When $3 Trillion Just Isn't Enough
Most conversations about the Chinese economy come with a reassuring caveat: With $3.3 trillion in foreign-exchange reserves at their disposal, Chinese leaders can bring almost unlimited firepower to bear to defend the yuan, recapitalize state banks or spread cheap loans abroad to win influence. Such confidence, however, may be misplaced.
Those trillions of dollars add up to a lot less than many people seem to imagine. The total, given out by the People's Bank of China, is considered relatively accurate. But that's not the whole story. According to numerous estimates, close to a third of China's reserves are held in illiquid assets -- for instance, long-term investments in infrastructure projects that are part of the so-called New Silk Road. That implies that more than a trillion dollars could only be tapped in a longer time horizon of at least one year. Even if the true number is half as much, that would reduce the range of useable FX reserves to around $2.8 trillion.
Add to this the question of how much foreign exchange China needs to hold in order to be prudent. The IMF has developed a suggested framework based upon research into previous currency crises. According to this formula, countries should maintain reserves equivalent to the sum of 30 percent of their short-term foreign-denominated debt, 15 percent of other portfolio liabilities, 10 percent of the M2 or broad money supply and 10 percent of yearly exports.
In China's case, that would add up to approximately $3 trillion. The biggest share comes from M2, which in China totals approximately $21 trillion. Currently, even China's seemingly huge reserves amount only to 15 percent of M2 money supply, the lowest proportion since 2008; even if that share were lowered to 10 percent, China would still need $2.1 trillion to cover it. Covering short-term foreign debt, portfolio liabilities and yearly exports would add another $900 billion.
Right now, Chinese FX reserves stand at about 110 percent of this recommended number. Excluding the illiquid reserves, though, China's holding only 93 percent of the total. (In fact, the IMF suggests countries maintain reserves as high as 150 percent of the total number, which would make China's shortfall even more dramatic.)
Furthermore, official Chinese FX reserves held by the PBOC are falling fast, declining $100 billion per month since October. With Chinese citizens and firms racing to get their money out of the country -- spurring an estimated $1 trillion in capital outflows in 2015 -- the government has had to deploy reserves buying yuan, to prop up the currency's value.
There's little indication that this trend is about to be reversed. Indeed, the central bank is burning through more and more of its reserves every month and when worry sets in, numbers tend to gain speed.
Depending on exactly how fast capital leaves China, Beijing could be looking at a worryingly low level of reserves as soon as July. At current rates, China will drop beneath the recommended amount of $3 trillion at the end of the first quarter even if including all illiquid assets; excluding them, China could have fewer than $2 trillion in usable reserves by summer. By the end of the year, the government could face a situation where the only tools left to prevent the currency's slide could be hard capital controls that prevent money from leaving the country -- an embarrassing state of affairs for the world's second-largest economy.
How should Chinese policymakers respond? First, they have to accept that the financial laws of physics apply to China. The PBOC may have a good case to lower interest rates. But with loan demand down, fears rising over equity markets, and a huge overhang of surplus capacity, further monetary easing is sure to prompt additional outflows as investors seek higher returns elsewhere. That means continued downward pressure on the yuan, forcing the PBOC to spend billions more to buy up the currency.
By seeking both looser monetary policy and a strong yuan, the central bank is pursuing a set of contradictory policies that can't succeed. The PBOC needs instead to chart a course toward either floating the yuan or imposing capital controls. There simply are no other alternatives.
Second, China needs to address the domestic and international loss of credibility it's suffered over the past year. Last summer's surprise devaluation has rattled ordinary Chinese as well as international investors. State-owned media are running articles arguing that the currency is stable, even as reports emerge of increased administrative measures to restrict capital outflows. While economic fundamentals would suggest that outflows will continue, changing the psychology of investors could help stem the tide. That will require high-quality leadership in Beijing, including a clear and believable currency policy, to regain trust.
None of this means that Chinese leaders -- or the world -- should panic just yet. But rather than continuing to drain reserves, they'll soon need to decide if they're ready to float the yuan. The alternative -- to wall off the Chinese financial system and give up on dreams of making the yuan a global reserve currency -- is bleak.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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