In order to maintain the price competitiveness of China’s exports, China maintains a foreign exchange rate against the dollar that is lower than a floating exchange rate would produce. In order to do this, it restricts the convertibility of the Yuan and frequently intervenes in FX markets. By buying up the Yuan used to purchase Chinese goods by foreign countries at the target price it is able to maintain this peg against the dollar.
However, this policy has led to massive accumulation of foreign currency reserves. By March, 2014 this figure had reached almost 4 trillion dollars, almost three times as large as next biggest holder of FX, Japan. By 2019 it is estimated that these reserves had been run down to to around 3.2 trillion – still a vast mountain of money.
This figure is vast by any measure and would cover the total cost of all China’s imports for two years or payback every dollar of foreign investment. It also effectively makes a run on the Yuan extremely unlikely, as China could simply dump foreign currency in return to compensate.
Although one might imagine that calculating the total of China’s FX reserves seems like a relatively straightforward task, it is in fact more complicated than it seems. The first reason is that China does not release a detailed breakdown of the composition of its FX reserves. As some of its reserves are held in non-dollar denominated currencies, such as the GBP, Yen and Euros, fluctuations in the exchange rates between these currencies means the overall figure needs to be periodically revised. As the PBoC does not release how this done it leads to some uncertainty in the final accuracy of this figure.
Simply not included in this figure, are funds that China allocates to its sovereign wealth fund to manage and other several other categories of foreign assets. In total, this means that the official figure for China’s FX reserves underestimates the real figure by several hundred billion USD.
Additionally, China releases not information on how it invests this money. The reasons are simple. Notifying markets about changes to their investment strategy – especially given the massive amounts involved – would green-light speculation on a massive scale.
Despite this wall of silence, it is widely known that China invests the bulk of its reserves in sovereign debt. With around 70% invested in dollar denominated debt, 20% in Euro debt and 5% in Yen.
FX reserve data also provides a rough measure of hot money flows. With few good investment options around the world, there is large incentive for investors to circumvent exchange controls looking for high return opportunities in the real estate sector and stock markets in China. As this is effectively illegal there are no official estimates to measure this money. Subtracting known inflows from the total FX reserves gives a rough estimate of this hot money flow. These flows have become increasingly important in recent years, as quantitative easing programs around the world have continued to supply investors with cost money in western economies.