February 19, 2016
That is the theme of an article in the NYT yesterday with the headline, “China’s foreign exchange reserves dwindling rapidly.” The gist of the piece is that there has been a large outflow of capital from China in the last year, which has caused them to lose as much as $800 billion from their foreign reserves. According to the piece, China is down to its last $3.2 trillion.
If the idea of a country with $3.2 trillion in foreign reserves worrying about empty coffers sounds silly, it should. China has many economic problems (who doesn’t), but a shortage of foreign reserves is not among them.
First, just to get oriented, let’s keep in mind why China has been losing its reserves. As the piece notes, it has been trying to keep its currency from falling. Note that for years, the United States and other countries have wanted China to raise the value of its currency. The argument was that it had accumulated vast amounts of reserves to keep the value of its currency low in order to maintain large trade surpluses.
Now the story is that if China decided not act — it did not use its reserves to buy up the currency being sold by people trying to get some of their money out of the country — the Chinese currency would fall against the dollar and other currencies. Would this be a problem for China?
A lower valued yuan would mean higher prices for the goods China imports and lower priced Chinese goods everywhere else in the world. While China recently saw a modest uptick in prices in January, the conventional wisdom is that the country is far more concerned about deflation than inflation. From this perspective, it’s hard to see how a rise in import prices is a problem.
The other side of the equation is that China’s goods and services would suddenly be much cheaper for people in other countries. This would lead to more exports. Since the rise in import prices will reduce imports, the net effect of a decline in the yuan would be a rise in China’s trade surplus. That would be bad news for the United States and other countries, but it is certainly not a problem for China.
In other words, there is no obvious economic reason that China could not just let its currency fall in value. It would make other countries unhappy, but China’s government presumably cares more about its own economy than the economies of its trading partners.
Let’s imagine the Chinese government did let its currency fall by 5–10 percent against the currencies of other countries. There are two things that would happen. First, its already substantial trade surplus (@3.0 percent of GDP) would get larger. Among other things, this would get the country more foreign exchange.
The other thing that happens if China’s currency falls is that it changes the nature of the bet being made by investors, both foreign and domestic. Many of the people taking their money out of China presumably think there is a good chance that the value of the yuan will fall, but if it fell by 10 percent, would they still want to bet that the yuan would fall further? Keep in mind, at that point the country is likely running a very large trade surplus.
I wouldn’t try to read of minds of investors, but presumably at some low level of the yuan, they stop thinking that the yuan will fall further, and may even think that it might rise. In that case, investing in yuan sounds like a very good deal, especially since the country is still growing faster than almost anyone else, even if its days of double digit growth might be over.
In short, it is very difficult to see a story where the Chinese government need have much fear of running out of foreign reserves. China is a country with an enormous stockpile of reserves that is running large trade surpluses, and it is still growing very rapidly by any measure other than its own past growth. It is not a country that is going to face a foreign exchange crisis.
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