Since mid-2014 Chinese currency reserves have shrunk by about 10 percent. This reduction culminated in August 2015 when the Chinese Central Bank responded to market pressure towards a weaker CNY and let the exchange rate fall by about 4 per cent in several steps. By following market sentiments, the Central Bank underlined its announcements to give market signals larger weight in exchange rate determination rather than to defend exchange rates, in particular not to defend a fixed single currency peg against the dollar.
However, both the timing and the sequencing of the Central Bank’s interventions were negatively perceived by markets in a situation when sizable corrections in Chinese stock markets occurred and when doubts about the sustainability of the medium-term growth path of the Chinese GDP of around seven percent shocked both traders and investors. To contain overshooting in currency markets and stabilize expectations that the Chinese economy is not facing a hard landing, the Chinese authorities leaned against further pressure of capital outflows and CNY exchange rate weakening and sold foreign currency denominated assets.
What appears a balance sheet loss, however, is in fact an economic gain.
More exchange rate flexibility in general and the exchange rate depreciation in particular helps Chinese authorities to ease the so-called currency mismatch. Unlike many other emerging markets which are indebted in foreign currency and earn profits in local currency, China earns low profits in foreign-currency denominated interest-bearing assets and at the same time must foot the bill of eventually overindebted local investors, private and para-statals alike, all in local currency. Currency depreciation raises the value of currency reserves in local currency and helps to soften local budget constraints. In this respect, China is in a similar situation as Russia where the depreciation of the ruble has also helped to achieve balancing the local budget. Declining currency reserves (albeit from a record-high level) are the companion piece of reducing current account surpluses and stabilizing the Chinese current account surplus (as percentage of GDP) at a 3 percent level, much below pre-2010 levels.
Thus, the days are gone when the question whether Chinese-US trade were fair was answered sarcastically: yes, it is fair: China exports toxic toys and the US exports toxic papers.
In fact, while China now has sold some of the (non)-toxic papers, the structure of US (and other Western countries’) capital imports from China undergoes an important shift from interest bearing assets to equity assets, such as portfolio investment and foreign direct investment.
This shift decouples China somewhat from the sovereign risk of being exposed to possible debtor country defaults. At the same time, due to massive real wage increases in China over the last decade (equivalent to a real appreciation of the CNY) which was not at all compensated by recent nominal depreciation, Chinese companies for reasons of competitiveness were forced to substitute parts of direct exports for foreign production. Alternatively, China had to upgrade its export mix and thus to export more high-technology products such as commercial drones which are far from being discredited as “toxic”. Hence, fewer currency reserves not only improve the quality of remaining reserves (in terms of reducing the share of non-performing claims on debtor countries). They also let China participate in risk-sharing of global equity investment in foreign currencies such as US-Dollar, Euro, Pound Sterling and Yen. A further depreciation of the CNY would improve the net foreign equity position of China measured in local currency as foreign equity investment of China is denominated in foreign currencies and therefore benefits from CNY depreciation.
In short, on both sides of the balance, the degree of toxicity of traded products and papers decreases with decreasing size of imbalances and decreasing currency reserve accumulation. This is an important gain for the trading partners as well as for the world economy.
The decline of Chinese currency reserves has another politically important side effect. A country selling some of its foreign assets does the opposite of a country pursuing a “beggar thy neighbor” strategy of exchange rate undervaluation and currency manipulation. The suspicion that China manipulates its currency in order to defend jobs in the export industry is old. It is raised in the US quasi automatically when current imbalances rise and can gain momentum once nominal depreciation is identified as a political strategy rather than as a response following the markets. Chinese authorities would be well advised to act against this suspicion by beginning to swap external monetary anchors such as currency pegs for internal monetary anchors such as inflation targets.
Source Merics 2015