China's Forex Reserves: The Figures Don't Tell the Whole Story

China is facing a growing chorus of concern over the changes in the nation's foreign exchange reserves. This issue,while important,is not entirely as it appears. At the very least,it deserves greater attention.

The nation's foreign exchange reserves have reached what we could call a "new normal." From 1994 to 2014,China's foreign exchange reserves increased steadily as a result of a surplus in the country's balance of payments,peaking at US$3.99 trillion in June 2014. Over those two decades,the annual increase averaged more than 30%. During that period,the main concern of political leaders and academics was how to respond to an overly rapid rise in foreign exchange reserves.

Since mid-2014,however,the renminbi has shifted from its steady appreciation to a less predictable two-way movement. That shift has been accompanied by a greater willingness of domestic enterprises and individuals to hold foreign currency assets. It has also encouraged borrowers to speed up repayments of foreign currency debt.

At the same time,we have seen a transfer of foreign exchange reserves from the government to private hands. This has been called "foreign exchange reserves that are hidden among the people," and it is one factor in the reduction of official reserves from their peak levels. In 2016,foreign exchange reserves resumed their climb in March and April but then fell in May and rebounded again in June. By the end of June 2016,foreign exchange reserves had dropped to US$3.21 trillion. Now,the market has begun to worry whether the nation has sufficient foreign exchange reserves.

During the 1950s and the 1960s,the widely used measure of adequate levels of foreign exchange was whether reserves could cover three to six months of imports. Later,the test was expanded to ensure the capability of repaying foreign debt. Thus,the widely used adequacy ratio became 100% of short-term liabilities.

More recently,the International Monetary Fund (IMF) put forward a comprehensive index that attempted to measure the appropriate scale of foreign exchange reserves. It comprised four sub-indexes reflecting potential pressure of international payments - export earnings,broad money supply,short-term liabilities,and "other" liabilities. Additionally,different risk weightings have been given to the four sub-indexes according to different regulations on exchange rate,and the regulations for capital account movements. In keeping with this new standard,a reasonable scale for China's foreign exchange reserves would be between US$2.8 trillion and US$4.2 trillion. That means China's foreign exchange reserves are still at a satisfactory level at US$3.21 trillion.

In future,authorities are likely to put greater emphasis on the importance of keeping adequate levels of foreign exchange reserves. Fluctuations in the levels of reserves are the result of macro-economic developments rather than policy prescriptions,and we should make a more scientific judgment on the desired level of foreign exchange reserves.

First,we should have some confidence in the foreign reserves for the longer term. In the future,fluctuations in reserve levels will be routine. Though there are uncertainties,the fundamentals are generally positive. For example,domestic economic growth is reasonable,the current account remains in surplus,and there is a continuing inflow of long-term capital. With the inclusion of the renminbi in the Special Drawing Rights,a basket of global reserve currencies set by the International Monetary Fund,the relatively higher rate of return on renminbi assets will attract international capital and this will boost global capital allocations to the Chinese market.

Second,foreign exchange reserves need to return to their fundamental function in keeping the balance of the international payments. At present,facing the complex and volatile global economic environment,we should highlight the main contradictions and outstanding problems in our development path,so that foreign exchange reserves gradually assume their key role of keeping a balance in international payments. Foreign exchange reserves should be to maintain international payments and keep the foreign exchange rate stable. They should ensure reasonable liquidity in the market,help adjust short-time imbalances in international payments,provide a buffer to shocks from sudden capital flows,and avoid aggravating the vicious circle of currency devaluation and additional capital