Follow Up to the Question of Chinese Foreign Exchange Reserves

Balding's World

As usual, I want to do my follow up to the BloombergView piece about whether the $3.3 trillion in FX reserves is adequate.  I normally reserve what I do here on my blog as a more technical exposition on the ideas presented in the BV piece, so as always, start there.

  1. Many people make the assumption that the only thing FX reserves are used to do is defend the currency. That simply is not true.  FX reserves serve numerous other purposes acting like a bank account for the country.  Paying bills that come due in other currencies is the primary issue.  When you have a fixed currency and capital controls, the central bank has to provide the liquidity unlike in a floating regime where participants can just go to the market and buy whatever currency they need.
  2. Many people make the erroneous assumption that FX reserves can be taken down to 0. Again, not remotely close.  Because FX reserves serve multiple functions and are used in different ways, they cannot be taken to zero even if the government wanted to.
  3. China cannot take its FX reserves all the way down to zero. Doing so would essentially bring a halt to any international trade.  One item is international trade.  A comfortable amount is FX reserves equal to about 3-6 months of imports.  China currently imports almost $200 billion USD a month so let’s assume for round number sake, they need $800b-$1 trillion in FX reserves just to grease the wheels of international trade.
  4. Then lets add in the official numbers of what China classifies as “external debt” which they list as $1.5 trillion of which they classify $1 trillion as short term. It is worth noting that the BIS and IMF IIP data list China as having about $1.1 trillion with similar split in maturity.  If we assume that approximately $750b-$1t is coming due in 2016, that gives us another number to add to our list of what the FX reserves need to accomplish.
  5. For 2016, we are already up to say $1.5-2 trillion is needed in 2016 for foreign currency needs. Between just paying bills and having liquidity to engage in international trade, China needs about $1.5-2 trillion in FX reserves.  We could move it a little lower by taking on some more risk, but you can’t move it a lot lower without increasing your risk very very fast.
  6. Now let’s add into the equation that the PBOC has illiquid assets of about $1 trillion USD. These are tied to a variety of different commitments, but the PBOC has about $1 trillion linked to investments and holdings that they cannot easily access to defend the RMB.
  7. We are now at $2.5-3 trillion USD in reserves that are semi-in-use or committed elsewhere.
  8. When people say the PBOC has $3.3 trillion and years of defense left, that simply is inaccurate. They have to have liquidity to engage in international trade and pay the 35% of global EM debt they owe.  They cannot take $3.3 trillion to zero without creating a truly enormous crisis.  There are commitments before then that come with numbers.
  9. Add in, there is a lot more money leaving China than entering right now, and it becomes quickly apparent how serious the situation is.
  10. The PBOC spent a little more than $100b in December and began slow walking FX requests.  While there has been month to month fluctuations, the long term trend of capital outflows is clear and accelerating over time.  There is no obvious trigger that would cause the outflows to stop or reverse.
  11. If we take the numbers presented here that the PBOC has commitments of say $2.5 trillion, that means at current rates, the RMB peg/basket as we know it has less than one year of shelf life left. In other words, the PBOC will have to either impose hard capital controls (70%) or float (30%).
  12. One very important factor here is that the capital outflows out of China are clearly domestically driven. There is not one shred of empirical evidence that this is driven by international investors.  In fact, international investment via FDI and portfolio flows continues to hold up even in a rocky 2015.  The inflows were not as large as in previous years but they do continue to grow.  Pressure on the RMB is completely, entirely, 100% driven by domestic investor capital flight from China.
  13. The reason the composition of funds leaving matters is that this is not a temporary issue. This is been going on for more than a year and picking up speed as it goes.  This is not hot money these are not international investors looking for quick buck these are Chinese citizens and firms moving their money out of China at least semi-permanently.   Definitely more than a simple short term vacation.  That means this is a structural issue that will not be fixed with temporary solution but is structural and long lasting in nature.  Which means….
  14. Get used to this new normal. It isn’t changing anytime soon. Capital will not come flooding back. (Would you send your money back to China?) Deal with the situation and don’t pretend it isn’t happening.