It seems a long time ago that China was piling up foreign exchange reserves at a record pace as economists fretted about global imbalances from Beijing gobbling up US Treasury bonds.
Now investors are wondering how long China’s dwindling forex reserves — down to $3.5tn from a peak of $4tn in June 2014 — can hold out. Capital is flowing out of China at a record pace and the central bank is drawing down reserves to support the renminbi after its recent dramatic fall.
A lack of clarity over how China calculates its reserves and how much is readily available to deploy at short notice has intensified these concerns.
The prospect that reserves could be quickly exhausted raises doubts about the government’s ability to ward off crisis. It also limits the central bank’s ability to continue foreign exchange intervention, which may have cost as much as $200bn in August alone.
“The PBoC’s war chest is sizeable, no doubt, but not unlimited,” Wei Yao, China economist at Société Générale, wrote recently. “It is not a good idea to keep at this battle of currency stabilisation for too long. We think that $1tn is the absolute maximum the PBoC can sell.”
The composition of China’s reserves is a state secret and the figures themselves remain mired in confusion. China’s reserves are managed by the traditionally staid State Administration of Foreign Exchange, which typically put its money in US government bonds.
But the low returns that Safe earned on its conservative portfolio led the
government to launch a sovereign wealth fund, China Investment Corp, in 2007 to pursue riskier and less liquid investments. In recent years, rivalry between the two encouraged Safe to dabble in other investments such as British office buildings and Italian banks. But while CIC’s investments do not appear in official reserve figures, it is not clear if Safe’s CIC-style forays do.
Another source of mystery is China’s offshore intervention. The PBoC has traditionally confined its currency interventions to the domestic market, but recently it has bought offshore renminbi in an effort to narrow the spread between the onshore and offshore rates. Analysts suspect Safe may count offshore renminbi, known as CNH, as “foreign” reserves — in effect making its reserves look much bigger than they are.
Amid pressure for greater clarity as China seeks IMF endorsement for the renminbi as a reserve currency, Beijing has signed up to an IMF standard that requires it to disclose more information about its reserves — including how much is held as financial securities versus less liquid assets.
Tao Wang, China economist at UBS, estimates that China holds $1.4tn in US Treasury securities plus $800bn in those of other governments, mostly in Europe, the UK and Japan — far below the official figure of $3.5tn. Still, she believes concern about the liquidity of China’s reserves are overblown.
“We believe widespread worries about the adequacy and liquidity of reserves are more a reflection of current extreme market pessimism on China rather than facts and reality,” she wrote.
For an economy such as China’s, with a fixed exchange rate and capital controls, the IMF recommends that the central bank hold forex reserves worth 30 per cent of short-term debt, 10 per cent of exports and 5-10 per cent of M2 money.
Based on these criteria, China needs between $1.6tn and $2.6tn in reserves, says Mansoor Mohi-uddin, senior market strategist at Royal Bank of Scotland in Hong Kong. That matches Ms Yao’s contention that China can spend about $1tn more defending the currency before reserves would drop below safe levels.
Given the limited nature of China’s forex reserves, economists believe authorities will eventually have to allow further renminbi depreciation.
After August’s surprise devaluation, the PBoC intervened to calm the market’s panicked mood. But once the risk of uncontrolled depreciation has passed, authorities are expected to pull back. “Over a longer period of time we expect the Chinese government to allow for more [renminbi] flexibility and depreciation and, if necessary, tighter FX controls instead of depleting its FX reserves to defend the currency,” said Ms Wang.