UBS: Here's why everyone should stop freaking out about the sudden drop in China's FX reserves

Concerns over the abrupt decline in China’s FX reserves are to be expected given rising capital outflows and falling reserves, but widespread worries about the adequacy and liquidity of reserves are more a reflection of current extreme market pessimism about China rather than facts and reality.

That’s the reassuring view of Tao Wang, economist at UBS, who believes concerns over the depletion in the nation’s official FX reserves are overblown.

The decline in the nation’s FX reserves is shown in the chart below, something that has accelerated in recent months following the PBOC’s decision to allow market forces to play a great role in setting the valuation of the renminbi.

To defend the renminbi against large-scale capital outflows from the country, official reserves were likely sold to prop up the currency, something that was done in part to diminish speculation of further broad based renminbi weakness in the months ahead.

While Wang believes the government will continue to defend the renminbi in the short term, he suggests it will not last beyond the short term.

“We expect China to use FX reserves to help defend the currency, resulting in a further loss of reserves,” notes Wang.

“We expect China’s FX reserves to decline by another couple of hundred billion USD by end 2015. This is because the Chinese government places importance on USDCNY stability in the near term while continue to encourage “going out” strategy and pursue capital account opening, at the same time depreciation expectations lead to quicker winding down of foreign liabilities and diversification into foreign assets.

“Over a longer period of time, we expect the Chinese government to allow for more CNY flexibility and depreciation and if necessary, tighter FX controls, instead of depleting its FX reserves to defend the currency.”

Wang suggests that policymakers will be look to maintain stability in the USD/CNY exchange rate in the months ahead, predicting the pair will finish the year at 6.5 before weakening to 6.8 by the end of 2016.

At present the USD/CNY trades at 6.3620. If the pair finishes the year at 6.50 as Wang suggests — one of the more conservative calls out there — it would represent a further depreciation in the renminbi of 2.17% — modest in anyone’s language — particularly given some of the outsized movements in other major currency pairs this year.

On heightened concerns over the sharp drawdown in reserves seen in recent months, Wang suggests that the nation has more than enough FX reserves to cover external debt obligations and cover imports of goods and services.

“China’s $3.6 trillion official reserves can cover 20 months of imports of goods and services while the minimum requirement is 3 months coverage, and don’t forget China is currently running a current account surplus of over $300 billion a year,” he says.

“More importantly, current FX reserves are about 5 times that of China’s short-term foreign currency external debt.”

He also suggests that markets should not worry about a potential tightening effect due to declining FX reserves, pointing out that the government can release “frozen” liquidity in the financial system through the PBOC cutting reserve requirement or by using other liquidity tools.

“Every 100 bps cut in RRR can release 1.2-1.3 trillion in RMB liquidity,” he says.

“If RRR were to be lowered from the current 17.5% to 7.5% back in 2004-05, more than RMB12 trillion in base money liquidity would be released. Clearly, we are still a long way from there and China can easily manage its domestic liquidity.”

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