China’s headache in cutting forex reserves

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.