As the yuan grows into a truly international currency, China's foreign exchange reserves (forex reserves) will provide solid support for the nation's financial stability, and will continue to be an important source of external financial strength. However, China's forex reserves have been reduced by $500 billion compared to their historical high in June 2014, spurring widespread concern.
The decline in China's forex reserves can be analyzed in terms of both its sources and its deployment. China's forex reserves essentially come from three different sources: trade surplus, foreign direct investment (FDI) and international capital flows. The growth rate of the trade surplus of China has weakened, but it has remained stable in general; total absorbed FDI has increased comparatively as well without registering a significant change. Considering current international financial circumstances, the capital outflows that have been evident in recent months still fall within a reasonable and manageable range.
Although the fundamental sources of increases to China's forex reserves have not changed, and though there is still room for growth in the reserves, three main factors have contributed to their decline.
The first factor is that China's central bank has taken necessary measures with the reserves in foreign exchange markets to keep the yuan exchange rate within a reasonable range, which is necessary to the maintenance of the rate's stability and is also one of the main reasons why a nation holds reserves.
The second factor is that some of China's reserve holdings denominated in the euro, the Japanese yen and emerging market currencies have suffered a loss in book value due to a robust US dollar. This kind of reserves reduction, however, is due to digital evaluation rather than to a reduction in the actual amount of these foreign currencies, so we should not be alarmed by it. The last but most significant factor is that a certain amount of China's forex reserves originally referred to as "money" has been used in other areas and is no longer counted as reserves.
But if this money is no longer classified as part of China's forex reserves, where could it have gone? We can track the changes through China's external financial assets. Last June, China's forex reserves reached a record high. If we compare data for China's external financial assets last June with data for this June, we find that these assets increased from $6.31 trillion to $6.43 trillion, a net increase of $120 billion. China's forex reserves, which are a vital component of China's external financial assets, shrank by $300 billion from $3.99 trillion in June 2014 to $3.69 trillion this June. However, China's outbound FDI recorded rapid growth over the same period, rising from $640 billion last June to $1.01 trillion this June, an increase of $370 billion.
This indicates that a certain amount of China's forex reserves have been turned into outbound FDI. The purchase of US Treasury bonds and the sovereign debt of other countries has been an important investment channel for China's forex reserves thus far, as this kind of investment is safer and more liquid, though it has a lower rate of return. Comparatively speaking, outward FDI will realize much greater returns while generally offering guaranteed investment safety and liquidity.
Because of this, outbound FDI is largely reflected in the external financial assets of the world's advanced economies. For instance, the US is a net debtor nation whose external financial liabilities much outweigh its external financial assets. But because the US's external financial assets lie largely in outbound FDI that can gain relatively higher yields, the country's annual net profits from its international investments remain positive as a result.
An overly high proportion of forex reserves and excessively low proportion of outbound FDI has become a disadvantage in China's external financial outlook. Recently, China has become cautious about the issue and has strived to diversify its reserves to ensure that the country's capital can contribute to China's economic development and diplomatic goals. China's Belt and Road initiative and its bilateral investment treaties with the US and Europe both provide significant strategies to boost outbound FDI.
In light of this, decreases in China's forex reserves are not only normal but good, as they show that China is becoming more familiar with the ways of the international finance world and is thus on its way to becoming a financial powerhouse. As such, a decrease in forex reserves suggests that China could transform from a world creditor into a global investor.
