The Internal Cost of China’s Currency Policy

Joseph E. Gagnon (PIIE), Nicholas R. Lardy (PIIE) and Nicholas Borst (Federal Reserve Bank of San Francisco)



It is currently costing the Chinese central bank about $240 billion per year to hold down the value of the Chinese currency relative to other currencies. This cost is growing rapidly. The cost would decrease significantly if China allowed its currency to float and began reducing its foreign reserves, although there would likely be a one-time capital loss at the time the currency begins to float.

To put this cost in perspective, $240 billion is considerably larger than China’s trade surplus of $183 billion last year. It is about 4 percent of China’s GDP in 2010. Moreover, this cost does not include the implicit tax on the banking system associated with China’s reserve holdings, which is passed on to Chinese households in the form of depressed rates of interest on savings deposits.

As of June 30, 2011, China’s foreign exchange reserves were $3.2 trillion, having grown rapidly from $2.9 trillion on December 31, 2010. There are two components of the cost of these reserves: First, the interest rate earned on these reserves is below the rate of interest paid to finance them. Second, the value of the reserves in terms of Chinese yuan is declining and is expected to continue to decline.

China does not report the composition of its reserves, but they are widely believed to be held in bonds and bank deposits with an average maturity of roughly 2 years. The overwhelming majority of reserves are believed to be in US dollars and euros. We assume the breakdown is 60 percent US dollar, 25 percent euro, 5 percent yen, 5 percent UK pound, and a small amount of miscellaneous currencies (including Australian dollar, Canadian dollar, and Swiss franc). The exact allocation among US dollar, euro, yen, UK pound, and Swiss franc is not important because all of these currencies have similar interest rates and prospective rates of depreciation. Interest rates are a bit higher in Australia and Canada, but the shares in these currencies are too small to matter. The weighted average of 2-year yields in the United States, Germany, Japan, and the United Kingdom is 0.33 percent. Thus the annual earnings on China’s reserves amount to only $11 billion.

To pay for these foreign exchange reserves, the central bank must sell other assets, borrow in local markets, or raise the required reserve ratio for banks. (We assume that the reserves are fully sterilized, in other words, the central bank does not print more currency.) The cost of financing foreign exchange reserves by selling other assets is the foregone interest on those assets. We assume that the central bank would have held short-term government bonds currently yielding about 3.5 percent. The cost of borrowing is the interest rate paid on central bank bills, currently about 3.0 percent. The cost of required reserves is the interest rate paid to banks, currently 1.6 percent.

The required reserve ratio has been the primary method employed over the past several years, with the ratio reaching an all time high this year of 21.5 percent for large financial institutions compared to 6 percent ten years ago. We estimate that just over half of the foreign exchange reserves are financed in this way, at a cost of $41 billion per year. Central bank bills have been issued solely for the purpose of financing foreign exchange reserves; annual interest on these bills is about $10 billion. Finally, we assume that the remainder of the foreign exchange reserves equals the volume of assets that would have been held in government bonds, yielding $26 billion per year. The total interest cost, as of June 2011, is $77 billion per year.

The best measure of the cost of capital losses is based on current expectations of future changes in exchange rates. According to the September issue of Blue Chip Economic Indicators, professional economic forecasters on average expect the dollar to depreciate 5 percent against the Chinese yuan from December 2011 to December 2012. The euro is expected to depreciate 6 percent, the yen is expected to depreciate 9 percent, and the UK pound is expected to depreciate 3 percent. Thus, China’s foreign exchange reserves are expected to depreciate at an annual rate of 5.4 percent on average, implying a capital loss of $172 billion.

Overall, the total cost of China’s foreign exchange rate policy is estimated to be $238 billion (77+172-11). It is difficult to predict how the cost will evolve in coming years, because of the volatility of interest rates and exchange rates. However, the rapidly growing stock of reserves suggests that the cost of this policy is more likely to increase over time than to decrease.

The true economic cost of China’s exchange rate policy is substantially higher than the cost to the central bank. The low rates paid to banks on required reserves and central bank bills represent on an implicit tax on banks who would be earning much more at market interest rates. Ultimately this tax is passed along to Chinese households who earn meager rates (often negative in real terms) on their savings accounts in order to subsidize the profitability of the banks.

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