China’s foreign exchange reserves registered another significant drop last month.
So far, though, there’s little sign of the cascading capital flight that would call the sustainability of the country’s exchange rate regime into question.
Bloomberg Intelligence Economics’ base case remains that the People’s Bank of China will keep a close hold on the yuan through this period of selling pressure.
China’s foreign reserves fell to US$3.23 trillion in January from US$3.33 trillion in December.
The drop of US$99 billion was less than December’s US$108 billion fall and below expectations of a US$120 billion decline.
Capital outflows remain substantial, and the central bank continues to intervene to prevent those from tipping over into depreciation of the renminbi.
It’s possible the cost of defending the currency was even larger than the headline drop in reserves suggests.
That could be the case if the intervention in the Hong Kong market, which pushed the offshore borrowing rate for renminbi to 65 percent in January, was channeled through commercial banks rather than the PBoC.
The PBoC may also be taking positions in the forward market, which are not immediately reflected in the foreign exchange reserve data.
Even so, January’s drop was less than forecast. That suggests the worst fears of cascading capital flight have not come to pass.
Households are not maxing out their US$50,000 annual quota for purchases of foreign currency.
In part, that might reflect what appears to be a repeg of the renminbi against the US dollar since mid-January, which reduces the incentive for households to shift funds out of China’s currency.
A smaller-than-expected drop in reserves strengthens BI Economics’ view that the PBoC will be able to resist pressure for a disorderly depreciation.
That reflects a number of factors:
(1) The stock of reserves remains ample, enough to cover outflows at the current rate for more than two-and-a-half years.
(2) A portion of outflows so far has come from loan repayment by corporations and overseas loans by banks — the headline drop overstates the degree of capital flight.
(3) The costs of a disorderly depreciation would be substantial, and the government has other tools at its disposal to support growth.
BI Economics’ base case is that the PBoC’s management of the exchange rate in the months ahead will go through three stages.
First, the renminbi will be closely managed against the US dollar — as it has been since mid-January.
Then, as the dollar strengthens and a greater degree of calm returns to the markets, the PBoC will return to a peg to a basket of currencies.
Finally, the central bank will step back from day-to-day intervention in the exchange rate and manage a float against a basket of currencies.
Close management of the exchange rate has implications for China’s other policy choices.
Further interest rate cuts would place more downward pressure on the currency.
In the short term, that means the PBoC is more likely to rely on less high-profile tools, including its alphabet soup of lending programs, to guide down rates.
Fiscal policy will also play an expanded role.
Last month’s drop in foreign exchange reserves comes despite continued inflows on the trade account.
The consensus forecast is for a trade surplus of about US$60 billion in January.
The mismatch between an expanding trade surplus and shrinking reserves suggests China’s exporters are choosing to keep their earnings in US dollars rather than converting them into renminbi — another indication of bearish sentiment on the currency.
In past months, valuation effects have likely had a significant impact on the shift in headline reserves.
With little movement in the euro against the US dollar in January, valuation effects were likely muted.
The views expressed in this article are those of Tom Orlik and Fielding Chen, economists at Bloomberg Intelligence.
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