China is still running out of money - just more slowly

Chinese FX Reserves - the foreign money China's central bank uses to trade its own currency and bonds, and that of other countries- fell for a fourth consecutive month in February.

It dropped by $30.9 billion, to $3.2 trillion.

The only difference is that in February China's currency reserves fell by their slowest pace since December 2011, according to the latest piece of central bank data.

The figures fall in line with market expectations as an economist poll conducted by Reuters showed that consensus predicted FX reserves dropping by $30 billion.

But if you look over the past 12 months to February, the value of reserves dropped by $601.5 billion - the largest amount on record.

While the People's Bank of China data gives economists and analysts some form of hope that in fact the country has managed to stop hemorrhaging cash, analysts point out that the future is not as rosy as it seems at face value.

China's Feb data isn't as great as it initially sounds

While the decline suggests that capital outflows may have slowed, weakness in the US dollar may have also contributed to the sharp deceleration seen in February.

Richard Grace, chief currency and rates strategist at the CBA, explains the relationship between the US dollar and the valuation of Chinese reserves:

The large, non-USD share of China's foreign exchange reserves means that a rise in the US dollar will, by definition, generate a large valuation decline in almost half of China's foreign exchange reserves. When the USD rises, China's reserves decline.

According to the calculations in China's quarterly balance of payments data, some 44% (US$291bn) of the US$663 decline in total foreign exchange reserves since the end of December 2015, has been entirely due to valuation effects.

Essentially, because China's FX reserves are measured in US dollar terms, its fluctuations have a large bearing on the value of China's non-US dollar denominated currency reserves.

The chart below, supplied by CBA, explains what Grace is saying in visual form.

Up until recently the US dollar was rallying on expectations of further rate increases from the US Federal Reserve, helping to boost the US dollar index. As it rose the level of China's FX reserves fell, partially due to capital outflows but also valuation effects.

That wasn't the case in February. The US dollar weakened as markets all but priced out the likelihood of further rate hikes from the Fed this year, helping to increase the value of non-US dollar denominated assets, including part of China's FX Reserves.

While the deceleration in February won't be enough to appease many China bears, as Grace suggests, much of the decline seen in recent months was just as much about revaluation effects as it was about capital outflows.

The outlook for US monetary policy, and as a consequence the value of the US dollar, will continue to play a major role in determining capital movements and the level of Chinese reserves in the months ahead.

China is still running out of cash

Meanwhile, Barclays analysts Ajay Rajadhyaksha and Jian Chang said in a research note last month that "China arguably has six to 12 months before FX reserves fall below comfort levels."

In other words, China really doesn't have that long until it could find itself in a real mess.

"China still has $3.2trn in FX reserves, which is a very large number. However, it is not infinite," said the Barclays analysts.

China's economy is so massive that if only 4% of Chinese were to move $50,000 out of the country in a single year (for instance, to protect it from devaluing as the RMB collapses) then "the hypothetical capital outflows would theoretically wipe out the entire remaining stock of foreign reserves."

So really, February's data doesn't mean China is out of the woods yet - it's only slowly down the rate of pain.

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