Is SAFE Keeping A Tab On China's Reserves?

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Summary

China is running out of FX reserves and could breach its IMF adequacy metric by Q3-Q4 2016.

In macroeconomic terms it would then be running at negative day-to-day working capital.

China has been selling illiquid foreign securities to free-up dollar liquidity.

China's reserves are managed by the State Administration of Foreign Exchange (SAFE), which invests China's reserves mainly in US treasuries, European, UK and Japanese Government debt. China also has a sovereign wealth fund called the China Investment Corp (CIC) setup in 2007 to pursue higher risk/return investments abroad, such as property in the UK and stakes in European companies.

CIC assets aren't included in the IMF's official calculations of reserve adequacy, which stress that funds must be readily available to the monetary authority in question to be counted as reserves. As such these assets fail this liquidity test and wouldn't show up on the PBOC's balance sheet.

For an emerging market economy with a fixed exchange rate and capital controls, the IMF recommends that the PBOC hold foreign reserves worth 30% of short-term debt, 10% of exports and 5%-10% of M2 money. Mansoor Mohiuddin senior market strategist at Royal Bank of Scotland in Hong Kong estimates that China needs between $1.6tn and $2.6tn in reserves. Claudia Calich of M&G Investments in London estimates that it will need around $2.5bn. He forecasts that the lower bound of the recommended level could be reached by Q3 2016 regardless of further intervention.

China used nearly 10% of its reserves between November 2015 and February 2016 through direct intervention. This reversed in March and April 2016 with small back-to-back gains, but returned to the December 2011 level in May 2016.

In efforts to boost short-term dollar liquidity China has been selling US assets. Since the peak in 2014 US Treasury data show that China has sold around $250bn of US treasuries -- that has likely used to fund direct intervention efforts. Beginning in the same period and ending in March 2016, China reduced its US equity holdings by 38% to $201bn.

Two background aspects to note are that it is possible that actual foreign asset reserves are well below that reported by the government body SAFE.

Tao Wang of UBS estimated that China held $1.4tn in US Treasury and $800bn in other Government in October 2015. Since then the official figure has fallen nearly 20%. Another area of controversy is assertions that SAFE is accounting for offshore CNH currency as reserves -- the PBoC has been buying offshore CNH in a bid to narrow the spread between the onshore and offshore rates.

The overarching response to the PBOC's decision to float the RMB last year (attempt to become an international reserve currency) was that it would release massive deflationary pressures built up inside the Chinese economy, out into the rest of the world. It would also add a large depreciatory force on the RMB. The reasoning for that is that to become an international currency and hold its value there would need to significantly more demand for RMB assets compared to demand for international assets by RMB holders. As China imposes significant capital-flow restrictions on its own citizens it would be much easier for international capital to buy RMB assets than it is for RMB holders to invest their capital abroad. This would create a significant imbalance. The reason why the RMB hasn't depreciated more strongly is of course because of direct intervention but also because the PBOC decided to keep a firm hold on its ability to control the rate regardless of entry into the IMF SDR basket. It can achieve this because almost 80% of international RMB transactions are made between Chinese companies or between China and Hong Kong SAR.

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