International Conference on Education Technology and Management Science (ICETMS 2013)

The Impact of Chinas Foreign Exchange Reserves on Currency Mismatch

Ronghua Chen^1,2

1 Hohai University, Nanjing, China;

2 Jianghai Polytechnic College, Yangzhou, China crh321@hotmail.com;gong197509@163.com

Abstract—At present, China is facing very serious currency mismatch, and this has brought about some negative impacts on Chinarsquo;s economic development and financial stability. This paper makes an e mpirical study of the impact of foreign exchange reserves on currency mismatch. The results of the study show that foreign exchange reserves have a significant and persistent effect on currency mismatch. Finally, based on the findings of the study and the current situation of Chinarsquo;s foreign exchange reserves, this paper proposes some countermeasures.

Keywords- currency mismatch central bank foreign exchange reserves

I.INTRODUCTION

Currency mismatch,which refers to the use of different currency, is essentially exchange rate risk. When exchange rate fluctuates its related assets or liabilities, income or expenditure are affected. On the one hand, the increase of Chinarsquo;s foreign exchange reserves leads to foreign currency assets increase, and the assets are far more than the external debt, which in turn directly leads to the increase of currency mismatch. On the other hand, with the increase of Chinarsquo;s foreign exchange reserves, the management of the currency structure and maturity structure in foreign exchange reserves is more difficult, which also increases the risk of currency mismatch.

So, with the increase of foreign exchange reserves, China is facing serious currency mismatch. Based on this understanding, an empirical study about the impact of foreign exchange reserves on currency mismatch is made and some solutions are proposed in this paper.

1. THE NEGATIVE IMPACT ON CURRENCY MISMATCH IN CHINA

In recent years, Chinarsquo;s net foreign currency assets is too much and its structure is unreasonable. This makes China face serious currency mismatch and has brought about some negative impacts, as could be seen in the following:

A The high cost of ownership

First, the central bank has huge foreign currency assets, but can not invest in domestic projects that can generate higher returns, thus resulting in a high opportunity cost; second, when U.S. dollarrsquo;s purchasing power declines or

U.S. dollar devalue relative to other reserve currency, China will face a huge net foreign currency assets depreciation

loss; third, with Chinarsquo;s main foreign currency assets invested in U.S. Treasury and agency debt, Chinese interest rate financing through the international market is much more than the U.S. national debt interest rate. As a result, China suffers the loss of interest.

B The impact on the central bankrsquo;s monetary policy and exchange rate policy

First, the huge net foreign currency assets and the expanding trade surplus make many countries think that RMB is undervalued, thus giving China international pressure. If RMB does not appreciate, China will face international trade friction and even trade sanctions. If RMB appreciates, it will have a very negative impact on Chinese many low-tech traditional industries. Therefore, the central bank is in a dilemma; Second, the direction of Chinarsquo;s exchange rate system reform is floating exchange rate system, but severe currency mismatch affects Chinarsquo;s floating exchange rate system reform. If RMB appreciates, the domestic economy, especially exports be seriously affected. If RMB devalues, it will increase the external debt burden. So the central bank has to maintain exchange rate fluctuations within a narrow range; Third, currency mismatch affects money supply. The result of Chinarsquo;s holding a huge amount of net foreign assets is that the central bank puts in a large amount of base money. Because of its multiplier effect, the money supply doubles.

1. THE EMPIRICAL ANALYSIS ABOUT THE IMPACT OF FOREIGN EXCHANGE RESERVES ON CURRENCY

MISMATCH

This paper selects the balance of annual foreign exchange reserves as the foreign exchange reserves data (FER). Scholars have proposed a number of indicators to measure currency mismatch, such as, original sin index, net foreign currency asset or liability, foreign exchange risk exposure, AECM indicator. Goldstein and Turner proposed AECM indicator in 2004 and AECM indicator is used to measure the degree of currency mismatch. Compared with other indicators, AECM indicator is more applicable to Chinarsquo;s current status of currency mismatch. Therefore, this paper selects AECM indicator as the measure indicator of currency mismatch. As this paper does not study the measure of currency mismatch, it does not calculate Chinarsquo;s AECM indicator, but uses other scholarrsquo;s result. The results of different scholars are different. Comparing these different results, this paper selects the result of Xiyang

Huang and Zhaoben Fang (2009).

Generally speaking, most of the time series are not stationary, so first stationarity test is necessary for each variable, and then the cointegration test is done to test long-term stable relationship between foreign exchange reserves and currency mismatch, and finally, this paper uses impulse response function analysis to analyze the dynamic impact of foreign exchange reserves on currency mismatch. In addition, in order to eliminate heteroscedasticity of the series, before the empirical analysis, the series are handled by calculating natural logarithm.

1. Stationarity Test

using ADF to test the stationary of the series, the results are shown in Table 1.

Table 1: ADF test results of each sequence