Is China's $3 trillion foreign exchange reserve fund more or less?

Executive Summary:

Although the size of foreign exchange reserves decreased by US$18.7 billion from the end of the previous month, the central bank still held the world's largest foreign exchange reserves of US$3,219.3 billion in January 2024. Where have our more than $3.2 trillion foreign exchange reserves gone? Is the central bank's reduction of its holdings of US bonds a sign of China's reduction of its holdings of dollar reserves or dollar assets? Has there been a significant change in China's holdings of dollar assets in its foreign exchange reserve portfolio? Should the size of China's foreign exchange reserves be expanded or reduced?

1. Although the size of foreign exchange reserves decreased by US$18.7 billion from the end of last month, the central bank still has the world's largest foreign exchange reserves of US$3,219.3 billion in January 2024.

Since the beginning of 2023, due to the economic recovery after the end of the new crown epidemic prevention and control is not as expected, coupled with the continuous interest rate hikes in Europe and the United States in the first three quarters of last year, the geopolitical tensions have intensified, the real estate market has been sluggish for a long time, and the pressure from continued low inflation to deflation has increased, and the RMB exchange rate has been under pressure with the strong and powerful regulatory measures of the central bank.

Over the years, the central bank has built up a sizable pool of war money to defend the renminbi, including about $3 trillion in foreign exchange reserves.

But some argue that China needs to reduce the size of its foreign exchange reserves, while others believe that it is still important to have large foreign exchange reserves.

On February 7, before the Spring Festival, the latest data released by the State Administration of Foreign Exchange showed that as of the end of January 2024, the scale of the mainland's foreign exchange reserves decreased by US$18.7 billion from the end of the previous month to US$3,219.3 billion, a month-on-month decrease of 0.58%, but an increase of 1.1% year-on-year.

The State Administration of Foreign Exchange also explained in the announcement that the decline in the scale of foreign exchange reserves in the month was the result of a combination of factors such as exchange rate translation and changes in asset prices.

With foreign exchange reserves of US$3,219.3 billion, China has the largest foreign exchange reserves in the world.

2. Where did our more than $3.2 trillion foreign exchange reserves go?

According to the State Administration of Foreign Exchange, when announcing the size of foreign exchange reserves, it never disclosed where the central bank invested the world's largest foreign exchange reserves of more than 3.2 trillion US dollars.

But broadly from some of the data that has been disclosed, at least we know that one is investing in more and more gold, and the other is investing in less and less but probably the largest share of US Treasuries.

The central bank has increased its holdings of gold for 15 consecutive months starting in November 2022.

China's foreign exchange reserves fell slightly in January 2024, but continued to increase their holdings of gold by 320,000 ounces that month. Since November 2022, China's gold reserves have increased from 63.67 million ounces of about 1,948.31 tons to 73.05 million ounces of about 2,235.39 tons in January 2024, an increase of 14.7%. Converted to US dollars, it increased from $111.65 billion in November 2022 to $150.215 billion, an increase of 34.5%. Gold in US dollar terms increased at a higher rate than in gold reserves in volume terms because it accounted for changes in the price of gold.

According to the spot price of gold provided by the World Gold Council, gold was $1,752.7 per ounce at the end of November 2022 and $2,053.25 at the end of January 2023, up 17.1% over 15 months. As a result of a 14.7% increase in the volume of gold and a 17.1% increase in prices, the amount of gold reserves denominated in US dollars increased by exactly 34.5%.

From this, it can be calculated that the proportion of gold reserves in the central bank's foreign exchange reserves in January 2024 was 4.67%, an increase of 1.09 percentage points from 3.58% in November 2022.

But it's important to note that historically, gold prices have risen and safe-haven factors have been highly correlated. The Russia-Ukraine war in February 2022 and the Israeli-Kazakhstan war in October 2023 pushed gold prices higher. After the war factor subsides, the price of gold will naturally adjust to the downside.

The central bank has increased its holdings of Treasuries and reduced its holdings of Treasuries, but the general trend has been to significantly reduce its holdings of Treasuries since 2015.

But China, along with Japan, has historically been the top foreign holder of U.S. Treasuries, according to monthly data released by the U.S. Treasury Department on all foreign debt holders.

China held $782 billion in U.S. Treasuries in November 2023, up 1.6% from October, according to the latest data from the U.S. Treasury Department, remaining the second-largest holder of U.S. foreign Treasuries after Japan. However, it is a significant decrease of 27.6% compared with the $1,080.8 billion in U.S. bonds held in November 2022. This asset also fell to 24.3% of the PBOC's foreign exchange reserves from 34.7% in November 2022. This is a decrease of 10.4 percentage points in 15 months.

3. Is the central bank's reduction of U.S. bonds a reduction of China's dollar reserves or dollar assets?

However, it would be a mistake to equate a reduction in China's holdings of U.S. bonds or U.S. dollar reserves.

This is because, in addition to the PBOC's foreign exchange reserves, the US Treasury data includes debt held by institutional and private investors from China. As a result, only a portion of this data is purchased by the PBOC's foreign exchange reserves. But what the proportion, no one knows.

In his 2018 book, Following Money and Asia's Challenges to the Global Economy, American economist Brad W. Setser has a special chapter on China's holdings of U.S. bonds. He argues that the central bank's foreign exchange reserves are practically incomplete due to a separate item on the People's Bank of China's balance sheet, "other foreign assets" and a special item in the international investment position, "other, other, assets". On the one hand, the U.S. Treasury Department announced that some of China's Treasury holdings are held by corporations and individuals, and on the other hand, China's State Administration of Foreign Exchange has always had a significant institutional portfolio and a sizable U.S. equity book. This shows that the dollar reserves in the People's Bank of China's foreign exchange reserves are not equivalent to China's holdings of US Treasury bonds.

At the same time, in fact, as of November 2023, Chinese investors were net buyers of U.S. corporate bonds and net purchases of U.S. equities.

The U.S. stock market has outperformed in 2023, with the S&P 500 up 24.3%.

U.S. and government bond holdings by Chinese institutions increased to $1.04 trillion at the end of November, corporate bond holdings to $19 billion, and U.S. equities to $307.5 billion due to rising valuations.

This means that Chinese investors, including the People's Bank of China, corporations and individuals, held $1,366.7 billion in U.S. securities assets at the end of November 2023.

4. Has there been a significant change in China's foreign exchange reserve portfolio in terms of holdings of US dollar assets?

In recent years, China's foreign exchange reserves have hovered around $3 trillion, and in January 2024 they were down 16.1% from their peak of $3.84 trillion in 2014.

At the same time, China's holdings of U.S. Treasuries began to decline after peaking at $1,316.7 billion in October 2013. Compared with 10 years ago, China's holdings of U.S. bonds have decreased by 40.6%, and its portfolio share of foreign exchange reserves has decreased by 10.2 percentage points.

In 2015, the People's Bank of China (PBOC) contributed to expectations of a one-time depreciation of the renminbi by 2%, with an estimated $1 trillion in foreign exchange reserves used to defend the renminbi at the time.

In the second half of 2023, there was speculation that SAFE might use its dollar reserves to defend the yuan, and the volatility of the yuan widened sharply as interest rate differentials between China and the United States reached an all-time high following a series of Fed rate hikes.

The Fed's monetary tightening cycle of raising interest rates and shrinking its balance sheet in March 2022 coincided with the monetary expansion cycle of the People's Bank of China's (PBOC) RRR cut in November 2021. In 2023, the renminbi will depreciate by as much as 9.5% against the US dollar.

The deterioration in trade relations between China and the United States has also raised concerns about Chinese investors' exposure to dollar assets.

However, Brad Setser, a senior fellow at the Council on Foreign Relations, believes that China's data does not suggest that the yuan will come under increasing pressure between July and September 2023, and that China will use its dollar reserves heavily.

In an October blog post, Seser said that "the only interesting change in China's foreign exchange reserves over the past six years has been the shift to institutions." He refers to agency bonds issued by federal government departments or government-funded businesses in the United States.

This has led to a small reduction in China's holdings of U.S. Treasuries, but it also suggests that it would be a mistake to equate a reduction in China's holdings of U.S. bonds or a share of U.S. dollar reserves.

5. Should China's foreign exchange reserves expand or shrink?

Over the past few years, the size of China's foreign exchange reserves has been a topic of debate among the financial community and Chinese netizens.

The government is increasingly emphasizing increasing domestic demand and self-reliance, although we have yet to find a new growth engine to replace exports amid high levels of local government debt and a prolonged downturn in the property market.

Yu Yongding, a prominent economist and former central bank adviser, has been advocating an "orderly" reduction in China's investment in U.S. Treasuries, saying that the size of foreign exchange reserves should be cut, that China should move away from a model that relies on exports to drive economic growth, and that it should also be a measure to guard against the possibility of a deterioration of U.S. overseas debt.

However, Wang Yongli, former deputy governor of the Bank of China, pointed out in the article "Basic Issues of Foreign Exchange Reserves that Need to Be Accurately Grasped" published on the Economic Observer on May 28, 2022, that some people accuse the central bank of having too many foreign exchange reserves, which not only makes the RMB base currency supply more dependent on foreign exchange reserves such as the US dollar, but also easily loses the autonomy of monetary policy and causes currency over-issuance...... There is also a huge risk that relations with the United States and its allies will be frozen or confiscated in the event of a breakdown.

Some people have called for the need to compress foreign exchange reserves to less than $1.5 trillion as soon as possible, especially to quickly sell off their holdings of U.S. bonds, to get back the U.S. dollar reserves, or to buy a large amount of gold to ship back to China, or to invest in a large number of friendly countries along the Belt and Road or to help them repay foreign debts, or to buy a large number of oil and gas, minerals, Grain and other strategic materials are shipped back to China for storage, and it is also necessary to draw on the practice of the Russian export of natural gas ruble settlement order, and issue a renminbi settlement order for China's commodity exports, requiring China's exports to be settled in renminbi, accelerating the internationalization of the renminbi, and reducing new foreign exchange reserves.

Wang Yongli believes that the above-mentioned statements have had a wide impact on society and have been respected by many people, but these statements ignore the historical background of the formation of the central bank's huge foreign exchange reserves, the internal logic of the selection of foreign exchange reserves and the internal logic of the currency issuer, the strict conditions for a country's currency to become an international currency, and the market conditions required for the large-scale compression of foreign exchange reserves.

Wang Yongli emphasized that foreign exchange reserves are an important external liquidity buffer, especially for emerging markets. Therefore, there is no way to determine the "reasonable" size of a country's foreign exchange reserves. Foreign exchange reserves should be determined on the basis of actual conditions.

San Lang believes that Wang Yongli's understanding of foreign exchange reserves is undoubtedly relatively accurate. As a country that is still heavily dependent on imports, it will not be easy to change the economic structure with the world's largest manufacturing capacity in a short period of time, especially since we have an annual service trade deficit of about 170 billion US dollars, China's foreign direct investment stock is 3.82 trillion US dollars, and China's imports of goods in 2023 are 2.56 trillion US dollars. These must be supported by supporting foreign exchange reserves.

Although in terms of the size of foreign exchange reserves, bigger is not always better. But it is still important for China to have a sizable size of foreign exchange reserves to match imports of goods, services, and foreign investment, because the renminbi is not yet an international reserve currency, and the economy has not yet been able to get rid of its dependence on external demand.

When talking about foreign exchange reserves, we need to be clear that foreign exchange reserves are an important external liquidity buffer, especially for emerging markets. They can significantly reduce the risk of currency crises and are the ballast stone of financial stability.

[Author: Xu Sanlang]