There’s not much solid empirical evidence to suggest China’s macroeconomic health is deteriorating. But at the same time, Chinese authorities are finding it hard to rein in capital outflows. It is a peculiar situation, one that China is not accustomed to handling.
China’s foreign exchange reserves have been its biggest economic security. With almost $3.7 trillion estimated in July 2015, China’s forex reserves are by far the largest in the world. Japan, also with $1 trillion plus reserves and the next largest after China, has about a third of China’s total reserves. Europe and India with around $700 billion and $350 billion of forex reserves, hold less than one-fifth and one-tenth of China’s reserves, respectively.
With such reserves, China need not worry about fighting any economic exigencies. Indeed, China is the best placed among all countries in Asia, and also probably in the world, to tackle any repetition of the Asian currency and financial meltdown circumstances of 1997. But even then, concerns are arising over China’s macroeconomic health. And these are stemming from the fall in forex reserves over the last few months.
Since July 2015, China’s forex reserves have declined to $3.2 trillion at the end of January 2016. The People’s Bank of China (PBOC)’s official statement released just before the beginning of the Chinese New Year last week indicated a drop of around $100 billion in forex reserves in January. The drop has brought China’s reserves to the level they were in the middle of 2012. The drop has also been substantive enough to set the cat among the pigeons.
China’s capital account has been in deficit for more than a year now. The outflows have increased further in the second half of 2015. Current account surpluses have not been enough to compensate these losses. Capital outflows continue to remain high on the expectation that the Chinese currency will depreciate further. And this is where the Chinese policy seems to have run into confusion.
Capital outflows would not have led to an almost $500 billion depletion of reserves over the last six months had China not been trying to prop up the yuan. In order to stop the yuan from depreciating further, China has been using its reserves to sell US dollars so as to ensure that the dollar-yuan imbalance does not worsen to drag the yuan down further. The reserve outgo has been larger than expected as the PBOC has been trying to restrict the depreciation of the currency to a range of around 5% vis-à-vis the dollar.
For other countries of the world $500 billion depletion of reserves would have meant doomsday. Indeed, except Japan, Europe, Saudi Arabia and Switzerland, no country holds more than $500 billion of aggregate forex reserves in the first place. For China, the $500 billion depletion is less than 15% of the reserves it held at the end of July 2015. Thus in spite of spending more than what other countries could not have even imagined for defending their currencies, China can still afford to spend much more.
The point, however, is notwithstanding the enormous reserves it has, why is China using them for strengthening the yuan? Furthermore, till when does it plan to keep doing so? Clearly, defending the Yuan has not altered investor expectations of further depreciation and has not reversed capital outflows. Would the PBOC then continue to intervene in the market and keep spending reserves?
Many might argue that a stronger yuan is consistent with China’s overall macroeconomic objective of shifting to an economic model granting greater space to consumption and imports as opposed to investment and exports earlier. China is also keen on not being labelled a currency manipulator at a time when the yuan has been accepted by the IMF as a global reserve currency and the PBOC has expanded the ambit of offshore trading for the Yuan. But these considerations cannot justify defending the currency in perpetuity.
While China is well-placed to fight a run on its currency, it must also realise the inevitability of moving to a system of macroeconomic management that allows market determination of the currency and minimises interventions. At this point in time, the world is getting ambiguous signals from China on this front. It is unable to figure out whether China will allow the yuan to slide or halt its decline by pulling out resources from a bottomless pit of reserves. The indecision is inducing greater volatility and outflows.
China’s hesitation to allow the yuan to be fully determined by the market might also be driven by the incomplete reforms in the capital account of its balance of payments. China is still a considerable distance away from achieving convertibility in its capital account transactions. But even then, the use of reserves for shoring up the currency is unlikely to restore investor confidence in the short-term and would prolong depreciation expectations. Indeed, the PBOC might have begun wondering whether the reserves are really enough for winning the psychological battle it has been fighting for the last few months.
The author is senior research fellow and research lead (trade and economic policy) in the Institute of South Asian Studies, National University of Singapore.
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