China’s massive foreign currency reserves are dwindling at a more than half-trillion-dollar annual pace, a trend which may tighten global credit conditions.
China’s central bank said its reserves fell by US$43bn in July to US$3.65trn, in the first ever monthly report on the figure.
China’s foreign reserves, by far the largest in the world, have now been falling for more than a year, setting in motion what looks to be the long-term reversal of a trend in place since 1999.
Foreign reserves are falling because money is leaving China but its central bank, at least thus far, wants to hold the value of the yuan stable, in part because of plans to position it as a leading global reserve currency.
“Against the backdrop of capital outflows, the People’s Bank of China has shifted from accumulating reserves to prevent currency strength to drawing down reserves to forestall weakness,” Alvin Tan and Jason Daw, strategists at Societe Generale, wrote in a note to clients.
In an open economy flows outward would cause the currency to fall, but not in China, with its history of tight management of the value of the yuan.
It is hard to overstate what a massive force the buildup of China’s pile of foreign currency has been, driving its desire to buy up dollar assets, notably Treasuries, and thereby helping to finance all dollar-based borrowers everywhere.
This implies, in turn, that should the Chinese be turning into major sellers of the dollar and Treasuries that, all else being equal, credit, for everything from trade to investment to consumption, will become more expensive.
All else rarely is equal and thus far, at least, the dollar remains strong and interest rates low.
Reserves have fallen despite China exporting more than it imports, not to mention income from overseas investments flowing in. While foreign investors have cooled to Chinese securities, which recently suffered falls after even larger gains, a sizable amount of the money flowing out is likely Chinese-controlled money seeking either better prospects for investment or better protections against the possibility of confiscation.
This may be the irony of China’s Herculean efforts to support its own stock market: it is motivated in part by a desire not to spook investors but by doing things like going after short sellers it only reinforces fears.
Shift in economic power
While exporters in China would dearly love for it to allow the yuan to weaken, authorities are now preoccupied with efforts to convince the International Monetary Fund to decide in November to include the yuan in a basket of global reserve currencies it uses to calculate Special Drawing Rights, an instrument it creates and is used in central bank reserve management. A beggar-thy-neighbor depreciation might not go over so well internationally, a fact which argues for China holding the yuan steady and continuing to run down reserves.
Taking foreign exchange reserve flows and other movements out of China together, China exported $126 billion of capital to the rest of the world in July, a US$1.5trn annual clip, according to an estimate by research firm High Frequency Economics.
“We continue to watch the projection of China’s economic might by direct investments abroad. This is a massive change in the global balance of economic power,” Carl Weinberg of High Frequency Economics wrote in a note to clients.
Some of that capital is going to fund so-called Silk Roads projects, like the recently announced $46 billion plan to create an economic corridor linking China and Pakistan.
Other funds, privately controlled, are being used to buy real estate in Sydney, New York or central London, or to make private investments in companies and securities abroad.
It may simply be that, having built up a huge store of wealth, but now facing an economy which is both slowing and making a fraught transition from one centered on production and exports to consumption, Chinese capital quite reasonably will want to diversify.
This implies continued pressure on the yuan and reserves. There is little question that China has both enough money and resolve to continue its current support of the yuan. A falling currency might exacerbate its market problems at home, and make it less popular abroad.
Still, as dollars flow outward, it is likely that either Treasuries will be sold or, at the very least, the proceeds from maturing bonds not reinvested. The U.S. Treasury estimates that China, as of May, holds a bit less than US$1.3trn of Treasuries, by far the largest official investor.
Later this year we may get China selling alongside the Federal Reserve raising interest rates, both of which will act together to tighten credit.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
