Foreign exchange reserve figures no cause for panic

Adjustment is reasonable as China may not need to insure quite so heavily against export disruptions

China's foreign exchange reserves are now below $3 trillion (2.85 trillion euros; ￡2.42 trillion), the lowest in three years. In fact, relative to GDP, it's the lowest since the early 2000s.

China has seen a material decline in reserves-to-GDP since 2008, the result of declining global demand combined with growing outbound investment. More recently, the sharp decline in China's once heralded reserves has occurred in defense of the yuan, triggering concerns in global financial markets.

The burn rate is alarming: Reserves were down by $512 billion in 2015, and then by $320 billion in 2016. It is particularly disappointing that the drawing down of these reserves has been done to prevent capital flight, which seems rather wasteful. When seen as global purchasing power, reserves should rather be utilized in ways that support domestic consumption and rebalancing of the economy, such as running a trade deficit.

The numbers being bandied about, though, simply have no intellectual credibility, such as the notion that $3 trillion is some sort of danger level��a so-called "line in the sand". Of course, reserves have to meet a minimum requirement necessary for China's industrial base, money supply, trade business and so on. However, if a level is collectively agreed upon by markets, that perception will become self-fulfilling, triggering panic.

For years, China has run a substantial balance of payments surplus by exporting more than it imported and receiving more in investment than it made abroad. Without government intervention, these imbalances would have self-corrected by putting upward pressure on the yuan. Instead, the Chinese government purchased US dollars, resulting in ballooning reserves. Until the financial crisis, authorities had tried to sterilize issued domestic currency by locking it in the banking system.

Beijing got what it wished for: a floor under growth. However, it also pushed credit beyond 270 percent of GDP in 2016.

It is impossible to ignore that the investment-led and credit-fueled response exacerbated resource misallocations.

In 2014, President Xi Jinping launched the so-called new normal. Envisioned here is a Chinese economy that is expanding more slowly, but enjoying higher quality economic growth��an economy less factor-and investment-driven that shifts toward a pattern of growth led by services and consumption, led forward by innovation and with market forces determining the allocation of resources.

Wisely, policymakers have also moved away from the peg against the dollar toward a trade-weighted value of the yuan. China simply could not avoid the defaults and bankruptcies, and also maintain its exchange rate against the dollar. That adjustment was introduced in response to the rapid appreciation of the dollar since mid-2014, which had dragged the yuan with it. Back in August 2015, authorities created the CFETS basket and allowed devaluation, which unleashed a flood of selling. Loath to allow markets to determine the size and speed of depreciation, the People's Bank of China has tried to limit it, and this is what has sapped foreign exchange reserves.

Foreign exchange reserves have fallen to below $3 trillion, and are heading toward $2.8 trillion by the end of this quarter and likely to continue falling through year's end.

Since the 1990s, many emerging markets have recognized the benefits of building reserves as insurance against the volatility associated with financial globalization. Of course, in China's case the reserves are really about ring-fencing the economy against local residents' flight from domestic assets. The question is, does China have enough? In reality, no matter how large they are, foreign exchange reserves never last as long as anyone thinks they will in a crisis.

That said, the International Monetary Fund has reserve adequacy guidelines. To this end, a country needs around 10 percent of exports, 30 percent of short-term foreign exchange debt, 10 percent of money supply and 15 percent of other liabilities. These reserves must be external assets that are readily available to and controlled by monetary authorities for meeting balance-of-payments financing needs.

For China, that calculus equates to around $2.7 trillion. However, the figure probably can be revised downward because the IMF's calculus fails to take account of idiosyncratic features.

Does China really need to insure against export disruptions in the same way as most developing countries that tend to be heavily commodity-dependent? Given the capital controls, does China really need 2.1 trillion yuan (10 percent of its money supply) to capture capital flight risks and insure against residents' deposits leaving the mainland?

In other words, a diverse economy with a managed currency, capital controls and managed financial system does not need exactly the same minimum level of reserves as a single commodity-exporting country with a floating exchange rate and minimal central bank intervention.

Given the magnitude of these pieces of the reserve pie, it seems reasonable to argue that in the context of China that a downward adjustment of $500 billion or even $1 trillion seems reasonable.

Thus, while China is getting closer to concerning levels, and burn rates will always accelerate in times of duress, it seems fair to argue that in terms of foreign exchange reserves, somewhere between $1.56 trillion and $2.2 trillion is adequate for China's working capital.

The author is the Beijing-based China economist at Standard Bank. The views do not necessarily reflect those of China Daily.