All Eyes on China’s FX Reserves

Capital flight on trade tensions and depreciating yuan could dent reserves

A man looks at currency information posted on the window of a bank in Beijing on July 20, 2018. Wang Zhao/AFP/Getty Images

China’s foreign-exchange reserves rose modestly in July, which caught many analysts by surprise, given the ongoing trade dispute between the United States and China.

Foreign-exchange (FX) reserves increased by $5.8 billion to $3.1 trillion, according to figures from the People’s Bank of China, the country’s central bank. A decline of about $12.1 billion was expected by economists polled by Thomson Reuters.

China’s FX balances were higher month-over-month, despite a depreciating yuan currency—which heightens the risk of capital flight—and volatile onshore financial markets.

Yuan Depreciation

The Chinese yuan (CNY) depreciated by 6.8 percent from June 1 to Aug. 10, partially due to escalating trade tensions with the United States. July was also the fourth consecutive monthly decline for the yuan against the dollar, the longest such streak in three years.

Given this trend, economists expected Beijing to use some of its FX reserves to defend the currency. But that didn’t seem to be the case in July, or at least enough to move FX reserves lower in the face of other factors.

Asset appreciation and trade surplus most likely explain China’s unexpected FX reserve increase. The makeup of the country’s FX reserves is a state secret, but it’s generally believed that China holds about two-thirds of its foreign reserves in dollar-denominated assets, and the rest in yen, euros, and pounds sterling.

“Another reason for the lack of capital outflows could be the recent list of penalties announced by the cross-border regulator ... on entities that have breached cross-border fund flows regulations,” economists at ING Group wrote in an Aug. 7 note. “This might prevent future rules violations, and, therefore, massive capital outflows.”

Central Bank’s Levers

Going forward, Beijing has a few levers it could pull. On July 31, the People’s Bank of China (PBOC) imposed a 20 percent reserve requirement on short yuan, long dollar forwards, making speculative trades against the yuan more expensive.

“If the yuan depreciation speeds up again, like earlier this month (around 3% to 4% per day), then the PBoC is likely to reintroduce the ‘counter-cyclical factor’ to cap the yuan depreciation level,” according to ING. “By then, a stable yuan would discourage massive capital outflows.”

The PBOC last year employed a “counter-cyclical factor” in its calculation for setting the daily midpoint fixing rate for yuan, in an effort to reduce downside volatility. This factor was removed in January 2018, after the yuan strengthened steadily in the second half of 2017.

The PBOC has long argued that its currency levers are more of a policy tool, and would not be used to manipulate the currency in the face of devaluation or to stop capital outflows.

“It’s worth noting that with the counter-cyclical factor in place, it doesn’t mean the yuan will change course from depreciation to appreciation unless the dollar weakens against major currencies,” ING added.

Lastly, Chinese bond yields are still relatively high and remain attractive to foreign investors. The spread compared to foreign bonds have declined recently, however, as U.S. treasury yields climbed higher in July. The 10-year Chinese bond was yielding around 3.6 percent as of Aug. 10.

Future Dangers

The specters of capital outflows won’t go away as long as trade tensions are high. Economists will be paying attention to two data points going forward.

One is that China’s current account has become less supportive of the yuan, due to a shrinking trade surplus. China’s trade surplus in July narrowed sharply to $28.1 billion, compared to $44.9 billion in the same month a year ago. Imports surged 27.3 percent year-over-year, according to data from Trading Economics, despite some declines in American products subject to tariffs such as soybeans.

The other factor, which is longer-term, is a trend of foreign companies leaving China due to a hostile business and legal environment. This could instigate large declines in China’s FX reserves as the companies convert yuan to foreign currencies as they bring capital and profits home.

Some of these moves have been years in the making and are secular in nature, given China’s increasing labor costs and greater competition from domestic manufacturers.

There’s a slew of examples in recent years. In 2015, Japanese electronics giant Panasonic closed all of its manufacturing plants in China after 37 years, while in 2017, American hard-drive maker Seagate closed its factory in Southeastern China and laid off some 2,000 workers. This year, South Korean conglomerate Samsung announced closure of a factory in Shenzhen due to fears of U.S. tariffs on Chinese electronic goods.