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An Study of the Opportunity Cost of Holding Foreign Exchange Reserve

Author: ZhangZuo
Tutor: NiKeQin
School: Southwestern University of Finance and Economics
Course: International financial
Keywords: balance of payments foreign exchange reserves FDI income and costs active management
CLC: F832.6
Type: Master's thesis
Year: 2008
Downloads: 299
Quote: 0
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Abstract


With the acceleration of the process of reform and open up, rapid development of international economic integration , Chinese economy has become an important player in the larger international economic environment. At present, for the speed of international capital flows become more and more faster, financial and economic crisis take place more and more frequently and intensely. In an open economic environment, foreign exchange reserves is an important ingredient when reviewing a country’s external economic ability.There is no doubt that in today’s increasingly globalized economic environment, reasonable and adequate foreign exchange reserves play a very important role in the stabilization of the RMB exchange rate. In 1997 , the Thai financial crisis was a good example. It is due to our strong foreign exchange reserves, and has enabled us to adhere to‘not devaluing the RMB’, Eventually , we have made great contributions for the economic recovery in Southeast Asia.But it is not the more foreign exchange reserves , the better , because holding huge amount of foreign exchange reserves cost so much . China, as a developing country, raising funds from overseas must pay the risk premium. And because we consider of the safety and mobility, we use most of foreign exchange reserves to buy United States Treasury which only offer low return. Interest on such "revenue deficit" means the more foreign exchange reserves we have, the greater the loss in interest return.Moreover, the proceeds from the low-income flows to China instead of the high-income earners in the United States, from this viewpoint, China has huge foreign exchange reserve and borrow a large foreign debt, equivalent to a low-cost domestic funds will be used as loans to foreigners, but also to borrow capital from abroad at high prices. So, it is obvious that maintaining huge foreign exchange reserves means paying a high opportunity cost. This is a vicious circle, known as the" Stiglitz vicious circle". Due to a sharp rise of the current balance after 1997, the authors of this paper select data from 1997 to 2006 to estimate the yield of FDI in China. About the conclusion which are still not in line with the actual situation after adjusting data and the method of calculation , with the help of mentors , eventually the author has her own analysis——concluded that the yield of FDI in China is about 11% -14%.To calculate the yield of foreign exchange reserves in this paper, the author use United States 1-year Treasury yield as the lowest limit , and use 20-year yield as the highest limit . So 3.084% is the lowest limit of China’s foreign exchange reserves investment yield , and the ceiling is 5.057%, 4.52% is an average yield.In this paper, the analysis proved that the "Stiglitz vicious circle" does exist in China, and the possible loss between using of foreign capital and holding foreign exchange reserves is 6.48% - 9.48%.In the last, the author suggests that China’s foreign exchange reserves management should be divided into out of the appropriate scale and within the appropriate scale, and do assets management and currency structural arrangements separately.

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CLC: > Economic > Fiscal, monetary > Finance, banking > China's financial,banking > Exchange rate,foreign financial relations
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