China has $2 trillion in net overseas assets, but investment returns are negative, how to adjust?

A few days ago, an article "Nobody Cares About the Economy" was widely circulated, triggering a heated discussion about China's economy. At the same time, in the current complex environment, the international economic and financial challenges facing China cannot be underestimated. At the end of February 2022, the United States and Europe announced the freezing of $300 billion of foreign exchange reserves of the Central Bank of Russia, with a huge impact.

China has $3.3 trillion in foreign exchange reserves (equivalent to 22 trillion yuan), including more than $1 trillion in U.S. Treasury bonds. The "weaponization" of foreign exchange reserves by the United States and Europe has forced us to re-examine the security of China's foreign exchange reserves and overseas assets.

This article analyzes the origin of China's huge foreign exchange reserves, pointing out that the United States provides reserve currency for the world by opening "IOUs", and the more the "IOUs" of the United States open, the more foreign debt the United States has. China, with its high economic growth, is the biggest "creditor" of the United States. Due to the growing demand for dollar reserves in non-reserve currency issuers, the heavily indebted United States not only does not worry about repaying the principal and interest of its foreign debt, but also collects a large amount of interest.

The author believes that

The freezing of Russian foreign exchange reserves by the United States shows that the value of China's foreign exchange reserves will not only be damaged by US inflation, dollar depreciation and falling or defaulting on the price of government bonds, but also disappear in an instant for geopolitical reasons.

The authors suggest that the overseas "asset/liability structure" and the balance of payments structure should be adjusted to reduce the amount of external reserves. China's foreign exchange reserve adequacy ratio is much higher than the international level, but the yield is extremely low, and the cost of a large amount of foreign exchange funds is too high, which reduces the total yield of overseas assets. In the face of the potential risks of U.S. financial sanctions against China, China should also accelerate the construction of financial infrastructure. The author believes that relying on the internationalization of the renminbi, it is difficult to resolve the risk of China's foreign exchange reserves in the short term. Because no matter what currency is denominated and settled, the security of China's foreign exchange reserves depends on whether the United States can keep its commitment to repay the debt and interest, and whether China has the ability to make the United States keep its promises.

The article was originally published in the "Yu Yongding Personal Column" on May 19, 2022, originally titled "The Past and Present Life of China's Foreign Exchange Reserves and the Current Security Challenges", which only represents the author's views and is for the reader's reference.

The past and present life of China's foreign exchange reserves

and the security challenges we face today

On February 28, 2022, the United States and its allies announced a freeze on $300 billion in foreign exchange reserves of the Central Bank of Russia. China has $3.3 trillion in foreign exchange reserves, including more than $1 trillion in U.S. Treasury bonds. The "weaponization" of foreign exchange reserves has forced us to re-examine the security of China's foreign exchange reserves and overseas assets.

The security of China's foreign exchange reserves is not only an international financial issue, but also a geopolitical and asset management issue. What specific measures should China take to ensure the safety of China's foreign reserves? Answering this question is beyond the scope of my ability. This article only attempts to put forward some rough directional suggestions on the origin of China's foreign exchange reserve problem, the challenges faced and how to "make up for the dead" from the perspective of international finance.

▍ Gold reserves and the Bretton Woods system

Liquidity usually refers to assets that are easily realizable, such as currencies, gold, and short-term bonds; sometimes it also refers to how easy it is to liquidate. In international finance, especially in discussions of the "Triffin dilemma", the connotation of the term "international liquidity" overlaps with "liquidity" but the two are not the same concept.

Inter-State debt is paid through some internationally accepted means of settlement, such as gold, international reserve currencies or transfers of special drawing rights. International liquidity refers to the stock of these means of settlement. In particular, Trenifen noted that the increase in liquidity stems from an increase in the supply of gold and an increase in short-term indebtedness in key currency countries. It can be seen that the international liquidity that Trenifen spoke of at that time was what we now call foreign exchange reserves. In fact, Trenifen mixed reserves or international reserves with international liquidity.

The issuer of the international reserve currency (the United States) can provide international liquidity or international reserves to other countries through capital account deficits or current account deficits. Under the Bretton Woods gold-exchange standard (the dollar is pegged to gold), the United States provides international liquidity or international reserves to other countries through capital-account deficits. From 1945 to the beginning of the 1950s, Europe and Japan were in ruins and urgently needed to import goods from the United States. However, it is impossible to obtain enough dollars through exports, and the global "dollar shortage" is serious. During this period, international liquidity was largely provided by short-term U.S. capital exports and foreign aid such as the Marshall Plan. An increase in the liquidity of the us dollar means an increase in US debt on the one hand, and an increase in Japanese and European debt on the other.

In the 1960s, the European and Japanese economies were reborn and the trade balance improved. The United States, on the other hand, has seen a decline in the domestic economy, a decline in international competitiveness, a decrease in the merchandise trade surplus, and an increase in the service trade deficit (including overseas military spending). At the same time, due to the high interest rate in Europe, the capital account deficit of the United States has increased rapidly due to the high interest rate in Europe and the large amount of uncontrolled flow of US capital into Europe (forming the "Eurodollar market").

From the perspective of Japan and Europe, while the trade deficit is decreasing, the dollar is still flowing in large quantities, so the dollar's foreign exchange reserves have increased rapidly. The "dollar shortage" becomes dollar glut. From the U.S. perspective, trade-items surpluses have all but disappeared (deficits have already occurred for some countries), but capital-account deficits have increased dramatically, and in the terminology of the time, the U.S. "international balance of payments" deteriorated dramatically.

The U.S. capital-account deficit (capital outflows) should be balanced by the U.S. trade surplus (someone else takes your money and buys your stuff again). So the dollar flowed back to the United States. In this case, the foreign exchange reserves of dollars held by other countries will not increase. If other countries have larger capital-account surpluses (dollars inflows from the United States) than trade deficits (dollars flowing back to the United States), those countries' foreign exchange reserves will grow.

The dollar is pegged to gold ("gold-exchange standard") to reassure dollar holders that although the dollar you hold is a fiat currency printed in the United States and has no value in itself, the dollar can be converted into gold at a given proportion. Therefore, you can hold the US dollar with confidence. For the United States under the gold-exchange standard, the "balance of payments imbalance" means the loss of US gold reserves. Although gold may still be stored in U.S. vaults, the owner is no longer in the U.S. Foreign central banks can convert excess dollars into gold at any time and ship the gold back to their home countries.

As the U.S. "balance of payments" worsens, the ratio of dollar liquidity (foreign-held U.S. dollar foreign exchange reserves) to U.S. gold reserves continues to soar. Foreign holders of the dollar no longer believe that the United States can abide by the promise of 35 dollars to 1 ounce of gold, no longer believe that the dollar will not depreciate, and have begun to sell the dollar, and dollar speculation in the market has intensified. France simply sailed the gold home. By 1971, the United States had only about $10 billion in gold reserves, compared to more than $40 billion and more than $30 billion held by foreign officials and more than $30 billion, respectively. On August 15, 1971, President Nixon reneged on his promise of $35 for 1 ounce of gold and announced the closure of the "gold window." The Bretton Woods system collapsed.

▍ The inherent contradictions of the post-Bretton Woods system

Under the post-Breton system, due to decoupling from gold, the us dollar is pure fiat money and has no value in itself. The Bretton Woods system collapsed as international financial markets no longer believed that the United States could keep its promise of $35 to 1 ounce of gold. But international financial markets do not doubt that the United States will pursue responsible macroeconomic policies to maintain the stability of the dollar. After the U.S. dollar decoupled from gold, there was no excuse for the market to bet on the depreciation of the dollar against gold (and other major currencies). After fierce bargaining between the United States and European countries, the dollar was finally stabilized.

However, under the post-Bretton Woods system, the inherent contradiction of using a country's fiat currency as an international reserve currency has not disappeared. The dollar, as the standard of the international monetary system (or value scale, "anchor") must remain stable. This stability is multi-dimensional, for example, its purchasing power should be stable. On the one hand, for the dollar to play the role of a global public good, it should serve the global public interest. On the other hand, the dollar is printed by the US government, and whether the actual purchasing power of the US dollar can remain stable fundamentally depends on the domestic policy of the US government. The U.S. government has no obligation to sacrifice its own interests for the global public good.

Under the post-Bretton Woods system, since the United States is no longer a thriving economic power, the contradiction between the dollar as a national currency (serving the interests of the United States) and its status as an international reserve currency (serving the global interests) is manifested as the United States must provide the world with international liquidity or reserve currency mainly through the current account deficit (trade deficit). As world GDP grows, so does the international reserve currency needed for global trade and financial transactions. The more reserve currencies the United States provides to the world, the greater the U.S. trade deficit must be. A larger country's trade deficit means a larger domestic investment and savings gap and a greater degree of macroeconomic imbalance. This, in turn, means that inflation is out of control and the dollar will eventually depreciate.

To put it another way, the United States provides reserve money to the world by opening "IOUs", and the growth of the global economy requires the United States to issue more and more "IOUs", and the more IOUs open, the more foreign debt the United States has. When U.S. debt has accumulated to a certain extent, will investors and foreign central banks still believe that the United States can exchange these IOUs for "real money and silver"? It is not difficult to see that this problem is still essentially a "Triffin dilemma".

The U.S. first ran a merchandise trade and current account deficit after the war in 1971; beginning in 1977, the two ran consecutive deficits that continue to this day. This situation has remained so far. The current account of the United States changed from a surplus to a deficit, which meant that the United States' net worth abroad began to decrease. Maintaining a long-term current-account deficit will sooner or later turn creditor countries into debtor countries. In 1985 the United States really became a net debtor. American economists at the time exclaimed that because of the need to rely on foreign capital inflows to balance the current account deficit, the net investment income of the United States would also change from positive to negative, and it would not be long before the net debt of the United States would become unimaginably large.

But this prediction is only half true: In 1984 the United States still had $28 billion in foreign net worth, but by the end of 2021, the United States' net overseas debt had exceeded $18 trillion. But what economists did not expect was that, despite its large net debt, investment income on the U.S. balance of payments had been positive. For example, in 2020, the net debt of the United States was $14 trillion, but the net investment income was as high as $200 billion. Today, the Net External Debt of the United States exceeds 70% of GDP, and only four countries in the world, Ireland, Greece, Portugal and Spain, have a higher net external debt-to-GDP ratio than the United States. All four countries recently experienced severe financial crises. But the United States does not seem to have to worry about repaying the principal and interest of its foreign debt at all. Although the debt is heavy, it not only does not have to pay interest but also collects a lot of interest. Why worry?

▍The United States is the world's largest debtor, why can the dollar remain stable?

With the U.S. Treasury debt-to-GDP ratio rising and the U.S. overseas net debt-to-GDP ratio rising, the dollar has remained stable far longer than economists expected, and the fundamental reason is that the demand for the dollar as a reserve currency in the rest of the world has also been increasing. The increasing foreign exchange reserves held by other countries mean that other countries are willing to lend money to the United States and are willing to finance the United States' trade deficit. In this way, the gap between investment and savings in the United States is filled by foreign savings, and the pressure on inflation and dollar depreciation is greatly reduced. If the United States had indiscriminately issued dollars to make up for the lack of domestic savings, there had been no strong demand for dollar foreign exchange reserves in other countries, and the collapse of the dollar would have been inevitable.

The prevailing view in the 1980s was that non-reserve currency issuers did not need to accumulate foreign exchange reserves, because any country could easily borrow dollars in international financial markets as long as it had creditworthiness. In fact, in 1969, before the collapse of the Bretton Woods system, the total amount of global foreign exchange reserves was only $33 billion. By the end of 2021, the total amount of official foreign exchange reserves in the world has reached $13 trillion (of which $7 trillion is in U.S. dollar reserves), an increase of nearly 400 times.

There are many reasons for the increase in demand for foreign reserves in non-reserve currency issuers. First, it is used to intervene in the foreign exchange market and maintain the stability of the exchange rate. In order to cope with various disturbances and fluctuations, central banks need to hold foreign exchange reserves that are commensurate with the size and openness of the country's economy. Countries with fixed exchange rates need to hold larger foreign exchange reserves. Second, under the post-Bretton Woods system, capital controls were lifted, speculative capital was in turmoil, and central banks needed reserves outside the dollar to withstand attacks on their currencies by international speculative capital. After the East Asian financial crisis, the sharp increase in foreign exchange reserves of East Asian countries is a good illustration; third, under the influence of mercantilist ideas, the exchange rate has been underestimated, "rewards are limited to imports", and excessive pursuit of trade surpluses. Or due to institutional, economic structure or macroeconomic policy reasons, domestic demand has been insufficient for a long time, and export growth has become an important driving force or even the main driving force for economic growth. Fourth, due to distortions in domestic capital markets, companies still have to borrow from overseas or use preferential policies to introduce FDI in the case of abundant loanable funds in china. But these capital inflows did not translate into corresponding trade deficits (for importing foreign capital goods and technology), but rather into an increase in foreign exchange reserves. Fifth, domestic savings are greater than investments, but excess domestic savings cannot be digested (converted into consumption or investment) for a while, and domestic excess savings are temporarily converted into foreign exchange reserves. Seventh, due to economic system, institutional and policy reasons or external reasons, the trade surplus cannot be smoothly converted into capital output (foreign FDI or foreign equity, bond investment).

The United States has pursued extremely expansionary fiscal and monetary policies since 2008. Strong demand from foreign governments and investors for U.S. Treasuries and other U.S. assets has created the necessary external conditions for more than 10 years of low inflation and faster growth in the United States. But today, after all, the United States has accumulated $15.4 trillion in net external debt and $28 trillion in national debt — the ratio of the two to GDP is more than 67% (2020) and 137% (2021), respectively; in 2008-2019, the M2 of the United States increased from $8.2 trillion to nearly $18 trillion, an increase of 112%, while GDP grew from only $14.8 trillion to $21.4 trillion, an increase of 45%. The gap between the two is 67 percentage points. And the situation continues to deteriorate.

The United States borrows hundreds of billions of dollars of foreign debt each year ($600 billion in 2020), much of which is purchased by foreign governments and investors on U.S. Treasury bonds. Of the foreign exchange reserves accumulated by central banks, U.S. Treasury bills are the most important component. Foreign purchases of U.S. Treasury bonds totaled $7.55 trillion. Among them, Japan, China, Luxembourg, the United Kingdom, and Ireland alone bought 3.6 trillion yuan of U.S. Treasury bonds. If the rest of the world stopped buying U.S. Treasuries in large quantities, U.S. Treasury prices would plummet (yields would soar), raising the cost of financing U.S. Treasuries dramatically. The fiscal situation in the United States will accelerate.

According to the U.S. Congressional Budget Office (CBO), the U.S. Treasury debt-to-GDP ratio will reach 200% by 2051. The U.S. government itself acknowledges that the U.S. fiscal position is unsustainable. In this case, even if the Fed's interest rate hike policy can control inflation and stabilize the dollar for the time being, in the long run, due to the continuous growth of US Treasury bonds, the price of US Treasury bonds has plummeted (financing costs have soared), inflation has run out of control, and the sharp depreciation of the US dollar should not be a small probability event. In fact, China has been concerned about the safety of its dollar reserves. For example, on March 13, 2009, then-Premier Wen Jiabao noted, "We lend huge sums of money to the United States, of course, concerned about the safety of our assets." To be honest, I do have some concerns." He asked the United States to "maintain its credibility, keep its promises, and ensure the safety of Chinese assets." ”

The weird thing about finance is that if you believe it's okay, it's okay. No one knows how long investor confidence in the dollar and U.S. Treasuries will last in the face of america's deteriorating debt situation. Speaking of this, I am reminded of what Joshua Remo, author of the Beijing Consensus, called the "sand pile experiment." Grain after grain of sand leaks down from a container to form a cone. The intrinsic laws of physics cause these grains of sand to form a stable pile of sand. But when the sand pile reaches a certain height, even a grain of sand can cause the sand pile to collapse. But it is equally possible that even if thousands of grains of sand fall, the sand cone will remain motionless. The probability that a sand cone will collapse when a grain of sand falls is the same as the probability that a sand cone will collapse due to a thousand or ten thousand grains of sand falling. No one knows when the sand cone collapsed. Similarly, no one knows when the market loses confidence in the dollar and when the dollar collapses. But, out of prudence, are you going to take this possibility into account in your decision-making?

▍ Warning of the United States freezing Russia's foreign exchange reserves

With the outbreak of the Russo-Ukrainian War, the United States froze $300 billion in foreign exchange reserves of the Central Bank of Russia within 72 hours, and who can be sure that the United States will not freeze the foreign exchange reserves of other countries in the future? The U.S. freeze on the foreign exchange reserves of the Russian central bank has seriously undermined the international credibility of the United States and shaken the credit base of the dominant international financial system in western countries. The "weaponization" of foreign exchange reserves exceeds economists' worst estimates of the security of China's foreign exchange reserves. It turns out that the value of China's foreign exchange reserves will not only suffer due to inflation in the United States, the depreciation of the dollar and the fall or default of treasury prices, but also be wiped out in an instant for geopolitical reasons.

Will the United States take extreme action against China's foreign reserves? There are two views that do not. First, due to the close economic and financial ties between China and the United States, the United States will not do anything to "kill a thousand enemies and hurt eight hundred." This is first and foremost an international political issue, and secondly, there are many economic accounts that need to be clearly calculated. But we should also remember that as early as 2013, Financial Times columnist Martin Wolfe wrote that in the event of conflict, the United States could completely freeze China's foreign exchange assets. While both sides will suffer heavy losses, China's losses will be even heavier. Second, we don't give the United States a reason, and the United States will not go this far. I hope so. But who can guarantee that? One question that China may soon face is: is it not participating in the embargo on Russian oil and gas and comprehensive financial sanctions? So far, the United States has not imposed a comprehensive oil and gas embargo on Russia, and China and India are still allowed to buy Russian oil and gas. But once the United States believes that Europe can already get rid of its dependence on Russian oil and gas, the United States will point the finger at China and India. China's continued purchases of Russian oil and gas are likely to be grounds for the United States to impose sanctions on China's foreign reserves or chinese financial institutions. The bottle of "washing powder" displayed by former US Secretary of State Powell tells us that the reason is always not difficult to find.

▍ China's double surplus and foreign exchange reserves

China has long accumulated $3.3 trillion in foreign exchange reserves through a double surplus (current account surplus and capital account surplus). Regarding the causes, advantages and disadvantages of China's huge foreign reserves, the academic community has been discussing for more than 20 years, and there is no need to repeat it.

Here, I would like to make just three comments: First, by any measure, China's holdings of $3.3 trillion in foreign exchange reserves (excluding $478.7 billion in Hong Kong and $548.9 billion in Taiwan) have far exceeded the internationally recognized reserve adequacy requirement. The countries with the second, third and fourth highest holdings of foreign exchange reserves in the world are Japan at $1.3 trillion (January 2022), Switzerland at $1 trillion and India at $569.9 billion, respectively. It can be seen that there are only three countries in the world with more than one trillion US dollars in foreign reserves, and China's foreign reserves are nearly three times that of Japan, which ranks second.

Secondly, due to the extremely low rate of return on foreign exchange reserves, the proportion of foreign exchange reserves in overseas assets is too high, and the overall rate of return on overseas assets is bound to be too low. Of China's $9 trillion in overseas assets, reserve assets account for 37 percent of total assets; U.S. Treasury bills are $1.06 trillion, or 32 percent of reserve assets. It should be noted that in order to improve the rate of return on foreign exchange reserves, SAFE and other relevant institutions consider not only security and liquidity but also the rate of return when allocating assets. In addition to treasury bills of the United States and other countries, China's reserve assets also include international organization bonds, high-rated corporate bonds of various countries, local government bonds, constituent stocks of major national equity indexes (such as S&P 500, etc.), private equity investments, a small number of infrastructure in developed countries in Europe, real estate investments, and policy investments such as the "Belt and Road" with China Development Bank and Import and Export Bank through holding platforms. Their work should be very successful. However, in any case, due to the safety and liquidity requirements of foreign reserves, the proportion of foreign reserves in overseas assets is too high, which will inevitably lead to a decrease in overseas asset income.

Not only that, a significant proportion of China's foreign exchange reserves are "borrowed" through the introduction of foreign capital, rather than earned through trade surpluses. Under normal circumstances, an inflow of foreign capital, i.e. a capital account surplus, should correspond to an equal amount of trade-item deficit on the balance of payments. Because foreign-attracted funds are used to buy foreign machinery and technology, dollars flowing through the capital account surplus are flowing out through the trade deficit. However, for various reasons, the inflow of foreign capital may not be used for imports but sold to the central bank as an increase in foreign exchange reserves. Compared with the investment income of foreign reserves,

The debt cost of "borrowed foreign exchange reserves" is extremely high. According to the results of the 2008 World Bank office in Beijing, the investment income of American companies in China is 33%, and the investment income of general foreign companies is 22%. At the same time, the investment yield of US Treasury bills is less than 3%. This is also one of the reasons why China's investment returns are negative despite its $2 trillion in net overseas assets. This balance of payments and overseas investment situation in China stands in stark contrast to that of the United States. As mentioned earlier, although the latter is a net debtor of $15 trillion in 2021, it has nearly $200 billion in investment income. Looking around the world, only Argentina and Russia are associated with China.

Third, in the early days of China's opening up, the shortage of foreign exchange was the most important bottleneck in growth. Although there was one-sidedness and although some were too late, it was correct to vigorously develop processing trade in order to earn foreign exchange at that time, actively introduce FDI and a one-time large depreciation of the renminbi. However, after the Asian financial crisis in 2003, China did not allow the renminbi to appreciate slightly until 2005 due to "appreciation phobia". On the one hand, the trade surplus has increased sharply. On the other hand, domestic asset bubbles and strong expectations of RMB appreciation have led to a large inflow of hot money. The capital account surplus once exceeded the trade surplus and became the main source of new foreign exchange reserves. It should be said that China's failure to let the renminbi appreciate in time and the lack of flexibility in the exchange rate are necessary conditions for the excessive accumulation of China's foreign exchange reserves.

▍ Adjust the structure of overseas assets and liabilities and the balance of payments structure, and reduce the amount of external reserves

The main purposes of adjusting China's overseas asset-liability structure and balance of payments structure should be twofold. The first is to improve the structure of China's overseas assets and liabilities and increase the return on overseas net assets. To that end, China should reduce the share of foreign exchange reserves in overseas assets. The second is to improve the security of China's overseas assets, especially foreign exchange reserves. Under current conditions, China should compress its stock of foreign exchange reserves to at least the internationally recognized level of reserve adequacy. Exactly how much foreign exchange reserves a country should hold, in general, takes into account the size of the country's imports (or exports), the size of short-term external debt, the size of other securities liabilities, and the amount of broad money. At the same time, the country's exchange rate regime and capital controls need to be considered. For example, if the country introduced floating exchange rates and capital controls, the country's foreign exchange reserve adequacy ratio could be significantly reduced. Third, the possibility of the United States freezing and seizing China's overseas assets cannot be ruled out. But the greater likelihood is that the United States will launch SDN or 561 sanctions against China. To cope with this possibility, China needs to step up the construction of financial infrastructure.

For existing stocks of foreign exchange reserves, measures that can be considered include:

1. Increase holdings of other forms of assets while reducing holdings of U.S. Treasuries. In the past, fearing the depreciation of the us dollar, we advocated the diversification of foreign exchange reserves. But now it seems that under specific geopolitical conditions, this decentralization may not be of great significance.

2. China can increase its equity investment in strategic resource-producing countries, such as in oil fields in Central Asia and Arab countries.

3. In the event of a crackdown on Chinese stocks and a plunge in stock prices, the central bank may consider facilitating the purchase of high-quality Chinese stocks by Chinese investors.

4. Keep our commitments and strictly protect foreign investors' investments in China.

5. Provide necessary support to Chinese enterprises in overseas financing activities.

6. Accelerate the construction of financial infrastructure, such as the construction of settlement, clearing, and messaging systems that are not affected by the United States. Make full use of China's technical reserves and advantages in the field of digital technology, and improve the cross-border payment system that adapts to the new trend of digital trade.

7. Reduce the holding of US Treasury bills in accordance with the laws of the market. Recently, many central banks have reportedly been selling U.S. Treasury bills. This kind of trading activity is entirely commercial, and the United States should have nothing to say.

For the stock of foreign exchange reserves that have been formed, many things have been completed, and it is difficult to adjust in a short period of time, and once adjusted, it may also have a greater impact on the international capital market. But for current and future import and export trade and cross-border flows of capital, there are many things we can actively adjust. Adjustments that should be considered include:

1. Stimulate domestic demand and drive imports through expansionary fiscal and monetary policies. Only when the domestic economy is prosperous will it be possible for import demand to increase substantially, thus achieving a trade balance.

2. Eliminate as soon as possible the remaining export stimulus policies, for example, export tax rebate policies implemented to encourage exports.

3. Increase imports of specific commodities and strategic materials, and greatly improve China's strategic material reserve capacity.

4. Stop buying U.S. Treasury bonds (don't lend money to the U.S.), but import as much U.S. products as possible (cashing in U.S. IOUs). Implement U.S.-China trade agreements as much as possible (except in relation to force majeure).

5. Over a given period, the trade deficit can be maintained by increasing imports to use up excess foreign exchange reserves.

6. Adhere to the floating exchange rate system and try not to interfere in the foreign exchange market except in extreme cases. If it does not intervene in the foreign exchange market, Under the pressure of appreciation, China's foreign exchange reserves will not increase. However, when there is a trend depreciation pressure on the renminbi, the renminbi should be depreciated in place to avoid the waste of foreign exchange reserves. In doing so, other means, including capital controls, should be used to curb the "over-adjustment" of the exchange rate.

7. Maintain the necessary capital controls to curb the inflow of hot money and prevent capital flight.

8. In theory, overseas direct investment and investment with higher rates of return should be increased. However, due to the lag in institutional reform and financial market construction, as well as the blockade of the United States, this road has become more difficult to navigate. We should try our best to find out the origin of overseas investment to clarify the corresponding policies.

9. Investment in countries other than the United States, especially in developing countries, can take advantage of China's strengths in manufacturing and infrastructure, but beware of political instability and poor balance of payments in host countries, which can trap China in debt traps. Avoid wrong political judgments that lead us to "empty people and money".

▍What role can RMB internationalization play in the security of China's foreign reserves?

Due to the deterioration of the current geopolitical situation, the internationalization of the renminbi has once again become a hot topic. When China launched the internationalization of the renminbi, it was worried about the security of dollar assets. The subprime mortgage crisis broke out in 2008. Due to the holding of a large number of US Treasury bonds and government bond (Fannie Mae and Freddie Mac government bond), the bankruptcy of the "two houses" caused great uneasiness in the Chinese government.

In 2009, Governor Zhou Xiaochuan proposed replacing the US dollar with SDR as an international reserve currency. But the proposal was stillborn due to U.S. opposition. As a result, China decided to find another way to reduce the risk of China's overseas assets by internationalizing the renminbi. Later, due to the expectation of the appreciation of the renminbi turning into the expectation of depreciation, the process of internationalization of the renminbi was hindered. For some time after 2015, China had to tighten capital controls due to serious capital outflows and flights. The process of RMB internationalization has slowed down significantly.

Governor Yi Gang stressed on many occasions that "the internationalization of the renminbi should be driven by the market, and the central bank will not take the initiative to promote it." I very much agree with This proposition of Governor Yi. President Yi's formulation is actually a summary of the historical economy of the internationalization of the renminbi in the past. In fact, from 2009 to 2014, the economic circles at home and abroad had detailed and full discussions on the pros and cons of RMB internationalization and the roadmap, and they have been tested in practice. For example, in that year, we pushed for RMB import settlement, and in the case of a large current account surplus, the US dollars that were originally used to pay for imports were replaced by RMB, and as a result, China's US dollar foreign reserves did not decrease but increased. For another example, it was hoped that non-residents would increase their holdings of RMB deposits and RMB treasury bonds in large quantities. However, after the expectation of RMB appreciation disappeared in 2014, the interest of non-residents in holding RMB deposits and other RMB assets also basically disappeared. Experience tells us that the internationalization of the renminbi is a meaningful undertaking, but we must adhere to the market-driven and cannot promote the growth of seedlings.

Where possible, the advantages of the buyer or the seller should be used to advance rmb denomination and settlement. For example, China is the number one buyer of many commodities, and it would be nice if those commodities could be denominated in renminbi. Driven by the market, the internationalization of the RENMINBI has indeed made very solid progress, although not very dazzling.

Overall, the renminbi has become an international currency, especially an international reserve currency, and it is needless to say that it can bring great benefits to China. However, in general, the internationalization of the renminbi should not be placed above commercial considerations. For example, Chinese investors buy foreign bonds in international capital markets, and the price and settlement of such bonds in what currency is the result of a commercial game between Chinese investors and foreign bond issuers. For Chinese investors, if the renminbi is in an appreciation channel over a long period of time, it is better for bonds to be denominated in renminbi rather than dollars. If a Chinese enterprise is in the position of a debtor, it is best to denominate and settle in a depreciating currency. Another example is that China needs to promote the internationalization of its capital markets. However, the purpose of promoting the internationalization of the capital market, especially the bond market, is not to internationalize the renminbi, but to improve the efficiency of China's financial resource allocation. At the micro level, the market knows best. The choice of currency in trade and financial transactions should be left to the discretion of businesses and financial institutions. With the increasing strength of China's economy and the improvement of the financial market, the renminbi will naturally be more and more selected as the international denominated currency and settlement currency.

The highest level of rmb internationalization is to make the renminbi a reserve currency for other countries. The renminbi can provide rmb to other countries through current account deficits and capital account surpluses. China pays for China's trade deficit in renminbi, which the central bank of a trade surplus country obtains and holds from the foreign exchange market and uses it to buy Chinese government bonds or certain highly secure and liquid Chinese bonds. In this way, the renminbi becomes the reserve currency held by the country. China, on the other hand, can take advantage of the RMB's status as an international reserve currency to obtain actual foreign resources by opening IOUs.

China can also make the renminbi a reserve currency for other countries through capital exports. After China supplies renminbi to foreign countries through capital exports, capital-importing countries will generally use these renminbi to import goods from China. And the renminbi will flow back to China. A chinese trade deficit and an equivalent capital account surplus will be recorded on the balance of payments of capital-importing countries, but the country's foreign exchange reserves will not increase as a result. If the country does not use the renminbi to buy Chinese goods, the renminbi may flow out through the capital account, or it may be sold to the country's central bank to buy Chinese government bonds or other highly liquid financial assets, thus forming the country's foreign exchange reserves.

However, for the host countries of China's capital exports, this part of the renminbi's foreign exchange reserves are borrowed from China, not earned through export surpluses. Attracting capital from China, but not using the funds to buy Chinese products and services, but instead holding low-return Chinese short-term capital, may mean a mismatch of resources. As a result, the host country of China's capital exports has compressed this part of the rmb foreign exchange reserves to a minimum. In other words, while China can provide renminbi to foreign countries through capital exports, other countries may have limited willingness to convert the corresponding renminbi into China's short-term bonds or treasury bonds (if there are treasury bonds to buy), thus forming the country's renminbi foreign exchange reserves.

All in all, for the renminbi to become an international reserve currency, China must meet a series of prerequisites, such as a sound capital market (especially the establishment of a deep and highly liquid treasury bond market), a flexible exchange rate system, free cross-border movement of capital, and credit established after a long period of repeated games. In short, China must be able to overcome the so-called "original sin" in international financial literature to be able to issue treasury bonds internationally in renminbi. Otherwise, it will be difficult for the renminbi to become an international reserve currency, and the internationalization of the renminbi can only be incomplete.

Can the internationalization of the renminbi strengthen the security of China's foreign exchange reserves? If you think about this question in the context of a complex global economic system, the answer should be yes. But in the short term, in terms of immediate effect, even if China's foreign exchange reserves are entirely RMB assets, the security of China's foreign exchange reserves will not change substantially. China's foreign exchange reserves include more than $1 trillion in U.S. Treasury bills. If the United States does not intend to repay the principal and interest as originally agreed, what can China do? No.

Suppose the U.S. Treasury issues 7 trillion yuan of Treasury bonds, and China has 7 trillion yuan instead of $1 trillion in foreign exchange reserves by buying this U.S. dollar bond — the panda bond issued by the U.S. government. At this time, if the United States does not intend to repay the principal and interest of the US Treasury bonds settled in renminbi as agreed, how is the dilemma faced by China different from the us treasury bonds that the United States does not intend to repay the principal and interest on the US Treasury bonds settled in US dollars as agreed? No.

Because the question is not in what currency China's foreign exchange reserves are denominated and settled, but whether China owes the United States money or the United States owes China money. Regardless of the currency denominated and settled, China's foreign exchange reserves are U.S. debt to China and money the United States owes to China. Therefore, the security of China's foreign exchange reserves depends on whether the United States will keep its commitment to repay its debt and interest, and whether China has the ability to make the United States keep its commitment to repay its debt and interest.

If China cannot ensure that the United States does not renege on its promise, it will have no choice but to gradually reduce its foreign exchange reserves. Of course, denominating and settling in renminbi in specific transactions (such as imports) can lead to a reduction in foreign exchange reserves, thus indirectly strengthening the security of China's foreign reserves. An interesting tidbit is that in early December 1950, the United States announced a strict "blockade" and "embargo" on China, while China tried to "rush" and "rush" materials from Western countries. By the time the United Nations passed the China Embargo Act in 1951, China had used up all of its accumulated foreign exchange.

In short, although the internationalization of the renminbi is a goal worth pursuing. However, the internationalization of the renminbi is a long-term process, and the water is far from quenching the thirst. In the face of geopolitical challenges, the internationalization of the renminbi has also played a very limited role in protecting China's existing overseas assets.

With regard to China's foreign exchange reserves, what we can do now is basically "make up for the lost sheep". Although it can no longer be said that "it is particularly late", "those who understand the past can be traced." The key is to correctly understand and implement the strategic principle of double circulation and domestic large circulation as the main body. Accelerate the adjustment of China's development strategy and realize the transformation of internal circulation as soon as possible. Build the engine of economic growth on meeting domestic demand.

Keynes warned us: You owe the bank forty thousand pounds to the bank, you owe the bank 4 million pounds, the bank is at your disposal. In the current treacherous geopolitical environment, if you can't protect your claims, you have to be as unscrupulous as possible.

In the near future, in the face of possible financial sanctions imposed by the United States on China, analyzing various possible scenarios and coming up with China's preventive, countermeasures and countermeasures are undoubtedly the top priorities of China's decision-making departments. It is important to come up with operational concrete plans as soon as possible, but because of the geopolitical judgments and operational details of financial markets, these specific plans are beyond the beak of my generation.

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