Jake's View

China’s foreign reserves picture not as bad as some pessimists think

In today’s world of floating exchange rates, foreign reserves are a matter of national vanity, not national necessity

PUBLISHED : Wednesday, 10 February, 2016, 5:19pm
UPDATED : Wednesday, 10 February, 2016, 5:19pm

China’s foreign exchange reserves, already at a three-year low, are poised to post a second consecutive record monthly drop as policymakers intervene to support the yuan ...

Bloomberg, SCMP, February 6

The reserves didn’t quite post this second consecutive record monthly drop. It was actually a consecutive second record monthly drop.

And while you’re trying to figure out what this could mean (I’ll help you: the decline in January was slightly less than in December but both were greater than in any previous month), let me tell that there is also a good deal less here than meets the eye.

What meets the eye superficially is that the mainland’s foreign reserves have plummeted from just a sliver under US$4 trillion in June 2014, to US$3.23 trillion as of the latest figures and if things keep going this way, they will soon be less than the International Monetary Fund says the mainland needs.

Let’s clear up one thing right away. The IMF is a French sinecure headed at the moment by a French labour lawyer who, as her country’s finance minister, was notable for wrecking its fiscal health. One consequence of all this is that the IMF’s mindset is stuck in 1950s France.

In today’s world of floating exchange rates, vast international capital flows, and instant communications, no country really needs foreign reserves. They may help politicians stave off punishment for ill-considered fiscal tinkering but they are a matter of national vanity, not national necessity.

Whatever the PBOC stuck into euro or other currencies over the past 19 months is now worth less in US dollar terms

And now to the major misperception, which is that a decline of US$762 billion in foreign reserves since June 2014 says the mainland suffered a net outflow of US$762 billion over this period.

Not quite. The mainland states its foreign reserves in US dollar terms but not all the money is invested in US dollar instruments. In recent years the Peoples Bank of China has diversified some of it into other currencies, although not saying how much.

It was a bad idea in any case. Since mid-2014, the US dollar has risen by a weighted average of some 22 per cent against the currencies of its trading partners. Whatever the PBOC stuck into euro or other currencies over the past 19 months is now worth less in US dollar terms.

As the chart shows, almost half of the contraction in the mainland’s foreign reserves is due to this phenomenon alone.

The blue line in the chart shows the stated US dollar value of foreign reserves. The red line shows what it would have been taking into account only the net amount of money that flowed out on the balance of payments since June 2014. The difference is currency valuation and represents no actual movement of money.

My point is that the US dollar will not strengthen forever. Eventually it will weaken again and growing indications of a recession say this time may be soon. Then the mainland’s foreign reserves will go up instead of down with foreign exchange valuations.

Thus things are not really as bad as they look on first sight. A closer look yields a more comforting picture.

But don’t get too comfortable just yet. The reason that things don’t look so bad in this view is that falling import prices have allowed the mainland to post a current account surplus running at present at US$300 billion a year.

That money is not flowing back home, however. Not only are the exporters who earned it keeping it offshore but they and others took out an additional US$340 billion last year and invested it abroad.

This hardly amounts to a vote of confidence. All we can really say is that the picture in foreign reserves is not as bad as some pessimists think.