China’s Choices

RBC’s estimate of the minimum required level of reserves (based on the IMF’s recommended equation) for the PBC is $2.7 trillion. If the drawdown were to continue at the current rate, RBC estimates that it would take around six months before the PBC compromises its external positions.

However, according to the report, the six-months buffer might even be lower because:

  1. There is evidence to suggest that over-invoicing of trade receipts has resurfaced in China, which would increase the minimum level of required reserves in the IMF’s equation. China’s reported export value to Hong Kong, South Korea, and Taiwan exceeded the value of imports from China reported by HK, SK, and Taiwan by 12.2bn in November, the biggest gap since late 2014. China first had the problem of export over-invoicing in Q2 2013. Chinese regulators vowed to crack down on counterfeit trade receipts, which worked for a year, only to recur in late 2013 and again in late 2014. Inflated export (or import) receipts of the current magnitude could lift the perceived minimum level of required reserves by up to USD14bn.
  2. Over the years, there have been many reports that China has diversified its reserves into alternative assets, e.g., real estate and private equity, through CIC and supporting Chinese companies expanding overseas through SAFE Co-Financing. China has also committed some of its reserves for other uses, e.g., AIIB, Silk Road. The exact size of the illiquid component is anyone’s guess, but it also adds up to a lower reserve buffer than it seems on the surface.
  3. Former academic advisor to the PBC Li Daokui said this week that China needs to keep its foreign exchange reserves above USD3trn. This estimate may account for some of that illiquidity. If USD3trn is the real minimum level of reserves, then China’s reserve buffer could run out around Easter.
  4. A rapid, unsterilised depletion in reserves could also undermine the PBC’s monetary policy objectives by tightening domestic liquidity.

From here on, China may reduce, maintain or increase its pace of FX intervention. RBC believes that if China maintains or increases the pace of intervention, then investors might have cause for concern come mid-year.

The level of currency reserves and the pace of intervention will determine whether or not China will succeed in its ambition to internationalise exchange rate or forget the whole idea.

Addendum (16th Jan): China has no intention to boost exports with yuan devaluation: Premier

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