Sharp decline of China's FX reserves may limit PBoC's ability to reverse market sentiment

Following a mid-August 2015 devaluation, the PBoC burned through Chinese currency reserves to boost the Yuan's value, which had fallen further than the bank wanted. China has continued to expend FX reserves at a fast face.

Data showed foreign-exchange reserves slumped a record $108 billion to $3.3 trillion as of the end of December from the previous month. December FX reserves data revealed a further decline by around USD128bn (excluding valuation effects), the largest drop on record.

The drop in December FX reserves was surprising, given that China had already started to allow faster CNY adjustment against the USD during that month and was perceived to have intervened less. This suggests sustained capital flight related to both the strong dollar and weakening domestic economy.

If the CNY continues to weaken or CNH-CNY spreads widen further, we could see further currency intervention by the PBoC. But any faster-than-expected decline in reserves may limit the PBoC's ability to reverse market sentiment in the medium term.

"We estimate trn as a 'safe' floor for China's FX reserves in 2016 to meet potential external claims, ie,150% of the composite FX amount indicated by the RAM (IMF thresholds are 100-150%). Indeed, we think the authorities may tolerate a further decline in FX reserves up to USD600bn from the current trn within 12 months," notes Barclays in a research note to clients.