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After building the largest stockpile of foreign exchange reserves in global history, China is now spending them at a rapid pace to keep its currency from depreciating. Is it plausible that China could be forced to devalue the renminbi because it runs out (or fears it may run out) of reserves? And what other use do China’s reserves have anyway?
It is highly unlikely that China would need to spend all of its reserves to defend the renminbi’s current value. Moreover, the reserves are not useful for anything except to manage the renminbi, so China may as well use them to keep its exchange rate stable in this time of volatility. Indeed, because the renminbi is bound to appreciate against the dollar and the euro in the long run, China is better off selling reserves while it can still get a good price for them.
Right now, gloom about China’s economic transition and market worries about potential policy responses have propelled so-called “hot money” out of China at a record clip. To maintain the renminbi peg to the US dollar, China’s central bank must take the other side of these transactions and supply foreign currency in exchange for domestic currency. Hot money gets its name because it moves around quickly. But hot money is not unlimited, and it would be a mistake to conclude that it will continue to flow out at the current pace for long enough to exhaust China’s reserves.
The reported value of China’s reserves dropped $94 billion in August. China must have spent more than that defending the renminbi peg because some of its reserves are invested in euro and yen, which rose in value about 3 percent during the month. In addition, China has a large current account surplus, averaging about $25 billion per month. Assuming that the euro and the yen stabilize against the dollar and the current account surplus remains near its current level, it would take more than two years of hot money outflows at the August pace for China to run out of reserves. I doubt there is anywhere near that much hot money in China, and sentiment on China is not likely to remain so bearish for so long.
Two years ago, a paper by researchers at the International Monetary Fund (IMF) estimated that China’s residents probably would invest more abroad than foreigners would invest in China if all barriers to such investment were eliminated. The net difference was worth between 11 percent and 18 percent of Chinese GDP. Based on 2014 GDP of just over $10 trillion, these results imply potential net financial outflows of $1 trillion to $2 trillion, notably less than Chinese foreign exchange reserves of $3.6 trillion. Moreover, China continues to maintain many barriers to cross-border investment that prevent most of these potential outflows from materializing.
In addition, the IMF study did not include potential investment in China by foreign central banks as part of their holdings of foreign exchange reserves. China has been pushing strongly to expand international usage of the renminbi and to get the renminbi included in the currency basket for the IMF’s special drawing rights (SDRs). If central banks outside of China allocated just 10 percent of their foreign exchange reserves into renminbi, that would imply a net inflow of $800 billion, further reducing any drain on China’s reserves from net private outflows.
Market rumors suggest that a large portion of China’s reserves are either invested in illiquid assets that would be costly to sell quickly or are committed for other uses that are not reported. For example, China has both an up-front and a contingent commitment to capitalize the new Asian Infrastructure Investment Bank totaling around $25 billion to 30 billion.[1] My colleague Ted Truman raised this issue in a recent blog post. The data China provides are far from satisfactory, but it seems unlikely to me that more than $500 billion of China’s reserves are encumbered with prior commitments—probably less. As much as another $500 billion may be in illiquid investments that could be liquidated over time. China almost surely has unencumbered liquid reserves of at least $2.5 trillion.
Another question is what the minimum level of reserves with which China would feel comfortable is. One metric is that a country should have enough reserves to cover 100 percent of short-term external debt. The most recent data from the World Bank (for year-end 2013) show that China had external short-term debt of around $600 billion. An alternative (not additional) metric is three months of imports, which is again around $600 billion. On either metric China has around six times as many reserves as required.[2] Moreover, as an aspiring issuer of a reserve currency, it is not clear that China needs to hold reserves at all. Neither the United States nor the euro area holds a substantial volume of reserves.
Some observers point to China’s large holdings of reserves as a potential resource to fund government spending in case of a domestic slowdown, possibly caused by a bursting property bubble. However, China is not free to use its reserves for domestic spending unless it gives up its exchange rate peg. Any large-scale conversion of reserves into domestic currency would push the renminbi up sharply and reduce Chinese exports. The last thing the Chinese government would want during a domestic crisis is a collapse in exports.
The hard truth is that China’s foreign exchange reserves are a costly byproduct of its strategy of export-led growth. Not only are they likely to decline in value (in terms of renminbi) in the long run, but they yield less interest than the Chinese government pays to borrow domestically to finance them. (See my earlier blog post.) China’s government should be glad of this opportunity to sell some of them at a good price.
[1] Reuters, “China, India likely to be biggest shareholders in AIIB,” May 22, 2015.
[2] Yet another metric is 10 percent of the broad money supply, or around $2 trillion as of year-end 2014. However, this metric is relevant only for countries with firmly fixed exchange rates and few capital controls. China retains substantial controls and is committed to increasing the flexibility of its exchange rate over time.
