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Are China’s Falling Forex Reserves a Sign of a Troubled Year Ahead? – FangWallet

Are China’s Falling Forex Reserves a Sign of a Troubled Year Ahead? – FangWallet

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The curious case of China’s economy and status in the world of forex continue to confound analysts as a pivotal year for the nation’s post-pandemic recovery gets underway. 

The beginning of 2024 saw China’s forex reserves fall by $18.7 billion to a total of $3.2193 trillion, representing a 0.58% decline. More volatility has taken center stage in February, with reserves edging upwards to $3.226 trillion by the end of the month. 

This has paved the way for some widespread uncertainty regarding China’s utility of its forex reserves and whether they’ll play a pivotal role in overcoming myriad economic troubles. 

The status of China’s forex reserves has been largely stagnant in recent years, following a series of declines in the wake of its $3.84 trillion peak in 2014. 

So what does China’s recent forex dips mean for the nation’s portfolio? And could it have a wider impact on its overall economic performance? 

Understanding China’s Forex Strategy

Due to a series of economic downturns prompted by a difficult post-pandemic recovery and a series of high-profile defaults from major national companies like Evergrande, China has been busy battling a weakening outlook for the yuan in recent years. 

The second half of 2023 saw speculation emerge that the State Administration of Foreign Exchange (SAFE) may have used its reserves to defend the yuan, which had experienced increases in volatility off the back of US Federal Reserve base rate hikes. 

Last year saw the yuan lose more ground on the US dollar as widening interest gaps saw yuan-denominated assets become less attractive to investors.

Additionally, the complex geopolitical relationship between China and the United States has caused more concerns over Chinese exposure to US dollar assets. 

However, it appears that pressure on the yuan hasn’t prompted any significant use of the nation’s formal reserves. 

“The only interesting evolution in China’s reserves in the past six years has been the shift into agencies,” explained Brad Setser, a senior fellow at the Council on Foreign Relations, referring to agency bonds issued by either a US federal government department or government-sponsored enterprises.

“That has resulted in a small reduction in China’s Treasury holdings – but it also shows that it is a mistake to equate a reduction in China’s Treasury holdings with a reduction in the share of China’s reserves held in US bonds or the US dollar.”

In fact, there’s a growing school of thought that China will seek to increase its foreign exchange reserves significantly in 2024, with the return of optimism buoyed by improving export growth and recovering capital inflows. 

In December, capital inflows reached a two-year high, and China’s gold reserves increased by the widest margin in eight years in 2023, with a clear emphasis on diversification away from dollar-denominated assets while capitalizing on the growing price of gold. 

Solving the Riddle of China’s Economy

Should China begin to add to its forex reserves again as appears to be the plan, this will present a conundrum for analysts. With the yuan consistently falling against the dollar, which has largely been the case since Q2 2022, the expectation would be that the People’s Bank of China would sell its reserves to soften the currency’s fall. 

While some shedding of reserves has taken place, the suggestion of higher reserves in the future is at odds with common practice. Additionally, this can present a challenge for bodies like the US Treasury and the IMF, both of which would be actioned with monitoring whether the country’s foreign exchange market practices impede orderly balance of payments adjustment or whether unwarranted interventions have taken place. 

Elsewhere, China’s economic struggles saw credit ratings agency Moody’s cut its outlook on the government’s debt to ‘negative’ from ‘stable’ in December. 

The downgrade comes as China sought to ramp up stimulus payments while competing against rising youth unemployment, weaker global demand in its manufacturing sector, and mounting problems throughout real estate markets as major construction companies face up to the prospect of insolvency. 

Although industrial production edged up in March 2024, consumer spending is weaker, deflation continues to hit markets, and entrepreneurs have become disillusioned amid the difficult outlook. On top of this, the nation is forecast to lose 20% of its workforce by 2050 and its ongoing property woes are expected to take many years to rectify. 

Despite this, the Chinese government remains resilient against its mounting concerns and has set a growth target of around 5% for 2024 while strategizing a wider economic recovery. Taking priority is the task of tackling China’s slow post-pandemic recovery, and the introduction of new initiatives to overcome problems in the property sector. Additionally, the government plans to add 12 million jobs in urban areas. 

Interestingly, Beijing also claimed that the economy grew 5.2% in 2023, but analysts remain skeptical of published figures. 

“I think the next five or 10 years is going to be difficult,” said Andrew Collier, managing director from China research firm Orient Capital Research. “A lot of economists think the numbers are completely fabricated. The idea of 5.2% or 5.5% growth is much likely wrong. It’s more like 1% or 2%.”

So what does China’s confusing economic recovery mean for its role in the world of forex? Short-term volatility may be set to linger before CNY has a chance to recover its recent losses. 

Could Resilience Bring a CNY/USD Recovery?

In the short term, markets are set to react strongly to China’s emphasis on stimulus, whether it ranges from rate cuts from the People’s Bank of China or fiscal stimulus from the government. 

Whether China’s growth ambitions are achievable or not, the nation’s difficult zero-Covid policy and Evergrande’s tumultuous collapse have already reached their disruptive peak and offer a platform for a more long-term recovery. 

The turnaround for USD/CNY will be relatively slow, and CNY’s 6.04 peak against the dollar in Q1 2014 will remain a pipe dream for now, but forecasts suggest brightening prospects are on the horizon. 

According to ING forecasts, a bullish short-term bias will give way to receding territory for USD/CNY over the next 12 months, with values set to fall to 6.90 by early 2025. 

Of course, a reversal of fortunes for the yuan will mean turning around a decade-long correlation of weakening against the dollar, but China appears dead set on fostering growth while maintaining its significant forex reserves. 

Taking Advantage of Volatility

For institutional traders, this trading pair is likely to see plenty of fresh opportunities emerge as China plots an economic recovery that’s dependent on myriad industrial improvements and flies in the face of some more bearish analyst outlooks. 

There’s also the threat of growing analyst suspicion in the face of the government’s ambitious plans for 5% growth in 2024 which could play out to more FX volatility. 

This will be coupled with what appears to be a close-run US presidential election as Donald Trump, the Republican candidate who has adopted an aggressive stance against China, bids for a second term in the White House. 

With this in mind, we may see a widespread push towards the digital transformation of institutional trading tools in order to discover more efficient pricing and market opportunities throughout impacted forex markets. 

For institutions seeking to truly take advantage of USD/CNY volatility, it’s worth utilizing a prime broker that’s built relationships with a wide range of Tier 1 investment banks like JPMorgan, Standard Chartered, and Natwest as a means of facilitating more liquidity solutions to be capable of trading the pair in a changing market outlook. 

China’s Recovery to Play Out on FX Markets

Although 2023 data has suggested that China’s yuan has a weakening correlation with other Asian currencies, it’s likely that we’ll see the nation’s economic challenges play out throughout other trading pairs throughout the region. 

For FX traders with a keen interest in Asian markets, the coming years will bring plenty of movements as the forex landscape adapts to China’s changing fortunes. For the best-equipped and most resourceful institutions, this is likely to present plenty of opportunities, and a fair level of risk, too.


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Advertiser Disclosure: This blog post may contain references to products or services from one or more of our advertisers or partners. We may receive compensation when you click on links to those products or services.

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