Chinese FX Reserves Fall $100B, Significant Depreciation Inevitable At Current Pace

BBC: China's currency reserves plunged in January

China has been running down its vast foreign currency reserves in an attempt to boost the value of its own currency and stem a flow of funds overseas.

At $3.23 trillion, China still has the world's biggest reserve of foreign currency holdings.

But that has declined by $420bn over six months and stands at the lowest level since May 2012.

The average pace of decline over the past three months is $100 billion.

Back in August, Charlene Chu had the $2.9 billion level as end of liquid reserves. At the current pace, if the PBoC hasn't freed up assets (which one must assume it has over the past 6 months), there's 3 months left before Chu's estimate of liquid reserves is exhausted. It it frees up all of those assets, it can battle for a year at this pace.

At an average pace of $100 billion a month, reserves fall 3% each month. Based on the current relationship, the renminbi will slide about 1% a month as long as this holds up. If the pace held for the whole year, there's a minimum expected depreciation of 10-15%, but this will not unfold in an orderly fashion. Depreciation of 15% to 20% is a conservative estimate based on current outflows. If they wait until late in the year to devalue, a drop of 30% or more is possible.

The longer China props up the yuan, the faster and larger will be the decline. For every $1 in reserves, there was almost 42 RMB in M2 in January. At present exchange rates, 16% of M2 speaks for 100% of reserves. Not a crisis in and of itself, but a problem due to the pace of outflows. At the present pace of reserve and renminbi decline, that percentage will be down to 11% in October, with the renminbi likely down to 7.4 USDCNY or lower. The renminbi would be in a worse position in October, with an even larger expected depreciation than predicted today.

If renminbi falls another $100 billion this month, the renminbi should drop to below 7 in order to balance the move. Of course, if the renminbi devalued that much, depreciation pressure might rise. Hence the need for a one-off depreciation to get ahead of the move and cause foreigners and China to move money back into China. Or float the yuan and completely break the linkage to the U.S. dollar, the same way the U.S. went of gold in the early 1970s.

In the run-up to 2008, the mainstream economic models said debt didn't matter. It did. The corollary for nations is that only foreign debt matters, domestic debt (and by extension money supply growth, since money supply includes credit) does not. China massively inflated its currency throughout the 2000s and is still inflating it today. The only reason the renminbi didn't tumble in 2008 was because the Chinese government re-instituted the hard peg. The yuan starting showing signs of stress in 2011, when the stimulus began to wear off. Emerging markets with similar credit growth have seen their currencies crumble. Any massive inflation that doesn't end in a deflationary event will eventually show up in the exchange rate when the domestic currency begins to bid for foreign currency. Chinese are bidding for dollars now.