A trillion-dollar question on China’s forex dilemma: just how low should its reserves go?
China’s foreign exchange reserves may be the biggest in the world but they are shrinking faster than ever, raising fears that they soon won’t be enough to meet the country’s needs
China’s foreign exchange reserves these days are like a melting iceberg under the sun.
Although the reserves are still the biggest in the world, researchers and investors are wondering: are they enough for China?
On the surface, the answer is obvious, given the US$3.33 trillion it has is enough to cover the country’s imports for over 20 months, well above the usual benchmark of six months. It’s also more than enough to cover all outstanding short-term debts. China’s reserves are almost triple the size of Japan’s total, which is the world’s second-biggest.
But the change is worrying – the monthly fall in December was the first-ever single month fall over US$100 billion for China.
“Whether China’s foreign exchange reserves are sufficient depends on what the People’s Bank of China wants to do,” Zhang Ming, a researcher with the Chinese Academy of Social Sciences, wrote in a note. If the central back dispersed speculation of a weaker yuan, the reserves would be enough, Zhang wrote.
“But if the central bank continues to intervene against the market by selling US dollars and buying yuan in the quest for a stable short-term exchange rate, and the opening up of the capital account is accelerated, China’s reserves may not be enough to deal with yuan depreciation and money outflows,” he wrote.
Broad money supply, M2, was another benchmark for reserves, Zhang wrote. A country with a fixed exchange rate system needed to have reserves equivalent to up to 20 per cent of its M2. In China’s case, that was up to US$4.26 trillion, Zhang wrote.
READ MORE: ‘It’s a kind of vicious cycle’: China’s foreign reserves fall by record US$107b in December
China’s reserves have already dropped over US$600 billion from the all-time peak of US$3.99 trillion in June 2014.
“There is a concern that the reserves are falling too sharply,” Zhou Hao, an economist at Commerzbank AG in Singapore, said.
“Remember, China still has a huge trade surplus, but the reserves are shrinking – capital outflows must be quite serious.
“In theory, China shouldn’t worry about this at all; but in reality, reserves are shrinking so sharply that people can’t help asking questions.”
Zhou said the once-bottomless cache of ammunition to defend the currency now seemed limited and the central bank was picking its battles.
Rather than keeping the yuan exchange rate at a stubbornly high level “the central bank just doesn’t bother to defend it at certain levels”, he said.
The central bank set the official midpoint rate of the yuan at 6.5646 per US dollar on Thursday, the lowest since March 2011 and 0.5 per cent weaker than Wednesday. That marked the biggest daily drop since August, when China shocked the world by devaluing the yuan by 2 per cent.
In a statement on its website, the central bank said it was determined to keep the exchange rate stable to fend off speculative forces.
“Some ... are trying to profit from speculating on the yuan. Their trading is irrelevant to real economic activity and doesn’t represent true market demand or supply – they are just causing abnormal swings in the yuan exchange rate and sending wrong signals to the market,” the statement said. “In the face of such speculative forces, the People’s Bank of China is able to keep the yuan exchange rate basically stable at a reasonable and balanced level.”
Ding Shuang, chief China economist for Standard Chartered in Hong Kong, said there was no strict formula to calculate how much reserves a country needed. “The market momentum or sentiment is more important,” Ding, who used to work for the International Monetary Fund, said.
“For instance, a level of US$2.5 trillion may still be sufficient, but the market will panic if the reserves hit that level too quickly.
“People have also started to doubt how much of China’s reserves are actually fluid.”
China still has plenty in reserve – at least for now – and Beijing is willing to use it, making it a tricky business to bet against the PBOC, according to Louis Kuijs, head of Asia economics for Oxford Economics in Hong Kong.
“If you are in the market, you want to ask the question: can I fight the central bank or how solid is their position?” Kuijs said. “Looking at China’s composition of foreign assets and liabilities, I would not yet want to be betting against the PBOC.”
In addition to the vast resources at the central bank’s disposal, Beijing can impose strict capital controls any time. A few foreign banks were already reportedly banned from certain cross-border transactions.
During the Asian financial crisis, then-premier Zhu Rongji vowed to maintain a stable yuan exchange rate, despite mounting pressures on the currency to weaken. Thanks to rigid capital controls, China managed to avoid the big currency depreciation suffered by its Asian neighbours, despite a small reserve base of less than US$150 billion.
Foreign exchange reserves were key for China to maintain financial stability as it opened up the capital account and embraced a freer exchange rate system, said Huang Yiping, a member of China’s monetary policy committee and a Peking University professor.
“Despite their reserves, India, Indonesia and South Korea were almost in crisis mode in the global financial crisis because they were exposed to big capital flows,” Huang said. “The key issue is to have a healthy financial system – developed countries with a sound financial system often worry less about capital inflows and outflows.”
The drop in China’s reserves is far from being a pressing issue for Beijing but the run will raise new challenges for China.
“It’s not a short-term change, it’s the new trend, and it’s the new reality – foreign exchange reserves of emerging markets, including China, will fall,” said Zhang Monan, a researcher at the China Centre for International Economic Exchanges, a government think tank. “It will bring much deeper problems, such as a new way of creating domestic liquidity in central banking.”
China’s reserves have ballooned over the last decade and a half, multiplying almost 20 fold from 2001 to peak at US$3.99 trillion in June 2014, thanks to trade surpluses and capital inflows.
To stop the yuan from rising too quickly or, as Washington had argued, to keep the yuan artificially low, the PBOC had kept buying incoming US dollars for years, inflating money supply at home.
During a visit to Kenya in May 2014, Premier Li Keqiang described China’s foreign exchange reserves as “a very big burden”. A large stockpile of foreign exchange forced China to enlarge its base money supply to add inflationary pressure at home, Li said.
The State Administration of Foreign Exchange, the agency in charge of day-to-day management of the portfolio, also came under harsh criticism over the years for investing too much into “low-yielding” assets like US treasuries. Against this background, China’s sovereign wealth fund, China Investment Corp, was created in late 2007, taking US$200 billion from Safe’s portfolio to diversify into higher-yielding assets and “strategic resources”.
“When China’s economy was strong and its reserves were rising, the priority was about how to keep a lid on it and how to diversify the reserves,” said Li Jie, head of the foreign exchange reserve institute with the Central University of Finance and Economics in Beijing. “But if the yuan depreciation pressure is really big, if China wants to defend the yuan from a sharp depreciation, it means China will consume a lot of foreign exchange reserves, and reserves will become precious. That’s the situation now.”