Toward Understanding China's Reserves and Yuan as a Reserve Asset

China reported that its currency reserves fell for the third consecutive quarter in the three months ending on March 31.  The dollar value of reserves fell $113 bln to $3.73 trillion.    Over the three quarter period, China's reserve holdings have fallen by roughly $263 bln.   

To appreciate what is happening in China it is helpful to place it within the global context.  IMF COFER data covers only through the end of last year.  In Q3 and Q4, the IMF estimates that world reserve fell by almost $390 bln.  The PBOC reports that its reserves fell by about $150 bln over the same period. 

The decline in global reserves, of which China then is a subset, appears driven by two forces:  valuation and capital outflows.  The euro, sterling, yen and other reserve currencies lost value when converted into dollars. For example, by the IMF's reckoning the value of global reserves fell by about 3.3% in H2 14.  During this period, the euro lost 12.5% of its value.  The yen fell by 19% and sterling slipped 3.7%.  All else being equal the dollar's appreciation exerts downward pressure on the value of global reserve holdings.  

In addition to valuation adjustments, a strong dollar may have encouraged capital outflows from some countries, especially emerging markets.  Some of these flows are from the private sector as foreign investors repatriated funds.    Some flows appear to have been from the official sector.   One of the key reasons why central banks, especially in emerging markets,  build reserves is an effort to keep their own currencies weak.  When the dollar is strong, they have no need to push it higher.  To the contrary, when the US dollar is strong, central banks can liquidate (take profits?) on some of their dollar holdings and/or intervene to slow the descent of their currencies, contrary to the currency war meme.  

Both valuation considerations and capital outflows explain the decline in China's reserve figures.   China does not report the currency allocation of its reserves.  This could change in the not too distant future.  If China wants to increase its chances that the yuan will be included in the SDR basket, it behooves it to adopt the IMF's best practices, which means among other things, reporting the allocation of its reserves.  Although the IMF's COFER data does not reveal country specific data, the market will quickly try to back out the new information, and by doing so, will have a good sense of China's allocations.

In the H2 14, as China's reserves fell by $150 bln, it recorded a merchandise trade surplus of $278.5 bln.  In Q1 15, reserves fell by $113 bln with a $123.7 bln trade surplus.  The gap between the two exaggerates the portfolio capital outflows because other factors, like a deficit on services and foreign direct investment, in addition to the valuation adjustment. 

Conduct a simply exercise. At the end of last year China held $3.84 trillion in reserves.  We do not know the euro's share, but let's assume it is the same as those that report currency allocations, which is 22.2%. The euro fell by 11.3% on Q1.  That alone could account for $96 bln of the $113 bln decline in reserves that China reported earlier today.  

When the dollar is depreciating, Chinese exporters have little incentive to hold on to greenbacks and likely turn them over to the PBOC.  China has begun a liberalization process and exporters have greater discretion.  In a rising dollar environment, there is less need to covert to yuan. 

This is an important point.  Under conditions of a falling dollar, the dollar value of reserves tends to increase.  Under conditions of a rising dollar, the dollar value of reserves tends to decline.  Part of the internationalization of yuan that has captured so many imaginations is a function of a bull market.  Now that the yuan is not so easily a one-way bet, the internationalization has slowed.  Its share of trade settlement under SWIFT fell by two places to seventh, and an industry survey found that the percentage of companies settling trade in yuan fell to 17% from 22%. 

A survey by the Central Banking Publications of central bankers last month found two interesting developments.  First, central banks queried estimate that by the end of this year, the yuan will account for 2.9% of global reserves.  Second by 2025, its share will increase to 10%.   

The former seems a bit on the high side.  Global reserves stood at $11.6 trillion at the end of 2014. Assuming no change in reserves over the course of the year would mean some $336 bln of yuan in reserves at the end of 2015.  Among the $6.085 trillion of reserves where the allocation is reported, there was  $191 bln in other currencies, where the yuan can likely be found (alongside a host of other currencies, including Sweden, Norway, and Singapore would be found).  A 2.9% allocation to the yuan would be worth about $176.5 bln.   

There are $5.515 trillion of unallocated reserves.  Of which we know that China accounts for the $3.84 trillion.  That leaves $1.675 trillion.  Of those, some 8.65% would need to be allocated to the yuan to meet the 2.9% survey results.   It seems to be a stretch.  

That said, dramatic liberalization could take place that would make it easier to conceive.  For example, currently for the most part, leaving aside some of the nuances of the Hong Kong-China equity market link, foreign investors, including officials, require Chinese authorization to buy yuan or mainland bonds.   However, there is a front page commentary in the China Securities Journal that argues for scrapping the current quota system of QFII and RQFII. 

This may be putting the proverbial cart before the horse.  The lesson that Chinese officials appear to have drawn from both Russia's experience and the East Asian financial crisis (1997-1998) is that before opening the capital account, it is essential to ensure a robust banking system.  China has liberalized lending rates, but not deposit rates.  In order to liberalize deposit rates it needs to introduce deposit insurance.  There are some indications that such program can be unveiled as early as next month.