Dec 04, 2013 03:43 PM

Yi Gang: China's Forward-Thinking Forex Chief

(Beijing) -- China's foreign exchange reserves reached an extraordinary US$ 3.66 trillion as of October 1, up from about US$ 2 trillion in July 2009 when People's Bank of China Deputy Governor Yi Gang was given a dual position as administrator of the State Administration of Foreign Exchange (SAFE).

Yi has thus presided over a period of dramatic growth for the nation's forex reserves, supervised by SAFE under the control of the central bank. He has also personally experienced every notable twist and turn in China's evolving financial sector since joining the central bank in 1997 and winning the deputy governor position in 2007.

Yi's latest priority, he told Caixin in a November 25 interview, is to curb growth for a foreign reserves stash that has gotten too big for its own good. He also wants to put the reserves to work through efficient investment.

Toward the latter goal, SAFE has launched an investment agency called China Reform Holdings Corp. Ltd. and opened an office to coordinate forex reserves-related loan activities. Only investment targets with the power to deliver results will be selected, Yi said.

Yi also discussed China's effort to balance international payments and reform the process by which authorities adjust the yuan-foreign currency exchange rate. Forex rate reform is now eight years old, and since then the nominal exchange rates for the yuan against a basket of currencies and the U.S. dollar have risen 29 percent and 34 percent, respectively.

The yuan's exchange rate is approaching an equilibrium level, Yi said, which means attention has shifted from the Chinese currency's appreciation to the government's interest in building a market-driven rate-adjustment system that is flexible and requires little if any central bank intervention.

Opening the capital account via a "convertible currency" is another financial reform issue that's attracted considerable attention and more than average controversy, Yi said. The government first announced plans for a free-floating yuan 17 years ago, but so far there has been no breakthrough. The next step, he said, will have to be guided by the market.

Excerpts from the interview follow.

Part I: Forex Reserves

Caixin: China's forex reserves totaled more than US$ 3.6 trillion at the end of September. Is that beyond its optimal level?

Yi Gang: I think so. There are those who are preparing for a hit from events more disastrous than the Asian financial crisis in 1997 and the collapse of Lehman Brothers in 2008. But I think China's US$ 3.7 trillion in forex reserves is enough for any scenario. Keeping forex reserves strong has many advantages. It reflects the nation's power, strengthens confidence and serves as a mighty deterrent that can keep speculators who want to attack China at bay. It's a safe guarantee for the financial and economic system.

But everything needs to be moderated. Beyond a certain threshold, there are fewer and fewer benefits coupled with higher and higher costs. When we pass the equilibrium point that lies between marginal cost and marginal benefit curves, any further increase in the forex reserves' level would not be worthwhile.

Here, marginal costs include the tremendous impact on the environment imposed by huge exports, and interest paid by the central bank in the course of offsetting excess liquidity, which results as it acquires U.S dollars and increases the monetary base. Also, it is not an optimal choice if the bank intervenes in the market. The market should play a decisive role.

Where in terms of the two curves is China right now?

We have passed the intersection of the two curves. That's for sure. But there are different views as to how far we have gone from that point.

What is the optimal size for China's forex reserves? Some think it should meet the payment needs of several months' worth of imports. Some say it must be in proportion to the country's external debt. Some link it with trade, others with investment. Some search for the amount of forex reserves that would be needed if there is a maximum-force attack. That's the so-called stress test. I have run models from all perspectives including trade, external debt, imports, exports and stress test. The results indicate our forex reserves are high enough.

Do you have any ideas about how to diversify forex reserves investment? There has been talk about launching several funds for this purpose.

Everyone is welcome to think outside the box and make suggestions about forex reserves investment. But the final decision will rest on performance and what's conducive to sustainable development. Foreign currency that the central bank bought through market intervention corresponds to its liabilities on the balance sheet. It's an asset that has to be managed well, or there will be grave macroeconomic consequences.

In terms of a solution, establishing China Investment Corp. (CIC) was a good one. Then we have China Reform Holdings Corp., which has been dubbed CIC II. Each of these firms has its own characteristics. Forex reserves investing by the SAFE has posted achievements. We can compare these across the board.

In general, assets should match liabilities. Rights and obligations should match as well. We cannot have the kind of power that comes with no obligations. That means if we are to manage an asset, we must be responsible for it. It takes a relatively long time to prove an investment's asset quality and results, so we cannot readily divide and transfer assets, because it would make it hard to tell who is responsible for which result. Therefore, we should, from the institutional level, ensure that assets are matched with liabilities and rights are matched with obligations. There should be an adequate incentive mechanism and proper competition.

Any further advice would be welcome, as long as it clearly states responsibilities. It's better if the mechanism and tactics can be demonstrated as having the ability to yield good results.

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