It’s mostly symbolic, but in financial markets symbols count.
In January China’s foreign exchange reserves dropped below the $3 trillion mark for the first time in almost six years, the People’s Bank of China announced today, February 7.
The drop, the seventh straight monthly decline, took the country’s foreign exchange reserves down $12.3 billion to $2.9982 trillion from $3.0105 in December. The $12.3 billion decrease was far smaller than the $41.1 billion decline in December.
The total was in the middle of the range of $2.95 trillion to $3.03 trillion projected by economists surveyed by Bloomberg.
Economists say that reserves of $2.25 trillion are adequate for China so why is the drop below the $3 trillion level important?
First, because China does need to stabilize its capital outflows, one of the factors causing the drop in reserve levels. Net capital outflows are estimated at $596 billion in 2016. A sustainable level is in the neighborhood of $450 billion. That means global financial markets can expect to see another tightening of controls on the yuan that will restrict the ability of Chinese companies and citizens to move cash overseas and crimp the export of balances by foreign companies doing business in China. These new restrictions on top of measures already in place amount to a major setback to China’s efforts to turn the yuan into a global currency.
Second, because those capital outflows are a vote of worry by wealthy (and not-so-wealthy) Chinese about the safety of their Chinese assets. Money is moving out of China and into investments in overseas real estate, bonds, and other assets. That’s money that could be spent or invested in China. This is a complication that a country trying to boost economic growth and make the transition to a consumer-oriented service economy does’t need.
Third, efforts to support the yuan and to stem the outflow of cash lead to higher interest rates in China. Higher official interest rates are one way to stem cash flows, but companies also face higher interest rates in the financial markets as lenders ask for a higher premium in order to protect against a decline in the yuan and match the total returns they could earn if they could figure out a way to invest cash overseas. Chinese companies that are struggling with tight operating margins certainly don’t need higher interest rates.
And fourth, the drop in foreign exchange reserves is a result of the market interventions by the People’s Bank to support the value of the yuan against other currencies, especially the U.S. dollar, by buying yuan in the market and selling dollar assets. A drop in the value of the yuan might be good for Chinese exports but it would likely accelerate the flow of cash out of China as Chinese individuals and companies looked to protect against a decline in the value of their own currency.
In short, the drop below $3 trillion in foreign exchange reserves isn’t a crisis today. And it won’t be a crisis tomorrow. But it does increase worry over the direction of the trend. Which increases the incentives for