This analysis is by Bloomberg Intelligence economists Fielding Chen and Tom Orlik. It appeared first on the Bloomberg Terminal.
Does China have enough foreign-exchange reserves to defend the yuan? In principle, yes. In practice, maybe not.
According to a methodology developed by the International Monetary Fund, reserve adequacy depends on two sets of variables. First is the type of foreign exchange rate regime and capital controls a country is running. At one extreme, a country with a fixed exchange rate and no capital controls requires very large foreign-exchange reserves to defend its currency. The U.K. in 1992, when it crashed out of the European Exchange Rate Mechanism, fell into this category. At the other extreme, a country with a floating exchange rate and capital controls requires comparatively fewer foreign-exchange reserves.
China's FX reserves as % IMF recommended level
The second set of variables covers a country’s vulnerability to balance-of-payment shocks. The IMF methodology assesses the required level of FX reserves as a weighted average of exports, short-term foreign debt, other foreign liabilities and the money supply. A country with substantial exports needs FX reserves to defend against shocks to foreign demand. High foreign debt requires FX reserves as a backstop to pay it off. A bulging money supply means scope for capital flight, which also makes a big FX reserves buffer desirable.
China is currently running a fixed exchange rate regime, with the People’s Bank of China intervening to hold the yuan stable against a basket of currencies. On the assumption that the country’s capital controls are effective, the IMF methodology requires it to hold reserves equal to 10% of annual exports, plus 30% of short-term foreign debt, 20% of other foreign liabilities and 5% of M2. That adds up to $1.8 trillion, which is well below the $3.3 trillion the PBOC actually held as of December. On that basis, even at the current rate of decline in FX reserves, China could defend the yuan for more than a year and still be in the IMF’s comfort zone.
In principle, China’s reserves are ample. But in practice, what if China’s capital controls no longer have any bite? Drops in banks’ FX holdings averaging about $100 billion a month at end-2015 and rampant abuse of the trade account to disguise capital flows suggest this may be the case. If China’s capital controls are now ineffective, the IMF methodology would require them to hold $2.9 trillion in reserves. That suggests the current $3.3 trillion yuan doesn’t provide as large a buffer as it appears. If reserves continue to fall at the current pace, China would be below the IMF’s red line before the middle of the year.
The next question is whether all of China’s $3.3 trillion in reserves are liquid. Over recent years, reserves have been used to pay for everything from the founding of the China Investment Corporation to seeding the Silk Road Fund to making cash-for-commodities loans to countries like Venezuela. A portion of reserves are likely also invested in non-liquid assets. China has more than $200 billion invested in U.S. agency debt and another $280 billion invested in U.S. corporate stocks. Getting a clear read on exactly what portion of reserves are illiquid is tough to do. If investments in non-liquid assets are already subtracted from the total published by the PBOC, it could be zero. A more pessimistic assumption is that several hundred billion dollars of the PBOC’s $3.3 trillion are not available for immediate use.
The risk, then, is that if capital controls are ineffective, the exodus of funds continues and a portion of China’s reserves is illiquid, then the PBOC will soon have insufficient funds to maintain currency stability. So far, the response to that risk has been tightening foreign-exchange controls. Lenders in offshore yuan trading centers have already been required to lock up more funds, some foreign lenders have been suspended from cross-border business and there’s been a crackdown on illegal money transfers. If those moves prove ineffective and the outflows continue, a shift to a floating exchange rate might be the only option.