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Analysis of internal and external equilibrium model based on China scale of foreign exchange reserve

Author: PengBin
Tutor: LuYaQin
School: Yunnan University of Finance
Course: World economy
Keywords: Foreign Exchange Reserves Optimal Scale The External andInternal Equilibrium
CLC: F832.6
Type: Master's thesis
Year: 2014
Downloads: 1
Quote: 0
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Abstract


In1978, the shortage of foreign currency was still serious, since the great reformand opening, China’s foreign exchange reserves has grown nearly23,000times. Atthe end of the first quarter of2013, the size of China’s foreign exchange reserveswas equivalent to the Germany’s GDP and reached3.8trillion dollars at the end of2013. In recent years, China’s foreign exchange reserves continues to grow, causedthe academic circles for Chinese foreign exchange reserve scale suitability of theextensive research and analysis.The root cause of the sustained high growth of China’s foreign exchange reservesis its economic unbalance. On one hand, the lack of domestic demand and lowefficiency of financial market would make excess supply of savings go abroad in theshape of China’s trade surplus; on the other hand, as a developing country, theinternational monetary system dominated by developed countries transforms China’strade surplus into huge foreign exchange reserves.To clarify the source of foreign exchange reserves,this paper has carried on theanalysis from the perspective of international balance of payments.We can see thatthe main origin of foreign exchange reserves are "Double Favorable Balance", hotmoney, residents’ changing foreign currency deposit into RMB, profit from theinvestment of foreign exchange reserves. For lack of official authoritative data, it’shard to answer where has the foreign exchange reserves gone, we could onlyestimate that China’s foreign exchange reserves consist largely of u.s. governmentdebt.In addition, after analysis, the three deciding factors which lead to faster increaseof foreign exchange reserves are domestic excess savings, processing mode of trade,long-standing expectations of yuan appreciation.This thesis is to discuss whether the scale of China’s foreign exchange reserves isgreater than its optimal scale and if indeed it is, then how to make the downsizing happen. The thesis builds up a theoretical framework of the external and internalequilibrium. Following logical rules, we select two indicators, by data processing,we reach a conclusion that external and internal imbalances both exist in China,China’s foreign exchange reserves is excessive, but the excess of the foreignexchange reserves is guarantee that jobs will stay put.As we have confirmed that China’s foreign exchange reserves is excessive, weanalyze the excessive reserves’ positive impact and negative effects on Chinaeconomy. The core function of the reserves is maintaining confidence in RMB,however, there are four negative effects: China will further lose much moremonetary policy autonomy, increasing difficulty in conducting macroeconomiccontrol, the cost of holding reserves goes up, self-strengthening mechanism leadingto the accelerating increase in Forex Reserves.As we see the excessive reserves does more harm than good, the proposedmethods are: reducing the supply of foreign exchange; stirring up additional demandfor foreign exchange; improving the efficiency of domestic financial market; themethod of changing the pattern of growth in China based on the theoreticalframework of the external and internal equilibrium.We have mentioned the two operating models in the first part of this paper: mostof the reserves is invested in fixed income products and Forex outside PRC by theState Administration of Foreign Exchange; Then sovereign wealth funds representedby China Investment Corporation (CIC) invest a small part of the reserves in equity,fixed income and alternative assets, in both developed and emerging markets. Itsalternative investments include hedge funds, private equity, commodities and realestates, etc. Last but not least, Zhu Changhong resigned as China’s chief investmentofficer at the end of January this year, the leaders in the government should give himmore care and support and understanding, a bigger cut of the reserves’ scale is moreimportant than boosting the investment yield by a few basic points.

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