Understanding China's Forex Reserves
Dipping below the $3 trillion mark is no disaster
By Lan Xinzhen  ·  2017-02-24  ·   Source: | NO. 9 MARCH 2, 2017

Statistics issued by China’s central bank in early February revealed that China’s foreign exchange (forex) reserve stood at $2.9982 trillion at the end of January, a drop of $12.3 billion compared to the previous month. Upon receiving the data, some analysts expressed concern, claiming that China’s forex reserve had breached the psychological barrier of $3 trillion.

The so-called “$3 trillion psychological barrier,” however, is neither a scientific nor an accurate expression, as a country’s forex reserve is not a fixed number, but something that keeps fluctuating according to a set of financial activities like the country’s inbound and outbound investments, as well as residents’ forex activities.

The forex reserve is crucial for China’s economy. Concern for the psychological line of demarcation is essentially apprehension over whether the reserve will continue to decrease. Here, we have to clarify two questions: First, why has the amount fallen? Second, what amount would China consider to be appropriate?

The forex reserve relates to the internalization level of a country’s economy. Since 1978, the year China began adopting the policy of reform and opening up, Chinese has attracted a huge amount of international investment and registered a favorable balance of trade. This led to the accumulation of China’s forex reserve, which jumped from $167 million in 1978 to $3.84 trillion in 2014.

These figures once triggered concern among Chinese economists, who were afraid that the flood of foreign capital would affect the economy negatively. Meanwhile, the practice of solely purchasing U.S. treasury bonds for hedge was widely criticized.

Since 2014, China’s forex reserve has been in decline. There are several reasons for this trend:

To begin with, other major foreign currencies such as the euro are depreciating against the U.S. dollar. Since part of China’s forex reserve is in these currencies, their depreciation has contributed to the decline of the reserve.

Second, most of China’s forex reserve is spent purchasing foreign assets like U.S. treasury bonds. When the price of these assets begins to drop, the value of China’s forex reserve also falls.

Third, as the world’s second largest economy, China is spending more and more of its forex coffer on imports and outbound investment, as well as on residents studying and traveling abroad. For example, China’s outward investment cost $17 billion in 2016, up 44.1 percent over the previous year.

Fourth, since 2015, the renminbi has undergone sharp depreciation against the U.S. dollar. This has incurred anxiety about China’s economic development, particularly in 2016 when it depreciated 6.5 percent, the sharpest drop within a year since 1994. In response, China used around $300 billion from its forex reserve to stabilize the renminbi's exchange rate. Some American politicians have accused China of devaluating the renminbi through manipulation. If China had not intervened, we could have witnessed a drastic reduction in the Chinese currency's value. The continuous depreciation of the renminbi is detrimental to both the Chinese and U.S. economies.

There is no need to worry about the drop of China’s forex reserve, as the country still holds the largest reserve in the world, accounting for 28 percent of the world’s total. Nevertheless, there are concerns that if China’s reserve continues to decline, its international payments will be affected. Then, how much reserve is enough for China?

Actually, there is no scientific answer to this question, as there is no unified international or domestic standard for a rational level of forex reserve holding. Such a figure would depend on a raft of factors such as a country’s macroeconomic conditions, its level of economic openness, the ability to make use of foreign capital, international financing ability, as well as the maturity of a country’s financial system.

If we take globally recognized indexes such as the value of imports in three to six months, or 100 percent of short-term external debt as the criterion, $2 trillion in reserve is enough for China.

Given the global economic situation in 2017 and China’s capital flows, the foundation for China’s cross-border payments remains stable. Besides, the pace of the renminbi's internationalization is expected to accelerate. Therefore, China’s forex reserve will continue to play a positive role in facilitating the country’s economic development in the coming years.

Copyedited by Bryan Michael Galvan

Comments to lanxinzhen@bjreview.com

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