How much is enough? 'We can't really say'

Too much in foreign exchange reserves may actually be harmful, academic says

Michael Pettis believes China has probably double the minimum foreign exchange reserves it needs.

The professor of finance at Peking University's Guanghua School of Management also insists that January's fall in the level to below $3 trillion is a non-event.

"What is the right amount of reserves for China? You know, there is no real science to it so we can't really say but I doubt it is much above $1.2, $1.3 or $1.4 trillion, so they now probably already have twice as much as the minimum amount they need."

Michael Pettis, professor of finance at Peking University's Guanghua School of Management, says the fall of China's foreign exchange reserves in January - to under $3 trillion - is a non-event. Zou Hong / China Daily

Pettis, who was speaking at his home in a hutong area of Beijing's Houhai Lake area, takes the perspective of a financial and economic historian.

He argues that countries get into difficulties when they have too much in reserves rather than too little.

"When you look at the three biggest foreign reserves in history as a share of global GDP, you have the United States at the end of the 1920s, Japan at the end of the 1980s and then China about a year ago. If you look at the two previous cases, they both had disastrous subsequent decades."

He believes the fall in China's foreign exchange reserves is the right direction of travel but is concerned by the excessive liquidity in the economy they have created over the past 15 years.

China's foreign exchange reserves grew from $210 billion in November 2001 when the country joined the World Trade Organization, to a peak of just under $4 trillion in June 2014, falling back to $2.998 trillion last month.

The additional liquidity is created in the economy because the foreign exchange earned by companies trading with the outside world has to be converted into Chinese yuan, which increases the money supply and can lead to asset bubbles.

"Too much reserves is a bad thing. With so much liquidity creation, too much debt gets created and that is what we have seen in China. Just a way too rapid increase in debt."

Pettis, however, says it is very difficult to row back from this position as Chinese policymakers are currently attempting to do.

"The money supply has grown too rapidly, but it doesn't mean the best way out is a contraction because that is also very painful. The best thing would have been not to have seen such rapid growth. What we really need now is a slow, stable growth in the money supply."

Pettis, 58, was born in Spain and is the son of a well-known US consulting engineer and a French mother. He was brought up in Pakistan, Peru and Morocco.

He initially studied physics at Columbia University but switched to development, economics and finance.

His early career was as a Wall Street investment banker working for companies like Bear Stearns, where he headed Latin American capital markets.

He came to China on a holiday in 2001 and after a week staying in the Hilton Hotel he decided to stay permanently.

He has combined his academic career with promoting indie bands and running his own record label Maybe Mars.

Apart from being one of the best-known regular commentators on the China economy, he has written a number of books, including Avoiding the Fall: China's Economic Restructuring.

Pettis says the PBOC's current policy of attempting to constrict capital outflows is a better option than a sudden contraction in the money supply.

"The giving up of free movement of capital is less painful than having a contraction of the money supply. So they are choosing to constrain the outflows."

He says, however, that such restrictions inevitably delay internationalization of the yuan and the opening-up of capital markets, which will be the long-term solution to financial problems relating to reserves.

"A central bank only needs reserves if it wants to intervene in the currency markets," he says.

The economist says that the United States and the major European economies that have open capital markets focus on domestic monetary policy and not managing their exchange rate.

"If you have open capital markets you get to choose. Either you maintain the value of your currency or you determine interest rates. You can't do both," he says.

"The British don't buy and sell dollars neither do the Americans. They let the currency do whatever it is going to do. Their priority is domestic monetary policy and interest rates."

Pettis says it is a common misconception that the US does not hold reserves because its own currency is used as the global reserve.

"If the US wants reserves it buys euros, anything except dollars. European reserves can be anything except euros. For China it is anything but the renminbi."

He says he finds it astonishing that even economists sometimes do not understand this.

"Many economists get this wrong. It is amazing. I heard a senior guy from the Hong Kong Monetary Authority on a panel discussion that I was part of say the reason China wanted the renminbi to become a reserve currency was that they could hold it instead of dollars or euros. It is actually illiterate to think that."

The academic says that having a high level of reserves is not a symbol of vitality and can be an indication of weakness rather than strength.

"If you are Ecuador you not only have reserves to affect the value of your currency but also to assure yourself of the ability to import whatever you need. The major developed countries don't have to worry about that because everyone will accept their currencies," he says.

Pettis is also adamant that China cannot use its reserves to get out of trouble if it has a banking crisis.

"The Chinese banks all own renminbi and not dollars. So you would have to give them money in the form of renminbi. So the authorities would have to sell those trillion dollars to get renminbi. But who else can they sell them to but themselves? It is therefore a meaningless transaction."

He insists reserves cannot be used as some sort of last-resort "piggy bank".

"People think you can use them on some rainy day in the future. They forget the central bank has to borrow money in renminbi to buy dollars. So if you take a trillion dollars and give it to the banks, your net indebtedness goes up by a trillion dollars."

Pettis is therefore adamant there is no need for concern about China's reserves slipping below what was supposed to be the totemic $3 trillion mark for the first time in nearly six years.

"The actual figure does not matter. The reserves are reported in dollars and the special drawing rights in renminbi, so you can just about pick any number," he says.

andrewmoody@chinadaily.com.cn