Yesterday’s announcement from the People's Bank of China (PBoC) showed foreign reserves up over US$10bn in March. FX reserve declines (not outflows) had averaged $98bn between November 2015 and January 2016 before slowing to $29bn in February. Returning to a slight positive last month makes previous anxieties (and many loss making shorts) look increasingly misplaced. On a longer perspective the decline has decelerated from quarterly outflows of 5% in the second half of 2015 to 3.5% YTD. The downward trend continues to warrant monitoring; but the fact that it has been decelerating throughout 2016 should help adjust fears of an imminent tipping point towards more longer term concerns of slowing growth and the inevitable volatility associated with reform.
We noted a couple of times last month (see “China Silk Road” and “Opening China's Bond Market”) the various misunderstandings and oversimplifications of the Chinese economy and were anticipating such forthcoming data to support our view and begin to dispel media roused worries; particularly with regards to China’s mountain of FX reserves – both the expected rate of decline and the perceived minimum level of FX reserves to adequately shelter the “developing country” from the threat of a currency crisis.
Clearly the first concern has abated; +$100bn declines have neither accelerated nor persisted. Yet this latest rise still conceals an estimated $20-30bn outflow in March (counteracted by $30-40bn of currency effects on euro and yen reserves due to a weaker dollar). But steep downward “forecasts” were only half the concern. The other half is the required level of reserves that the market suddenly came to demand around mid-2015 - touting that as China approached this level it would no longer be able to defend its position and policies. With the likelihood of ongoing, but slower, declines in reserves it is still important to refute this accompanying fallacy (again see above referenced articles for further details on the causes of slowing outflows).
A precise required level of $2.7tn seems to have gained market consensus. Such an extraordinary demand seems excessive in the context of China’s recent history of reserves. 3 years ago when China reserves first reached current levels of around $3.2tn many, including ourselves, hailed the figure as a hallmark of protection for a growing and reforming net creditor. Of course they then accelerated to $4tn over the subsequent 2 years and retraced to this persistent $3.2bn level over the last 21 months.
So why have such premature worries become so prevalent while China continues to maintain such high levels of reserves? Of course trend is an important factor. Following an inflection point it takes time for markets to adjust, with many erring on the side of caution. Instead, it seems, the abundance of cautious press articles on the topic has led many into shorting as much as into taking a cautious position (which is very different - we estimate that, in the first quarter of 2016, even unleveraged shorting the offshore CNH would have yielded a 3.5% loss from its appreciation and cost of carry). Of course such a determinant can have self-fulfilling effects if pervasive enough but the proposed $2.7tn critical level is finally being increasingly challenged.
Its origins stem from the misuse of a very broad-brush IMF formula. The formula can be used for a preliminary ballpark level of reserves necessary for a “developed country” to protect its currency. For China taking 10% of Exports + 30% of Short-term FX Debt + 10% of M2 + 15% of Other Liabilities of course provides the handy and quotable figure of $2.7tn. The problem is however that this is quite close to current levels and had seemed all but imminent a few months ago. Even at current steady declines this level remains in sight. But for a number of reasons this ballpark figure is largely irrelevant and misleading for China.
The first problem with this figure is that China’s exports are much less vulnerable than most “developed countries” and are more diversified and less commodity dependent. The more significant red herring however is the M2 factor (which makes up ~80% or $2.1tn of the $2.7tn level). Chinese M2 is considerably more rigid and less liquid than comparable measurements. Such inefficiency in the Chinese financial system, along with purported underreported NPLs, are usually widely critiqued. But they are suspiciously unaccounted for when a positive factor for reducing the critical reserve level. Of course much more can be said about this. Also more general factors like China’s size and net creditor position add to reasons why such a level is likely much closer to $1.5tn than $2.7tn. At the current trend, or even the accelerated decline of late 2015, such a juncture should discourage complacency but remains distant enough to allow the Chinese government flexibility to see through reform and investors time to reassess their exposure to China.