China Carrying More Than the UK Economy in its Books - But is it Enough?

Published on 04 Mar, 2016

China Economy 2016

Sitting on copious foreign exchange reserves, China is on a spending spree to defend its depreciating currency and stem capital outflow.

Its foreign exchange reserves peaked at USD4 trillion in June 2014, but subsequently declined by almost USD 760 billion to USD 3.2 trillion as of January 2016. Capital is flowing out of China at a rapid pace, with asset values shrinking as international holdings depreciate in US dollar terms.

The sharp fall in reserves over 2015 will likely raise concerns about China's reserve sufficiency, liquidity, and adequacy.

How Much Foreign Exchange Reserve Does China Have?

As per the State Administration of Foreign Exchange (SAFE), China's official foreign exchange reserves amounted to USD 3.33 trillion at end of December 2015.

Total official reserves, which include gold reserves, special drawing rights (SDRs), and other reserve assets, were moderately higher, at USD 3.41 trillion.

In addition, China has USD 200.7 billion in "other foreign currency assets" as of December 2015, which are liquid foreign currency assets and aren’t included in official reserve assets.

Continuous current account surpluses contributed to about 70% of the foreign exchange reserve accumulation between 2005 and 2014. FDI inflows were another key source for the increase during the same period.

China's Foreign Exchange Reserves

China's Foreign Exchange Reserves

China's Foreign Exchange Reserves are Mostly Liquid

As per the Bank of America Merrill Lynch estimates, about two-thirds (65%) of China’s foreign exchange reserves are held in dollar-denominated assets, whereas 35% of its reserves are non-U.S. assets. Most of these non-U.S. assets are held in short-dated euro-denominated bonds, with the rest in G10 currencies and a very limited amount in Emerging Market currencies.

According to the latest monthly US Treasury International Capital System (TIC) data, China remains the largest holder of U.S. Treasuries, with direct holding of USD 1.25 trillion in US treasuries as of December 2015.

China's Foreign Exchange Reserves Composition

China's Foreign Exchange Reserves Composition

While it’s difficult to know the exact amount of reserves that are illiquid, the majority of China’s foreign exchange reserves are held in US Treasuries and other major countries’ government bonds.

The US treasury market is the world’s most liquid securities market, while other European bonds are also considered highly liquid. Though these assets are liquid and readily available for sale, they could prove difficult to sell in a short period of time without causing some turmoil in the financial markets.

Capital Flight Risk

China is experiencing rapid capital outflows.

As per IIF estimates, capital outflows from China — including errors and commissions — amounted to USD 676 billion in 2015. Heavy capital outflows resulted in falling official reserves, as the central bank used reserves to defend its currency.

The People's Bank of China had spent about USD 405 billion in 2015 to stabilize the RMB.

These interventions helped slow the pace of CNY depredation, which weakened by 4.6% against the USD in 2015.

China Net Capital flows(USD)

China Net Capital flows(USD)

Does China Have Enough Foreign-exchange Reserves?

China’s reserves have dropped by 13% in 2015 from a year ago.

This substantial decline has raised concerns about China's reserve adequacy to cover its potential liabilities. Going by traditional measures, China’s routine international payments and external debt obligations are well protected. Its reserves are sufficient to buy all the imports for the next 24 months while the relevant international standard requirement is 3 months.

China’s foreign debt repayment ability monitoring indicators have also remained well above international standards.

As per State Administration of Foreign Exchange (SAFE) data, China's foreign currency denominated external debt declined to USD 804 billion as of September 2015, down USD 91 billion from its peak in Q2 2014. The short-term external debt ratio stood at 3.25, well above the recommended ratio of 1.

Over the years, the IMF has refined its composite metric to calculate the ‘reserve-adequacy’ metric. Based on the latest IMF Metrics, China may need to hold at least USD 2.8 trillion of reserves without capital control or about USD 1.8 trillion if adjusted for capital controls to be "adequate".

China has strict restrictions on capital outflows through quotas and administrative regulations.

The People's Bank of China has also stepped up its efforts to curb capital outflows by cracking down trade over-invoicing and freezing outbound investment quotas. However, imposing strict capital controls could upset the market and likely to derail the RMB internationalization process.

Weights Under the Fixed Exchange Rate Regime

Without Capital Control With Capital Control
EXPORT: potential loss from drop of external demand 10% 10%
SHORT TERM DEBT: Rollover risk 30% 30%
OTHER LIABILITY: Portfolio outflow 20% 20%
BROAD MONEY: Potential resident’s outflows 10% 5%

Source: OCBC Bank

Will the Dragon Lose its Trove?

In the last three months, China’s exchange reserve declined by about USD 300 billion.

If the current pace of fast capital outflows of USD 100 billion per month were to continue, its reserves would fall below the IMF’s minimum security line in next three to six months. However, with effective capital control, its exchange reserves are still high enough to defend against exchange rate volatility.

The clock is ticking.

Amid worries of an intense economic slowdown, the speed of reserves depletion may be somewhat alleviated in the short term. The People's Bank needs to decide if (and how much more) they can afford to spend to defend a currency that’s stronger than what it should be.