China’s 3 trillion dollar question

We face the same scenario year after year: the Christmas holidays have only just ended, the New Year hangover is cured and the first resolutions for the New Year thrown overboard, when China attracts attention with alarming headlines. Unlike the doomsday mood of January 2016, the current uncertainty is no more than a storm in a teacup. Rather than being worried about the global implications of a hard economic landing in China, markets are currently more concerned about the lack of success in the relentless battle to stem the outflow of capital. China’s most recent reserves data are rubbing salt in the wounds again this year and bringing China’s intervention policy to the international stage. Even though China’s reserves just about managed to stay above the psychologically important USD 3,000bn mark, the question is how far can they fall before the situation becomes precarious.

The ARA (Assessing Reserve Adequacy) is a development of traditional indicators, such as import coverage or the ratio of reserves to short term-debt, and takes into account other parameters that illustrate the threat of a flight of capital and foreign portfolio shifts. The recommended reserve requirement to be derived from this is by no means a fixed threshold in the style of the Maastricht criteria.

Not all studies arrive at the same optimum value, nor are specific sanctions imposed if the reserves fall below the recommended value. However, the ARA methodology could play a key role once the financial markets see the reserve requirements as being a problem alongside the usual concerns about China (US trade policy, capital flight, enterprise debt,….).

China’s reserves are still comfortable at present and even above the recommended range of USD 1,850 to 2,770bn. If they continue to fall at the same pace as in the last three months, the pain threshold would be reached by the end of 2018. The once comfortable cushion of reserves would dwindle noticeably and would not be covered up even by the most expert juggling of numbers. According to the ARA approach, China hardly has sufficient reserves even now to remove all capital controls and still be in a position to continue to manage the exchange rate through interventions.

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