Rolf J. Langhammer
Investors’ fears over China selling off its foreign currency reserves are short sighted. Rather than signalling an impending crisis, the development shows that China is now investing globally and that the yuan is on track to become an international currency.
One of the hottest bets in today’s financial markets is over the question of how long China can keep selling US dollars (USD) before the People’s Bank of China runs dry. At the rate at which the central bank currently employs the country’s once legendary currency reserves to defend the Chinese yuan (CNY) against an unwelcome speed of depreciation, some investors are betting on less than three years.
This assessment is a symptom of the economic myopia that so often befalls financial markets. Until recently, China was scolded for its extraordinarily high level of reserves, which were seen as an indicator of currency manipulation and exchange rate protection. These complaints have now been replaced by concerns that China’s reserves could be exhausted and trigger a new financial crisis in China and beyond.
China’s reserves are still unrivaled
But like there was no reason to panic in light of China’s massive build-up of reserves, there is no reason to be overly concerned about the opposite trend. First of all, let’s keep in mind that the level of Chinese currency reserves may have dropped considerably, but that it is still unrivalled. China’s reserves dropped from covering 26 months of imports in October 2015 to 22 months of imports in March 2016. This level is still far above the average level of currency reserves in OECD countries. The European Central Bank’s reserves would only cover about 1 month of imports, while the level of Australia’s reserves are considered high at about 3 months worth of the country’s import volume. Nobody would argue that the reserve levels in these two economies indicate a coming crisis.
When markets now worry about the decline of China’s reserves – which admittedly occurs at extraordinary speed – they disregard the context in which this dramatic shift occurs. Rather than announcing an imminent crisis, its dwindling reserves symbolise the China’s increasingly successful integration into the world economy. Fewer dollars in China’s official coffers indicate that the yuan begins to mature into a truly international currency and that China is now a “global equity investor” with worldwide production facilities rather than being the world’s factory.
The yuan is now held as a reserve currency by other countries. This was facilitated by the decision of the International Monetary Fund’s 2015 decision to treat the CNY as a freely usable currency. Starting on 1 October 2016, it will be included in the Special Drawing Rights basket (SDR) along with the US dollar, the euro, the Japanese yen and the British pound sterling. As a reserve currency country, China will need fewer reserves to buffer against financial and real sector shocks than a country that has to pay its import bills in a foreign currency. And China now begins to enjoy the privilege of issuing a currency that is viewed not just as an invoice currency, but as a true reserve currency by its foreign partners.
Fewer dollars at home, but more equity abroad
The second important change in the Chinese economy is China’s new status as a global investor. Chinese public and private businesses have started to heavily invest abroad, from dubious resource extraction projects in poor economies to manufacturing and service industries in OECD countries.
These investments are made in the currencies of the host countries and yield returns in currencies other than the CNY. If the yuan depreciates, it improves China’s net foreign equity position measured in CNY. At this point, this benefit may already outweigh a possible deterioration of China’s foreign debt position, meaning that Chinese companies’ debts in foreign currencies would weigh more after a depreciation of the yuan. And there can be no doubt that China will continue to invest abroad once restrictions for capital exports are relaxed. This should not to be misunderstood as capital flight. It is quite natural that Chinese investors would seek gains in foreign markets from which they were previously excluded.
The resulting currency depreciation is no reason for concern as long as it coincides with an improvement of the foreign equity position and with a consolidation of the CNY as a reserve currency. International financial market participants who are betting against China as well as China’s monetary policy-makers who still refuse to allow the yuan to float freely, should keep these long-term trends in mind before worrying too much about declining currency reserves.
Once market participants adjust their expectations to China’s new economic situation, the prospect of a sudden drop of a more flexible CNY exchange rate would appear much less alarming. And if markets are no longer scared, this drop may never happen in the first place.