The Dangerous Myth That China “Needs” $2.7 Trillion in Reserves

$2.7 trillion is well over 3 times China’s short-term external debt (around $800 billion per the IMF). It is roughly two times China’s external debt ($1.4 trillion, counting over $200 billion in intra-company loans). It is enough to cover well over 12 months of goods and services imports (total imports in 2016 were around $2 trillion).*

There are two good reasons why a country might need more reserves than it has maturing external debt. The first is that it has an ongoing current account deficit. A country arguably should hold reserves to survive one year without any external financing – the sum of the current account and short-term external debt. The other is that a country has lots of domestic foreign currency deposits.

Neither applies to China. China’s runs a $200 to $300 billion current account surplus, so its one year external financing need is now around $500 billion. China has a relatively modest $250-$300 billion in foreign currency sight deposits, and just under $600 billion in domestic foreign currency deposits (to put that in context, it is about 5 percent of GDP). It would take just over a trillion in reserves to cover China’s external (short-term debt) and internal (domestic fx sight deposits) fx liquidity need.

The $2.7 trillion number (or $2.6 trillion) stems from the initial application of the IMF’s new (and in my view flawed) reserve metric to China. The IMF’s metric revived M2 to reserves as an important indicator of reserve adequacy, and China is off the charts on this indicator (China has very little external debt, but a very large domestic deposit base – so a composite indicator that includes the domestic deposit base gets a very different result than metrics that focus on external debt). In the composite indicator, emerging economies with a fixed exchange rate and an open capital account need to hold 10% of M2 in reserves. That alone is about over 20% of China’s GDP – as China’s M2 to GDP ratio is a bit over 200%. For China, the weighted contributions from short-term debt, “exports” (the IMF uses exports rather than imports) and long-term external liabilities are trivial. For China, the entire reserve need more or less comes from one of the four variables in the IMF’s composite indicator (more here).

But that calculation is now outdated. The IMF has refined its metric to give more weight to the presence of capital controls, and China has tightened its controls. Assuming that there are capital controls, the IMF metric indicates that China would be fine with $1.8 trillion in reserves (though that sum rises over the course of 2017, thanks to the ongoing growth in M2 as a share of GDP).**

I am not a fan of the even the updated new metric. I am not a big fan of composite metrics in general. And if you are going to use a composite metric, I think the composite metric should put more weight on foreign currency deposits than domestic currency deposits, while the IMF’s metric typically weights all domestic deposits at 5%. The IMF’s metric thus ignores one of the key insights of balance sheet analysis.

No matter. The world would be in a better place if there was a broad recognition that China can burn through another $1 trillion in reserves and, with $2 trillion still in reserves, be above every nearly all metrics of reserve adequacy.

This isn’t to downplay the scale of China’s reserve loss. The BoP data shows a reserve outflow of a bit more than $440 billion in 2016. That is significant. But I suspect that much of the outflow that led to the fall actually was the state actors. The build up of foreign assets in the banks, loans from the state banks to the world and easily controllable portfolio outflows from large institutions likely accounted for about $250 billion of the total fall in reserves. This leaves the true fall in the total foreign assets of China’s state sector at more like $200 billion. Still big, but not quite as big.

Set that debate aside though.

The reason for concern about China is the rapid pace of the reserve decline, not the risk that China is about to run out of reserves. China might conclude it doesn’t want to continue to finance outflows with reserves, in which case its currency would depreciate until the trade surplus was large enough to finance the outflow.

One final point. The IMF’s initial metric implied China needed far more reserves, relative to its GDP, than other emerging markets economies – more than Brazil, more than Turkey, more than Russia, more than Ukraine (see this post, or play with the IMF’s data tool***). That never made sense to me, even though China does have a more managed exchange rate than most. Domestic capital flight can force a country off a peg, no doubt – but the negative macroeconomic impact of a depreciation is proportionate to the amount of foreign currency debt in the economy, not the size of the domestic deposit base.

*  The IMF metric uses exports rather than the traditional imports, but China is just fine using exports too. China’s export to GDP ratio has come down after the global financial crisis.

** In the absence of capital controls, the IMF’s latest reserve metric spreadsheet suggests China now needs more than $2.7 trillion using the 10% of M2 weighting, incidentally. The estimated 2017 reserve need is -- gulp -- $3.3 trillion. One way of interpreting that is that China lacks the reserves to open its financial account if it wants to continue to manage its exchange rate. Another way of interpreting it is that the metric doesn’t really work for an M2 to GDP outlier like China.

*** The IMF’s reserve data interface is now quite useful. And all the underlying data is available in a convenient spreadsheet. That makes it easy to check out the contribution of various components. I would be thrilled if the IMF added the foreign currency/ domestic currency split of M2 so that those of us who are interested in the foreign currency deposit base would have a new resource for cross country comparison.