Achilles' Heel of China's Foreign Currency Reserves

By He Qinglian on January 14, 2016
Source article in Chinese: 中国外储的阿喀琉斯之踵何在?

Right at the very beginning of 2016, the way the Chinese government manages the country’s stock market and currency exchange market has drawn a chorus of criticism. In response, the Chinese government announced the suspension of the “circuit breaker” of the stock market, and, at the same time, steps up its control over the currency exchange market.

The underbelly of China’s foreign exchange market

Everyone knows about the changes to the figure of China’s foreign currency reserves: from its peak of 3.99 trillion US dollar in June 2014, China’s foreign currency reserves fell to 3.33 trillion US dollar in December 2015 and saw a net reduction of more than 500 billion US dollar.

The criticism of China’s currency exchange market from the international investment sector focuses chiefly on two matters: first, they think that the Chinese government regulation of the Renminbi is a violation of the pledge made when the Chinese currency is included in the IMF SDR basket and would greatly embarrass the IMF; second, the international investment sector finds the Chinese government interferes too strongly with the offshore market, widening the exchange rate deviation between the onshore and the offshore markets as a result.

These critics view the Chinese currency exchange market with their own interests in mind—a Chinese market that is open and allows free floating of currency exchange rate and free exchange of currencies would be a new place to make profit; and it seems that there is sound reasoning behind their criticism. However, both the IMF and the Chinese government are full aware of the actual content of the promise made when Renminbi became an SDR currency.

In November 2015, when the IMF altered the criteria to approve the inclusion of Renminbi as an SDR currency, the Chinese government only promised that the clean floating of Renminbi exchange rate would be implemented in the future. But the Chinese government did not state clearly the time it plans to implement the free floating of China’s currency without government intervention. Besides, PBoC President Zhou Xiaochuan openly stated the day before Renminbi acquired the SDR currency status that, to cope with “financial attacks” from beyond the border, the Chinese government would continue to interfere with the currency exchange market and implement the floating of Renminbi exchange rate under the government regulation.

The IMF representative in Beijing knew about all these public statements.

If the stress to depreciate Renminbi is not too great; if the risks of huge amount of bad debt and excessive debt do not exist in China’s financial system, then Beijing might think that it would not be too risky to allow the free floating of Renminbi exchange rate.

From June 2015, however, the above risk factors became increasingly apparent, there is no wonder that the Chinese government would choose financial security over honoring its pledge to the IMF.

And then, let’s explore why the Chinese government wants to intervene in the currency exchange market, in particular, the offshore Renminbi exchange rate. There are two reasons for this. First, Renminbi faces tremendous inflation pressure inside China owing to the country’s status as the world’s largest money printer. Second, China is facing immense pressure of capital outflow. As a result of the Chinese government stepping up its anti-corruption campaign from 2012 on, political risk in China became greater. Seeing that with each deposed top official several entrepreneurs fall, many tycoons flee China with their assets, thereby bringing down the country’s foreign currency reserves.

How much of China’s 3 trillion foreign currency reserves still remain?

Beginning from August 2015, the Chinese government has been forced to sell US Treasury bonds to facilitate payment made in US dollars. In December 2015 alone, China sold US Treasury bonds at a record pace and cleared about 108 billion US dollar worth of the country’s foreign reserves so as to meet the demands of domestic foreign exchange market.

From this, the international investment sector came to realize that the trillions of US dollar worth of foreign reserves of China is but nominal assets that the Chinese government had long spent away in various areas, The Bloomberg report on January 8, “China Finds $3 Trillion Just Doesn’t Pack the Punch It Used To”, was precisely about this topic.

As that Bloomberg report showed, China’s foreign currency reserves have been used in the following areas:

One, US Treasury Bonds:

According to data from the US Treasury, in October 2015, the estimated amount of US Treasury Bonds in China’s possession was worth about 1.25 trillion US dollars. The Treasury added that the estimate may not have truly reflected the amount of US Treasury Bonds possessed by third party accounts on China’s behalf.

Two, Overseas Investment:

Although China has not formally made public the sum of direct investment it committed abroad in 2015, Reuters estimated the figure would exceed one trillion US dollars for the first time. The bulk of this one trillion US dollar was investment the Chinese government and China’s State-owned enterprises committed in other countries. For instance, the Silk Road Fund, an overseas investment fund owned by the China Development Bank and the Export-Import Bank of China alongside other government bodies and state-owned institutions, aims to foster investment projects in countries along the One Belt, One Road and to promote China’s political interests.

The China Development Bank and the Export-Import Bank of China got a combined injection of 93 billion US dollars from China’s foreign currency reserves.

Three, External Aid:

When it comes to external aid, China can be very generous. It often announces new aids to developing countries as it writes off debts owed by those countries that are due for reimbursement. Without doubts, these aid projects are financed by China’s foreign currency reserves.

What Foreign Currency Reserves Really Are

Finally, I would like to point out a common misconception of both the Chinese government and the people in China: they see foreign currency reserves as asset of the Chinese government (or the Chinese people). The reality is that, while foreign currency reserves are asset of the People’s Bank of China (PBoC), every dollar of this asset corresponds to an equal amount of debt. The reason that this is the case can be found in the way China accumulates its foreign currency reserves. The PBoC stipulates that when companies doing business overseas wire their profit in US dollar (or Euro or Japanese Yen) back to China, they must do the settlement of exchange through banks and hand over the foreign currencies to the PBoC before they receive from the PBoC Renminbi of the same value. In this process, the foreign currencies handed over to the PBoC become its foreign currency reserves—an asset, yes—but at the same time a new liability—the newly issued Renminbi—is added to the balance sheet of the PBoC as well.

To summarize, the PBoC accumulates its foreign currency reserves by “borrowing” US dollars from individuals, foreign companies in China and domestic companies engaging in foreign trade and export. Every dollar of the foreign currency reserves corresponds to a dollar of debt. To spend these reserves on purchasing US Treasury bonds, overseas investment and external aids is to spend away borrowed money as its own. And the move to sell US Treasury Bonds to provide the US dollars needed in currency exchange market shows that the PBoC does not have enough US dollar cash. If the government does not take action to limit currency exchange in China and allow the people to freely do so, it is possible that the PBoC would go broke.

Currency Exchange: a battle that the Chinese government cannot lose

Many specialists are of the view that a decline in the Renminbi exchange rate would boost the country’s export. The problem is, the benefit of increased export is slow to materialize, but the pressure of capital outflow following a drop in the Renminbi exchange rate would be imminent. For the authorities, the truth that the 3 trillion US dollar worth of reserves are spent away is like the Achilles’ Heel that must never be discovered.

Currently, the Chinese government is gradually tightening its foreign currency exchange policy.

According to a Reuters report on January 8, some branches of the State Administration of Foreign Exchange (SAFE) instructed banks within their jurisdiction to step up regulation of currency exchange transaction conducted for clients of those banks, and to observe the cap for the total amount of currency exchanged in January so that the agency can curb the piecemeal capital outflow of enterprises and institutions.

According to the same report, SAFE raided a large number of underground banking houses (shadow banks); issued a rule in Beijing, Shanghai and Shenzhen stipulating that any person who wants to withdraw more than 2000 US dollars must place a booking three days in advance. Some banks even lowered that limit to 1000 US dollars.

On January 14, SAFE official dismissed the Reuters report and said the Agency has never put forward policies mentioned in that report. “The Agency does not rule out the possibility that some banks initiated some regulation because they don’t have enough US dollar cash”. Such a clarification only serves to make people realize that if needed, banks all across China can initiate regulation on their own without getting prior approval.

To sum up, the international investment sector sees China’s foreign currency exchange market as a new ground to make profit, people in that sector thus complain about over-regulation and ask the Chinese government to meet the open standards outlined by the IMF. But for the Chinese government, currency exchange market is a matter of financial security. The real threat of a drop in the Renminbi exchange rate is capital outflow. The outflow of capital would affect the Chinese stock market and the Chinese housing market, making it more difficult for the Chinese government to shore up both markets; besides, the outflow of capital would also mean a huge deleverage pressure for the real economy in China.

Some people predicted that the currency exchange market would be the flashpoint of a financial crisis in China, and the collapse of the regime would ensue. This thinking is too naive. The Chinese government knows better about its own weaknesses than outsiders and is taking all measures to guard against risks.

For this prediction to come true, the prerequisite would be that the central government ceases being able to function overnight—the possibility of this would be next to zero.

In his piece about the Great Wall of China, Franz Kafka tried to explain the purposes of the Great Wall and the reasons why that construction was built in ancient China. But it seems that Kafka did not truly comprehend why the Chinese wanted to build the Great Wall. For the Chinese people, the Great Wall serves just one purpose: protection against the enemy, and keep all dangerous external factors outside of the Wall. Understand this Great Wall mindset and one would see why the Chinese government wants to control the foreign exchange market.