About Those Reserves

FT Alphaville: China and FX reserve adequacy, redux

[China's] reserve stock stands at only 114% of risk-weighted liabilities, if we assume a fixed exchange rate regime. The reason for this is that the multidimensional measure, unlike standard ones, considers broad money supply (M2) and exports as liabilities; China has very large levels of both of these. China’s falling stock of reserves over the past 18 months has also contributed to the current position. Reserves have been drained to keep the currency stable amidst persistent capital outflows driven by slowing growth and the rebalancing of the Chinese economy. Further, an unwinding of the long CNY carry trade has also put pressure on the currency, on the back of diverging monetary policy with the US.

The analysis thus far does not account for the effect of capital controls. If we assume no capital controls and a fixed exchange rate regime (as we have done for China so far), the risk-weighted metric would imply that reserves of USD 3.5tn would be adequate, above the current reserves level of USD 3.2tn.

However, one must account for capital controls in China’s case. This would involve reducing the weight on M2 in the risk-weighted liabilities calculation, as effective capital controls would prevent capital flight. The base case we have assumed thus far is one of no capital controls and a fixed exchange rate; but given the rapidly changing policy space on these two fronts and the eventual aim of opening up the capital account and moving to a floating exchange rate regime, we need to consider alternative scenarios as well.

China is trying to open the capital account and increase international capital flows. It would be a political failure to reverse course. Probably not as big a failure as a currency crisis/devaluation (depending on who/what it was blamed on), but choosing to reverse reforms is a painful political step, whereas kicking the can down the road and buying time has been working so far according to most.

Alhambra: The Search For Cause

It is the view of “reserves” as if they were anything like actual reserves, which is what economists have been suggesting for decades. It was conventional wisdom after the Asian flu that all that would be necessary to avoid serious economic and financial disruption was to carve out huge stockpiles of “reserves.”

Now, those countries with the hugest of stockpiles are those with the biggest (and most intractable) financial, “dollar” issues. Turning convention around in that way can only be mistaken assumptions about “reserves” in the first place. I wrote in August 2013 a post under a title I increasingly lament (Brazil May Already Be Toast) for its throwaway carelessness even though it describes the specific nature of modern, wholesale “reserves” and the Brazilian experience since. In other words, the nightmare scenario is that they are a misrepresentation and do not, in fact, provide salvation but rather, as China and many others are finding out, they become the rationale for undertaking the worst possible measures.

The greatest problem about the “global dollar short” is not the “dollar” part but the “short.” From that view, under these kinds of systemic circumstances, stockpiles of “reserves” are not that at all but rather an indirect indication of just how “short” a specific country or currency connection to the eurodollar system might be. It is not a source of strength but a partial indication of fragility.

Most simply, China has created a huge amount of claims on its reserves called renminbi. The market values those claims lower than the central bank set price. That demand is not going away anytime soon. Meanwhile, the U.S. political situation is trending in a very negative direction for anyone short U.S. dollars.