China’s Foreign Reserves Position a Victim of Economic Success

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China has seen its foreign reserves decline precipitously as a percentage of GDP since the start of the decade as a result of the continued robust growth of its economy.

The strength of the Chinese economy saw it post a mammoth trade surplus of USD$422.5 billion in 2017, helping to drive foreign reserves to over USD$3.12 trillion by the first quarter of 2018 for an increase of around 18% in dollar terms since the start of the decade.

An ironic outcome of this economic, however, has been the associated decline in the country’s currency reserves as a percentage of GDP,, with its reserve position plunging from 47.6% in 2010 to 28.7% in 2017.

Writing for Forbes magazine Salvatore Babones, a specialist on China’s New Silk Road policies at the University of Sydney in Australia, points out that currency reserves of between 25% and 35% of GDP should be more than sufficient to deal with any major contingencies under standard conditions.

China’s reserve position is enough to pass three out of the IMF’s four tests for measuring reserve inadequacy.

The only test that China fails is the requirement that reserves cover 20% of the M2 money supply, when this reading stood at 13.1% as of the end of 2017.

Babones says that China’s monetary system is highly leveraged, with the broad money supply having hit approximately 300% of GDP.

The state-owned nature of China’s bank-dominated financial system means that official reserves continue to play a vital role in shoring up overall stability.

“The China risk is a credit risk, and since the government is the ultimate holder of nearly all debt, that makes it a sovereign risk,” writes Babones.

“Since the government owns nearly all the banks, the Chinese government is essentially on the hook for the debts of the entire banking system.

“As a result, China’s official reserves are a hedge not only for the country’s currency, but for its entire financial system.”

Beijing’s ability to deal with crisis is abetted by its meagre borrowings from abroad, as well as the control it exercises over the yuan.  Should contingency arise, Babones expects the central government to allow the yuan to depreciate instead of spending away its reserves.

“If the Chinese government faces a choice between a painful economic adjustment, during which it sells off its currency to pay off its debts, and letting the yuan value to reduce the debts while keeping the economy humming, don’t expect China to spend its currency reserves protecting the yuan.

“To any ordinary person, $3 trillion sounds like an awful lot of money…but if a bubble bursts in an economy the size of China’s, the money goes fast.

“China would have little incentive to defend the yuan int he case of a burst bubble. The easiest way to deflate the (real) value of assets in China would be to just let the currency take the cut.”

 

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