China Reserves: Enough or Not Enough?

China's reserves are adequate if the risk is solely driven by foreign imbalances and short-term (maturing) debt. If the economy and financial markets are chaotic systems driven by waves of human emotion, the less adequate are China's reserves. Everyone thinks of outflow from the currency in literal terms because it has immediate impact in the market, but outflow from the currency is also done within the currency, through high rates of inflation. Government attempts to ban the purchase of foreign currency, gold, commodities or other alternative assets may only serve to fuel a desire to exit the currency. Markets are also reflexive and tend to work through multi-year cycles. The yuan peaked in 2014 and measured by time alone, likely has at least a couple of years of decline left (whether it joins a declining U.S. dollar or diverges from a rising dollar is the trillion dollar question). Throw in fundamentals and various anecdotes such as China's historic debt buildup, and you have at least the seeds for an historic move in the currency market.

Over at the CFR blog, Brad Sester looks at China's reserve adequacy: $3.2 Trillion (Actually a Bit More) Isn’t Enough? The Fund on China’s Reserves
Reserves are over 400 percent of short-term debt (way more than enough). ***

Reserves are now “only” 15 percent of broad money (not enough; 20 percent of M2 is the traditional norm).

You cannot really fudge the difference; you have to tilt one way or the other. (Hat tip to Emma Smith of the Council on Foreign Relations’ Greenberg Center for Geoeconomics, who prepared the charts).

...I personally put more stock on balance sheet indicators, and reserves to short-term external debt is the most important. From a balance sheet point of view, there is also a strong case for paying attention to reserves relative to domestic sight deposits (a measure of liability dollarization). The Fund though sees things differently; in the design of the new reserve metric the Fund leaned strongly against balance sheet indicators of reserve need (see the discussion of liabliity dollarization here), and instead went with a composite of the three traditional indicators (short-term debt, m2, and imports—though the Fund prefers using exports), with an additional factor for longer-term external liabilities.

The Fund’s reserve metric effectively says China needs to hold more reserves, relative to its GDP, than a typical emerging economy. Especially if China opens its financial account before its currency floats freely.

Bloomberg: Why We Still Need to Worry About China's FX Reserves
China's pile of foreign exchange reserves has long been touted as a bullish signal for the country's ability to weather economic storms. But China is now in a policy trap as it expands the domestic money supply in order to funnel liquidity into the banking system to roll over its bad debts.

Data released in July throws into sharp relief the cost of Beijing's approach: a depleting war chest of foreign-exchange reserves relative to its expanding domestic money supply, which could prove insufficient in the looming battle against capital outflows.
Where people go wrong on China reserves is failing to understand that every dollar of reserves in spoken for by renminbi in circulation. China has restrictions on capital outflows, but it doesn't change the fact that the renminbi is convertible into U.S. dollars at a current exchange rate of about RMB 6.64 to $1. If everyone wanted to exchange their renminbi for dollars and the PBOC decided everyone would receive and equal amount of dollars, they would hand out dollars at a ratio of 46 yuan per greenback.
People aren't rational. A market is more "rational" than an individual because it is a system that ruthlessly punishes mistakes (where markets are allowed to work...), but it doesn't prevent markets from being from overshooting reality. Markets also tend to trend, swinging from irrational optimism to irrational pessimism. Back in the late 1970s and early 1980s, people were genuinely worried the U.S. dollar could collapse and gold climbed above $850 an ounce. At that point in time, U.S. gold reserves covered more than 100 percent of base money and more than 40 percent of M1 money supply. Markets can and will go to extreme valuations at the end of long-term cyclical moves.

China is currently below the IMF required reserves given it's money supply. The ratio is also heading in the wrong direction as money supply grows faster than reserves. Even if China can maintain its reserves at current levels, the growth in money supply will push the ratio of reserves to M2 lower. The target for M2 growth is 13 percent and the economy risks deflationary crisis if M2 slows below 10 percent. Reserves are stable, so at current trends, M2 will be at least 10 percent larger a year from now, but reserves will probably be the same or lower. Instead of 14 percent coverage of M2, China will be below 13 percent coverage.
The risk of an "accident" in the currency market is rising.

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