Should China worry about its falling foreign exchange reserves?
The Chinese government has rushed to play down the significance of its foreign exchange reserves falling below US$3 trillion, but concerns remain that China is losing a key guarantee of its financial stability.
The question of what level of reserves China really needs prompts different answers depending on what method is used to calculate the figure.
If measured by totalling half the year’s imports and sufficient cash to repay foreign debts, China’s US$3 trillion stockpile of foreign currencies are more than enough.
If calculated, however, by using yardsticks adopted by the International Monetary Fund to assess the adequacy of reserves, then China is close to levels required to defend the yuan’s exchange rate.
The State Administration of Foreign Exchange issued a question-and-answer statement immediately after the central bank published details of the nation’s foreign exchange reserves at the end of January. They had dropped to US$2.998 trillion, the lowest level since February 2011.
The agency said it was “normal” for the size of foreign exchange reserves to move up or down and there was no need to put a special focus on a specific number such as US$3 trillion.
However, the fact that the statement was issued reflected Beijing’s recognition of market concerns and its efforts to influence, or even guide, traders’ sentiments.
“The foreign exchange regulators realised they cannot disregard market talk on the US$3 trillion level, so they quickly sent messages to the market to dispel these concerns,” said Xie Yaxuan, research head at China Merchants Securities.
Beijing’s efforts to control the rhetoric over its reserves and the yuan exchange rate, together with its interventions in the market, have achieved limited results.
China’s reserves have shrunk by about US$1 trillion from a peak in June 2014. The yuan’s exchange rate against the dollar has also weakened over 10 per cent from the renminbi’s peak of 6.04 yuan to the greenback in early 2014.
The debate over whether China should continue to burn its foreign exchange reserves to defend the yuan is still continuing among Chinese analysts.
While economists such as Yu Yongding, a former member of China’s monetary policy committee, have argued that China should stop intervening in the yuan exchange rate to protect the reserves, a front-page opinion piece published by the Economic Information Daily, a paper published by the state-run Xinhua news agency, argued that the authorities should not shy away from propping up the currency.
“The purpose of foreign exchange reserves is to use the reserves ... and it’s absolutely unnecessary to worry about a specific level,” Zhao Qingming, the chief economist at the China Financial Futures Exchange, wrote in the opinion piece. “It’s not a reasonable choice to guard the reserves at the cost of permitting big exchange rate movements,” Zhao added.
Japan holds more than US$1 trillion in foreign exchange reserves, but it seldom uses them to shore up the value of the Japanese yen to avoid provoking the ire of the US. The foreign exchange reserves of the European Central Bank are much lower, a figure over US$200 billion.
China’s reserves fell in January despite a moderate US dollar deprecation, which should boost the valuation of non-dollar assets in the nation’s portfolio and also Beijing’s measures to curb capital outflows.
The People’s Bank of China said in a brief statement there were major uncertainties in Donald Trump’s economic and diplomatic policies and the pace of possible interest rate increases by the US Federal Reserve was unclear.
It also foresaw possibilities of “black swan” events politically and economically to shatter financial markets, but predicted the yuan would remain stable supported by sound fundamentals.
Debate over what is an acceptable level for China’s foreign exchange reserves has raged for years, even among senior government officials.
After China’s reserves surged above US$3 trillion mark in March 2011 due to huge capital inflows, Zhou Xiaochuan, the central bank governor, said they were too large and “exceeded the reasonable level”.
Premier Li Keqiang also said in 2014 the large reserves were “a heavy burden” for the nation as they brought inflationary pressures.
Large and growing foreign exchange reserves, while inviting criticism from trade partners, gave Beijing the confidence prior to 2014 to accelerate overseas investments in resources and helped widen the nation’s influence.
Many strategies aimed at boosting overseas spending are now under review as China’s foreign exchange reserves are shrinking.
Chinese companies’ investments in overseas property and hotels have been pared down and President Xi Jinping said earlier this week that China needs to be more prudent in the way it allocates foreign aid.
Using the IMF methodology, China needs at least US$2.7 trillion in foreign exchange reserves. This assumes a fixed exchange rate.
A minimum of US$1.5 trillion is needed if the yuan exchange rate is free in light of the country’s exports and money supply size, although the IMF calculation is purely a theoretical model.
“The yuan’s exchange rate is neither strictly fixed nor floated and it has capital controls,” said Xie at China Merchants Securities. As a result, the ideal reserve size for China could fall in a wide range of between US$1.5 trillion to US$2.7 trillion, said Xie.
Shen Jianguang, chief economist at Mizuho Securities Asia, said Beijing should make the yuan’s exchange rate a priority this year rather than the size of the nation’s reserves.
“A stable yuan exchange rate is currently the most important policy target for China,” he said.