China’s foreign exchange reserves, once the pride of the nation’s policymakers and citizens, may continue shrinking in 2017, as a yearlong capital outflow shows no sign of abating. That may exert pressure on the government to tighten the screws on remittances of the yuan to stabilize the currency, analysts and economists say. The Chinese foreign exchange reserves shrank by about a quarter from US$3.99 trillion in June 2014 to US$3.05 trillion as of November, and the country was displaced in October by Japan as America’s top foreign creditor, as the People’s Bank of China spent more of its reserves to defend the yuan. China must “safeguard the foreign reserve pool” as this is a higher priority than propping up the yuan’s exchange rate, best left to market forces, said Yu Yongding, a Chinese Academy of Social Sciences professor and a former adviser to the central bank. “The key issue is the foreign reserve,” Yu said. “If we keep guarding the currency rate, the reserve drops, and when it drops to an inadequate level, we will face even bigger depreciation pressure for the currency,” he said. China’s US Treasuries holdings fell to US$1.12 trillion at the end of October, slightly less than the US$1.13 trillion held by Japan, losing the crown of being America’s largest foreign creditor for the first time in six years. Money is leaving China’s shores at a faster clip, as more citizens and companies rush to get their currency out of the country before the yuan’s value deteriorates faster. The average daily turnover of China’s foreign exchange market reached US$34.2 billion as of December 19, 12 per cent more than the US$30.5 billion daily average in November, according to research by investment bank China International Capital Corp (CICC). “Expectations for a strengthened US dollar is dominating the markets and sentiments in China, making it particularly difficult for decision makers to handle,” said Aidan Yao, senior emerging Asia economist at AXA Investment Managers Asia. “For them, the current imperative is to stabilise outflows through tighter capital control. Although it doesn’t seem like a sustainable solution, it can win time and space for the government to manage the situation as domestic and exterior condition evolves.” Market watchers warn of yuan depreciation China’s government may further enhance the administrative measures at its disposal, or “asymmetric capital account management measures” in financial jargon, to make currency inflows easier while outflows become harder, Yao said. “The management of portfolio flows, mainly investments in equities and bonds, will be stricter than direct investment control,” Yao said. “Companies eyeing non-core business acquisition overseas will definitely meet bigger obstacles.” The “errors and omissions” entry in Chinese national account statistics, a catch-all for cross border transfers that haven’t been properly classified, caused net outflows of US$89 billion in the first half of this year, almost double the US$46 billion net foreign direct investment outflows in the same period. This suggests there are loopholes in China’s capital account system. The Chinese government is likely to “throw sand in the gears” and create friction in capital remittances such as scrapping or adjusting the annual US$50,000 individual foreign exchange swap quota, CICC analysts said, instead of imposing hardline capital controls. China’s foreign exchange reserves are adequate and won’t be a threat to external payments as long as they remain above US$2.6 trillion, CICC said. “We don’t rule out the possibility of some window guidance at the bank level, or even requiring additional documentary proof for foreign exchange purchases,” CICC said. Window guidance is a form of moral suasion by the central bank, which doesn’t require across-the-board policies. “A reserve level higher than US$2.6 trillion would’ve met all the traditional adequacy standards, including 3-month import coverage (US$420 billion), the size of debt coverage (US$921 billion), and the International Monetary Fund’s composite metric (US$1.7 trillion to 2.6 trillion),” CICC said. Fear of yuan depreciation driving China’s outbound investments China’s strict restrictions on outbound direct investments and yuan flows could mitigate the pressure of outflows and help the yuan avoid near-term volatility, albeit at the cost of delaying or cancelling Chinese firms’ overseas investment deals, and slowing the pace of financial liberalisation and yuan internationalisation, Morgan Stanely said last week. The fundamental reason for the yuan’s outflow, caused by a “decline in investment returns and lower real rates in China while the US enters the rate increase cycle” will likely keep capital outflow pressures alive in the medium term and drive the yuan weaker, the bank said.