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LAGOS (Capital Markets in Africa) – China’s foreign exchange reserves are now below USD3tr, the lowest in three years. In fact, relative to GDP, this is the lowest since the early 2000s. China has seen a material decline in reserves-to-GDP since 2008 resulting from declining global demand combined with growing outbound investment.
More recently, the sharp decline in China’s once heralded reserves has come with the defence of the renminbi, triggering concerns in global financial markets. The current burn rate is alarming: down by USD512bn in 2015, and then by USD320bn in 2016.
It is particularly disappointing that the drawing down of these reserves has been done to prevent capital flight, which seems rather wasteful. When seen as global purchasing power, reserves should rather be utilized in ways that support domestic consumption and rebalance the economy, such as running a trade deficit.
The numbers being bandied about though simply have no intellectual credibility, such as the notion that USD3trn is some sort of danger level — a so-called “line in the sand”. Of course, reserves have to meet a minimum requirement necessary for China’s industrial base, money supply, trade business, and so on. However, if a level is collectively agreed upon by markets, that perception will become self-fulfilling, triggering panic.
For years, China has run a substantial balance of payments surplus by exporting more than it imported and receiving more investment than it made abroad. Without government intervention, these imbalances would have self-corrected by putting upward pressure on the renminbi. Instead, the Chinese government purchased USD, resulting in ballooning reserves. Until the financial crisis, authorities had tried to sterilize issued domestic currency by locking it in the banking system. Then, facing a potential global economic apocalypse, an enormous stimulus. Beijing got what it wished for: a floor under growth. However, it also pushed credit beyond 270% of GDP in 2016.
It is impossible to ignore that the investment-led and credit-fuelled response exacerbated resource misallocations. Come 2014, Chinese President Xi Jingping launched the New Normal. Envisioned here is a Chinese economy that is expanding more slowly, but enjoying higher quality economic growth; an economy less factor- and investment-driven, shifting towards a pattern of growth led by services and consumption; led forward by innovation and with market forces determining the allocation of resources.
Smartly, policymakers have also moved away from the peg against the dollar towards a trade-weighted value of the renminbi. China simply could not avoid the defaults and bankruptcies, and also maintain its exchange rate against the USD. That adjustment was introduced in response to the rapid appreciation of the dollar since mid-2014, which had dragged the renminbi with it.
Back in August 2015, authorities created the CFETS basket and allowed devaluation, which unleashed a flood of selling. Loath to allow markets to determine the size and speed of depreciation, the PBoC has tried to limit depreciation, and this is what has sapped foreign exchange reserves. FX reserves have fallen to below USD3tr, and are heading towards USD2.8tr by the end of this quarter, and are likely to continuing to fall through year-end.
Since the 1990s, many emerging markets have recognized the benefits of building reserves as insurance against the volatility associated with financial globalization. Of course, in China’s case the reserves are really about ring-fencing the economy against local residents’ flight from domestic assets.
The question is, does China have enough FX reserves? We believe so.
- There is no universally accepted standard for what is considered sufficient foreign exchange reserves. That said, the International Monetary Fund has reserve adequacy guidelines. To this end, a country needs around 10% of exports, 30% of short-term FX debt, 10% of money supply and 15% of other liabilities. The combination of these reserves must be external assets that are readily available, and controlled by monetary authorities for meeting balance of payments financing needs. For China, that calculus equates to around USD2.7tr.
- However, the figure probably can be downwardly revised because the IMF’s calculus fails to take account of idiosyncratic features. Does Chinese really need to insure against export disruptions or falls in commodity prices in the same way as most developing countries that tend to be heavily commodity-dependent? Given the capital controls, does China really need CNY2.1trn (10% of money supply) to capture capital flight risks and insure against residents’ deposits leaving the Mainland?
- In other words, a diverse economy with a managed currency, capital controls and managed financial system does not need exactly the same minimum level of reserves as a single commodity-exporting country with a floating exchange rate and minimal central bank intervention.
- Given the magnitude of these pieces of the reserve pie, it seems reasonable to argue that in the context of China, a downward adjustment of USD1tr seems reasonable. Thus, it seems fair to argue that in terms of FX reserves, somewhere between USD1.56tr and USD2.2tr would be adequate for China’s working capital.
- Indeed, this is far more consistent with the PBoC’s benchmark of three to six months’ imports and 100% of short-term debt. On that score, China needs around USC1.6tr.
Of course, China is getting closer to concerning levels. In reality, however, no matter how large they are, FX reserves never last as long as anyone thinks they will in a crisis. For a start, burn rates accelerate. Also, in crisis, the liquidation of assets would have harmful valuation effects which would alter the eventual value of assets available. However, at this juncture, the notion that China has just breached some dangerous threshold by slipping below USD3tr is simply wrong.