China’s Dollar Reserves are Shrinking – Take it as a Good Sign!
China’s monetary policies of the past years have been well observed by the financial markets. Especially the high level of reserves of foreign exchange held by the People’s Bank of China (PBOC) has often been regarded as a tool to manipulate the currency and protect the exchange rates.
Recently, this point of critique has been replaced by a new concern: How long will these reserves last? And if the Chinese run out of dollars, could that trigger a new financial crisis?
We asked Rolf J. Langhammer about the yuan, Chinese investments and all too scared markets. He is a Professor of Economics, former Vice President of the Kiel Institute for World Economy and expert on China’s economy. An opinion piece by the author on the same topic was first published on the Mercator Institute for China Studies’ blog “European Voices on China”.
The GES blog: Prof. Langhammer, do we need to worry about China’s reserve situation?
Prof. Langhammer: To put it straight: No. These concerns of the financial markets are not justified at all. It is true that China’s reserves of US dollars are declining, but they are still at a very high level. In October 2015, the reserves covered 26 months of imports. Five months later, in March 2016, it was 22 months of imports. This is a remarkable drop, but that is still significantly higher than the average reserves of OECD countries. The European Central Bank, for instance, covers only one month of imports. Or take Australia. Their reserves of covering 3 months of imports are regarded as high. Yet, nobody would consider these reserve levels as an indicator of an upcoming crisis.
The GES blog: If the reserves are still at such a high level, why do the markets react so sensitively to this issue?
Prof. Langhammer: It is a typical economic myopia that financial markets tend to fall for. The decline is very rapid, no doubt about that. Yet, there are various economic reasons for this development – and they signal a positive trend. China has become a true global player. The country is integrated into the world economy. The yuan has become a truly international currency, and China is a “global equity investor” with production facilities all over the world. It is no longer only the world’s factory anymore.
The GES blog: You mentioned the yuan. In 2015, the International Monetary Fund decided to treat the yuan as a freely usable currency. How did that decision affect the Chinese currency?
Prof. Langhammer: A major difference is that other countries now will hold the yuan as a reserve currency. As a result, China does not need to hold as many reserves in other currencies anymore to buffer against financial and real sector shocks. In addition, the yuan will be included in the Special Drawing Rights basket (SDR) along with the
US dollar, the euro, the Japanese yen and the British pound sterling by 1 October 2016.
The GES blog: What is the relation between the depreciation of the yuan and the large investments China makes abroad?
Prof. Langhammer: When the Chinese make investments in other countries, they do it in the currencies of these countries. The yield is also in those other currencies. If the yuan depreciates, China’s net foreign equity improves measured in yuan. Yet, at the same time, the debts of Chinese companies would increase. In the long run, however, China will continue to invest abroad if restrictions for capital export are relaxed. This will outweigh the negative effect on the debts. Chinese investors will seek profits in new foreign markets, something they were excluded from in the past.
The GES blog: So, coming back to the first question. All is fine in China’s exchange rate policy?
Prof. Langhammer: These three parts – depreciating the yuan, making it a global currency and the foreign investments of Chinese businesses – if they coincide, everything is totally fine. Then, there is no need to worry. Participants of the financial markets that don’t trust in China’s exchange rate policy and the yuan should look at the long-term trends and not be short-sighted. If they keep that in mind, they will react less alarmed to a new drop of a more flexible yuan exchange rate. Or even better, such drops will just never take place because the markets are not scared anymore.