opinion site. Yu Yongding is a Chinese economist who formerly served on the Monetary Policy Committee of China’s central bank. The article is a compilation of Yu’s speech delivered during the 2022 Tsinghua Wudaokou Chief Economist Forum on May 14. It has not been reviewed by Yu himself.