China’s forex chest

How it is depleting rapidly and what it means…

The big news is that China’s forex reserves have been depleting rapidly. To begin with China had a forex chest of nearly $4.1 trillion in late 2014. That not only made China the largest reserve holder but almost 4 times the size of the second largest reserve held by Japan. The Chinese reserve was built over decades of trade surpluses. As China emerged as the factory of the world, its exports boomed and that was largely aided by a cheap Yuan. But things have been changing in the last one year…

A sharp depletion in reserves…

 Since the beginning of 2015, the Chinese forex reserves have been depleted by nearly 20%. As of early 2016, the Chinese forex chest stands at nearly $3.2 trillion, which is still 3 times the size of Japan. But the rapid depletion of the chest is surely a sign of worry. Remember, China is the world’s second largest economy both in terms of GDP and in terms of market capitalization. Secondly, even a slowing China is growing at about 6.9% and that means China continues to contribute nearly 50% of the world’s GDP growth each year. For an economy of that size and centrality, a currency chest of $1.5-2 trillion is a bare minimum. So at $3.2 trillion it is surely comfortable, but then the question is why have the reserves been depleting so rapidly? The answer obviously lies in the currency management of the PBOC and also portfolio outflows from China.

Need a weak or a strong Yuan?

The currency reserves of China have been largely determined by the need of the PBOC to maintain the Yuan at an appropriate level. During the heady growth years the biggest worry for the PBOC was to prevent the Yuan from appreciating too much as it would have resulted in exports becoming largely uncompetitive. Even as the US kept protesting, China continued to follow a cheap Yuan policy to prop exports. But the huge export flows ensured that the reserves continued to build up. The problem in 2015 was slightly different. Slowdown in exports and GDP meant managing the Yuan at an appropriate level involved actual depletion of the forex chest. Capital outflows compounded this problem. However, it may not be much of a worry for China.

No overt worries for China…

Unlike Saudi Arabia that needs to worry about currency reserve depletion, China is in a different league. Less than 10% of Chinese reserves are locked up in illiquid long-term projects. Hence liquidity may not really be a major worry. China holds nearly $1.25 trillion worth of US Treasuries and that would mean that the US, Japan and EU would be keen to ensure that the applecart does not get upset. In a way, this will ensure that China’s forex reserves are put to more productive uses. That may be good for China and the world! ©

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