China's pile of foreign exchange reserves has long been touted as a bullish signal for the country's ability to weather economic storms. But China is now in a policy trap as it expands the domestic money supply in order to funnel liquidity into the banking system to roll over its bad debts.
Data released in July throws into sharp relief the cost of Beijing's approach: a depleting war chest of foreign-exchange reserves relative to its expanding domestic money supply, which could prove insufficient in the looming battle against capital outflows.
At first blush, this bearish projection sounds counterintuitive.
China's foreign exchange reserves have fallen this year, slipping to $3.2 trillion in July, $4.1 billion lower than June's reading. Still, recent reserve data have been better than expected from the perspective of some market participants, and China's FX reserves, more generally, look healthy relative to GDP and its balance-of-payment position.
But don't let that fool you, warns Worth Wray, chief economist at STA Wealth Management, a Houston-based advisory firm.
Wray is worried about China's FX reserves relative to M2, which is a broad gauge for domestic money supply. M2 has been rising in recent months as China seeks to stimulate growth and provide liquidity to banks as well as state-owned borrowers in order to service debts.
Put simply, if M2 represents the capital that potentially could leave China, FX reserves represent Beijing's resources for managing that outflow, Wray says.
According to July figures, the FX reserves/M2 ratio is now at its lowest level since June 2003, according to data compiled by Bloomberg.
"We've seen an alarming fall in the ratio over the last few years. It was as high as 27 percent as recently as 2014 — when FX reserves totaled more than $4 trillion — but is now closer to 14 percent. That's well below the [International Monetary Fund]'s advisable 20 percent threshold," he says.
Analysts are predicting further capital outflows. The valuation effect from a marginally weaker U.S. dollar flattered the capital-flow picture in June, Morgan Stanley economists led by Robin Xing wrote in a research report published on Monday. They reckon weak return on investment, loss of productivity, and the prospect of lower real rates will further fuel resident-driven outflows in the coming months.
If Beijing attempts to stem the oncoming tide by drawing down on FX reserves but keeps the money supply growing, the FX/M2 ratio would fall further.
Not everyone is worried, however. A research note published by Citigroup Inc. on Sunday strikes a more sanguine note on China's FX reserves, and, thereby, its buffers to weather external shocks. It calculates China's reserve adequacy at 177 percent relative to balance-of-payments funding needs, if one considers the yuan an effectively fixed exchange rate.
But Wray tempers bullish projections about China's FX reserve adequacy. "There's a difference between having enough reserves to meet normal balance-of-payments needs and adequate reserves to defend resident-driven capital flight in a panic. My point is that the buffers continue to fall and Beijing can't keep following this policy course forever."
Given the declining FX reserves-to-M2 ratio, China might need to bite the bullet, and make hard policy choices sooner rather than later.
China has sought to avoid a sharp depreciation of the exchange rate as that risks further fuelling capital outflows, among other things, and would result in a tightening of domestic liquidity. At the same time, the yuan's relative strength against the dollar is impeding the effectiveness of a looser monetary policy aimed at boosting growth.
As a result, Beijing is trapped domestic policy conundrum, analysts at Morgan Stanley write: "We believe policymakers have been trying to strike a balance to manage the trilemma challenge – flexibility of exchange rate, openness of capital account and control over domestic interest rates."