Some thoughts on China's foreign exchange reserves

China's foreign exchange reserves stood at USD 3.1426 trillion as of the end of September 2020, down USD 22 billion or 0.7% from the end of August, according to State Administration of Foreign Exchange (SAFE) data. This change ended the previous five consecutive months of rising momentum. A stronger dollar and falling stock markets in Europe and the U.S. were the main reasons for the decline in foreign exchange reserves. However, the change in China's foreign exchange reserves has always been the focus of the market and aroused a lot of discussion and analysis. It has also been regarded as an important indicator of China's economic and currency stability. In this regard, researchers at ANBOUND will provide some perspectives on foreign exchange reserves here.

In fact, foreign exchange reserves are not a concept of net assets, but rather a part of the balance of payments as external assets and internal liabilities. Since the balance of payments is mainly settled in U.S. dollars, from the perspective of international investment and trade, it can be understood as a similar position concept in which the main purpose is to maintain the smooth settlement of trade and investment between countries. Therefore, the amount of foreign exchange reserves for emerging market countries is a major reference indicator of currency stability and economic stability, which is conducive to the participation in the international market.

In terms of the balance of payments, the largest part of China's international income source is its trade surplus in goods and services over the years. According to SAFE, from 1982 to 2019, China's cumulative net inflows into its current account amounted to USD 3.5 trillion. This is the basis of China's huge foreign exchange reserves. The other is a continuing net inflow of foreign direct investment (FDI), in which the FDI stock stands at about USD 2 trillion. A considerable part of foreign funds inflow is external borrowing. By the end of 2019, China's total external debt stood at USD 2.0573 trillion. At the same time, foreign investment in China's securities market has also been on the rise in recent years. Foreign investors held USD 737.5 billion in domestic bonds and equities at the end of June 2020, up 2.2 times from the end of 2015, according to central bank data. These essentially constitute the main component of China's foreign exchange earnings.

In terms of the outflows, China's outward direct investment (ODI) consumed part of foreign exchange, which became a major factor for the decline of foreign exchange reserves around 2015 as China's capital outflow increased significantly. Statistics show that by 2019, China's ODI stock has reached USD 2.20 trillion, making it the third-largest ODI country in the world after the United States and the Netherlands. In addition, China has nearly USD 1.2 trillion of foreign loans and trade credits, nearly USD 600 billion of foreign portfolio investment, and about USD 800 billion in foreign currency deposits and foreign currency. On top of that, nearly USD 3.2 trillion of official reserve assets make up the bulk of China's external assets (liabilities internally).

Of course, much of the composition of official reserve assets is made up of China's official foreign exchange reserves, and there is no detailed data on their use. The size of China's actual foreign exchange reserves has been in a fog since it turned into a downward trend in 2015. On the other hand, China's marked increase in ODI around 2015, coupled with a narrowing of its foreign trade surplus and capital outflows caused by the depreciation of RMB greatly reduced the scale of its foreign exchange reserves by nearly one trillion U.S. dollars, which has now been maintained at about USD 3.2 trillion. Generally speaking, foreign exchange reserves refer to assets denominated in foreign currency, including cash, foreign bank deposits, foreign securities, etc. According to U.S. data, about USD 1 trillion is used to buy U.S. Treasuries, and another USD 1 trillion is used to buy securities such as bonds. About a third is spent on securities in other currencies such as euros and yen, with the rest supposed to be cash.

In fact, the main concern about China's foreign exchange reserves is focused on the stability of the RMB, which is of great importance to the development and stability of the Chinese economy in the context of the changing domestic and international economic environment. Of course, there have always been disagreements over how much foreign exchange reserves to keep and how to use it, with some arguing that to keep it at around 10% of GDP might be appropriate. For example, Japan's foreign exchange reserves stand at just USD 1.053 trillion, but it owns more than USD 5 trillion in foreign assets, guaranteeing the stability of the yen and the Japanese economy. The foreign exchange reserves should be moderately diversified in order to avoid the risk and asset losses caused by the fluctuation of the U.S. dollar exchange rate. However, for a large country like China, it is still necessary to maintain the stability of foreign exchange reserves dominated by the U.S. dollar while the U.S. dollar is still the major international currency.

On the one hand, China needs to guarantee its foreign debt of one trillion U.S. dollars (including both short- and long-term foreign debt, excluding offshore RMB foreign debt) and the payment needs of foreign investment of about USD 2 trillion, while short-term capital flow requires sufficient foreign currency to maintain China's expanding openness to the outside world. On the other hand, in terms of trade, China's imports of food, oil, and chips alone are worth about USD 588.8 billion a year. Under the changing international trade environment, there is still great pressure on China's export industry to maintain its trade balance. If the current trend of moving basic production capacity outward continues and a trade deficit emerges, the current level of foreign exchange reserves may not be able to withstand such a "depletion".

Of course, in the context of drastic changes in economic and trade brought about by the COVID-19 pandemic, avoiding the loss of foreign reserve assets is also a more realistic issue. In fact, the root of this problem lies in the improvement of the ability of enterprises and the private sector to invest abroad, so as to form high-quality foreign assets. In addition, the issue of foreign exchange reserves is closely related to the internationalization of the RMB. In the future, the expansion of overseas investment and trade in RMB and avoiding the use of U.S. dollars can certainly solve the problem of the foreign exchange reserves. Since the reform and opening-up of China, the continuous increase of foreign exchange reserves is the result of the continuous expansion of "external circulation" of the country's economy, and the scale and structure of foreign exchange reserves also need to be adjusted appropriately according to the future pattern of "dual circulation" of China's economy.

Final analysis conclusion

The size of foreign exchange reserves is closely related to the creditworthiness of the U.S. dollar and RMB. Maintaining sizeable foreign exchange reserves is still necessary for China's economy and currency stability. In the long run, strengthening the ability of ODI and increasing overseas assets are the basic measures to maintain a stable currency.