The $3 trillion question

China’s forex reserves have just dipped below $3 trillion mark

News that international payments made with the yuan fell by almost a third last year have added to the sense that the Chinese currency has slowed its journey towards becoming a global currency.

In fact, the yuan has dropped out of the world’s top five payment currencies after a long period of climbing the rankings, falling from 2.31% of total trade payments in December 2015 to 1.68% in December last year.

That took it down to sixth place, slipping below the Canadian dollar.

Analysts have been blaming China’s slowing rate of economic growth, a loss of faith in the currency overseas and measures taken at home to stem capital outflows (see WiC351).

What’s clear is that some of the impetus for the currency’s spread is receding as the authorities in Beijing focus more on stabilising the renminbi against the dollar. For the moment at least, foreign exchange regulators are pushing domestic companies to keep their money at home and bring it back from overseas. In Shanghai, for instance, every Rmb100 that goes global needs a corresponding inflow of the same amount, according to media reports. In Beijing the restrictions are tighter, requiring Rmb100 to be imported for every Rmb80 remitted internationally.

Part of the strategy in reducing the availability of the yuan is a bid to strengthen Beijing’s influence over the offshore exchange rate. Regulators have even less control if larger volumes of currency are remitted overseas, where the yuan trades more freely than back at home in China. And the trend of a weakening renminbi has been a problem for policymakers, the Financial Times says, as it signals that global markets are expecting it to drop further, encouraging Chinese holders of the redback to try to get more of their money out of the country and convert it into dollars.

One outcome of the tightening on cross-border flows is that the market for the currency outside China has been shrinking. Liquidity has been falling in key offshore trading hubs like Hong Kong, which reported a 12.9% decline in yuan deposits in December to Rmb546.7 billion ($79 billion), according to the Hong Kong Monetary Authority. The cost of borrowing the yuan in the territory has also increased because of the weakening of the currency, which fell 6.6% against the dollar last year, the most since 1994. The uncertainty is making it more expensive for companies to raise capital through renminbi-denominated ‘dim sum’ bonds, the main source of offshore investment products in the currency.

Another side effect of the tighter liquidity is that the renminbi spent the early weeks of the year trading stronger offshore than at home in China in a reversal of the typical trend (it has tended to do better against the dollar in the more restricted onshore market).

Currency strategists polled by Reuters still think the yuan will further weaken against the greenback in the months ahead, especially if the Federal Reserve raises interest rates, which could trigger new capital outflows. But the fundamental question for Chinese policymakers is whether to defend the currency or protect their reserves from falling further. China’s foreign exchange holdings breached another symbolic threshold last month, falling $12.3 billion to a fraction below $3 trillion. They are now down more than $1 trillion on their peak in mid-2014, although last month’s decline was less than December’s and the lowest for seven months, suggesting that capital controls and the stronger performance against the dollar have discouraged some of the outflows.

A statement from the State Administration of Foreign Exchange (SAFE) said that January’s drop was linked to purchases of foreign exchange for overseas travel and bond repayments due at the beginning of the year. “China’s capital outflow has moderated a lot and it will move towards a balance in the future,” the statement insisted. “The current reserves are adequate.”

The domestic media also professes itself unconcerned by the news that another threshold had been breached. “Any fluctuations of a country’s foreign exchange reserve within a certain range are normal, and the current reserves, although below $3 trillion, are still the world’s largest,” National Business Daily assured its readers. “In a complex and changeable economic and financial environment at home and abroad, one should not artificially set a ‘psychological limit’ for China’s foreign exchange reserves.”

Pan Gongsheng, the head of SAFE and deputy central bank governor, also moved to reassure offshore investors that their money wouldn’t be trapped in China. “The window we have opened will not be closed again. Foreign exchange management policy will not retreat backwards, let alone will we return to the old road of capital controls,” he told China Business News. The Financial Times then pointed out this was unual intervention: neither Pan nor his predecessor at SAFE had ever granted an interview before.

As a postscript: Brad Setser of the Council of Foreign Relations has been warning this week that China has more room for maneouvre on its reserves than many seem to think.

The problem, he says, is that sections of the media have seized on a widely reported figure of $2.7 trillion as a minimum level for an economy of China’s size. That makes the breaching of the $3 trillion threshold last month seem more ominous as China moves closer towards the danger zone. But Setser’s main point is that the standard methodology for calculating this figure (from the IMF) is as a percentage of M2 money supply. The metric works well enough in other cases but it isn’t as effective for China, which has a huge domestic deposit base. Against other recognised parameters, China’s reserves look much more robust. Even at $2.7 trillion they would be more than enough to cover the country’s short term external debt three times over, for instance, and sufficient to meet a year of goods and services imports.

Setser thinks that the Chinese could repay their short term debts and meet their liquidity needs with about $1 trillion in reserves because they run a large current account surplus of $200-$300 billion, and they have access to another $900 billion or so of foreign currency deposits. Setser agrees that China’s reserves have been declining rapidly but equally he says the above reasoning means there’s no need to panic yet.

“The world would be in a better place if there was a broad recognition that China can burn through another $1 trillion in reserves, and with $2 trillion still in reserve, be above nearly all metrics of reserve adequacy,” he writes.

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